May 22, 2015
May 19, 2015
by Mike Orszag, TowersWatson
Economists typically criticize price regulation because, for most products, competition is seen as sufficient to drive pricing to reasonable economic levels. Moreover, consumers are usually better off as a result of the competitive process. Exceptions would include cases where significant economies of scale exist, as in the case of utilities, and also where imperfect information impedes the orderly operation of markets.
Many would argue that pension plans and related long-term savings products fit into the latter category: that is, the complex and abstract nature of long-term saving can make it difficult for market pressures to drive down product fees and charges. International experience suggests that these markets do not function particularly well when there is no regulation at all.
Countries have taken various different approaches to deal with such market failures, including:
- Product regulation making the underlying product simpler and more comparable;
- Cost regulation capping product costs;
- Intermediary regulation regulating the sales process so it works more smoothly.
Interestingly, the UK has experimented with all three approaches over time, and hence its experience offers insights into concerns likely to arise for other countries. After the introduction of personal pensions in 1988, the UK heavily regulated intermediaries via a “polarization” regime for retail financial services. The term “polarization” was used because financial advisers either had to represent a single investment company, or remain independent and represent all companies on the market. During the early years of the UK personal pension model, administrative costs proved to be very high, and surrender values sometimes eroded years of contributions. By the mid-1990s, it had become clear that the regime did not work at all well, perhaps because the regulation was inadequate, or the approach on its own may have been insufficient to prevent product complexity and high costs. In particular, the regime did not eliminate the payment of commissions to intermediaries, possibly misaligning incentives. And in addition while various disclosure regimes were tried, all had serious deficiencies.
Next, the UK adopted stakeholder pensions in 2001, with prescribed charges, minimum contribution levels, and flexibility on timing of contributions. The regulatory regime accompanying this new pension model included a mix of product and cost regulation. Annual administrative charges were capped at 1% of assets. The government’s effort to cap charges did succeed in driving down overall pension management costs, and the regulatory change forced an industry-wide wave of cost reduction and modernization. Nevertheless, the reduction in surrender charges produced unexpected consequences, because surrender charges had subsidized fund distribution; accordingly, lowering these provided less incentive for companies to seek consumers. As a result, the regulatory and capital burden imposed under the new regime reduced the number of firms in the industry and hence narrowed options for consumers.
Even today, 15 years after the launch of stakeholder pensions in 2001, the move to impose charge caps on pensions remains incomplete. For instance, earlier this year, the government proposed a 75-basis point cap on the default investment funds used by participants who were automatically enrolled into pension savings products. This may sound straightforward in theory, but it has not been simple to implement in practice.
One problem is that existing plan participants who were previously defaulted into funds with charges over the new cap must be informed of the cap changes, and such communication can be costly, complex, and often difficult for many members to understand. Further complicating matters are implementing new rules, effective next year, to protect members by disallowing any commission payments that are indirectly paid by members.
Moreover, plan sponsors still have many unanswered questions about the charge caps. Practically speaking, pension charges are allocated variously into asset-based, contribution-based, and annual fees, making cross-plan comparisons difficult. Additionally, new measures will be required to ensure that non-contributing members are not forced to subsidize those who do contribute. Another practical consideration is how to obtain plan compliance certification, and how to clarify what to do when a pension plan inadvertently exceeds a cost cap.
The UK experience with capping pension fund changes suggests that such caps can drive down retirement plan costs. Yet the process is complex, and the regulatory burden may be unexpectedly heavy on providers as well as participants. In other words, charge caps have long-term consequences for the structure and nature of pension saving.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania
April 29, 2015
The Federal Reserve Office of Employee Benefits Joins Wharton’s Pension Research Council as Associate Member
Olivia S. Mitchell, Director of the Pension Research Council, is pleased to announce that the Federal Reserve Office of Employee Benefits has joined the Council for 2015. Read the full press release here.
April 21, 2015
Timothy (Jun) Lu, Olivia S. Mitchell, Stephen P. Utkus, and Jean A. Young
Abstract — Tax-qualified retirement plans seek to promote saving for retirement, yet most employers permit pre-retirement access by letting 401(k) participants borrow plan assets. This paper examines who borrows and why, and who defaults on their loans. Our administrative dataset tracks several hundred plans over 5 years, showing that 20% borrow at any given time, and almost 40% do at some point over five years. Employer policies influence borrowing behavior, in that workers are more likely to borrow and borrow more in aggregate, when a plan permits multiple loans. We estimate loan default “leakage” at $6 billion annually, more than prior studies.
April 20, 2015
April 17, 2015
Robert L. Clark, Emma Hanson, and Olivia S. Mitchell
Abstract — This paper explores what happened when the state of Utah moved away from its traditional defined benefit pension. Instead, it offered new hires a choice between a conventional defined contribution plan, versus a hybrid plan option having both a guaranteed benefit component and a defined contribution plan shifting investment risk to employees. We show that some 60 percent of new hires failed to make any active choice and, as a result, they were automatically defaulted into the hybrid plan. Slightly more than half of those who made an active choice elected the hybrid plan. Slightly more than half of those who made an active choice elected the hybrid plan. Interestingly, post-reform, employees who failed to actively elect a primary retirement plan were also far less likely to enroll in a supplemental retirement plan, compared to new hires who made an active plan choice. We also find that employees hired following the reforms were more likely to leave public employment, resulting in higher turnover rates than previously. This could reflect a reduction in the desirability of public employment under the new pension design. Our results imply that public pension reformers must consider employee responses, in addition to potential cost savings, when developing and enacting major pension plan changes.
To read this paper CLICK HERE.
April 15, 2015
April 10, 2015
April 8, 2015
Daniel Gottlieb and Olivia S. Mitchell
Abstract — We propose a model of narrow framing in insurance and test it using data from a new module we designed and fielded in the Health and Retirement Study. We show that respondents subject to narrow framing are substantially less likely to buy long-term care insurance than average. This effect is distinct from, and much larger than, the effects of risk aversion or adverse selection, and it offers a new explanation for why people underinsure their later-life care needs.
To Read this Paper CLICK HERE.