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For Official Use DAF/AS/PEN/WD(2017)3
Organisation de Coopération et de Développement Économiques
Organisation for Economic Co-operation and Development
13 June 2017
English - Or. English
DIRECTORATE FOR FINANCIAL AND ENTERPRISE AFFAIRS
INSURANCE AND PRIVATE PENSIONS COMMITTEE
Working Party on Private Pensions
Designing funded pension arrangements given the level of financial literacy and
behavioural biases
Background and assessment of policies
19-20 June 2017
This document is circulated for discussion under the agenda of the WPPP meeting
For further information, please contact Ms. Stéphanie Payet [Tel: +33 1 45 24 15 24; Email:
[email protected]] or Mr. Pablo Antolin [Tel: +33 1 45 24 90 86; email:
JT03415950
This document, as well as any data and map included herein, are without prejudice to the status of or sovereignty over any territory, to the
delimitation of international frontiers and boundaries and to the name of any territory, city or area.
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Table of Contents
Designing funded pension arrangements given the level of financial literacy and behavioural
biases: Background and assessment of policies .................................................................................. 3
1. Introduction ...................................................................................................................................... 3 2. Why financial literacy levels and behavioural biases matter in the context of DC pension
arrangements? ...................................................................................................................................... 4 3. Participation decision ....................................................................................................................... 7
Issues posed by poor financial literacy and behavioural biases ....................................................... 7 Assessment of policies ..................................................................................................................... 8
4. How much to contribute................................................................................................................. 16 Issues posed by poor financial literacy and behavioural biases ..................................................... 16 Assessment of policies ................................................................................................................... 17
5. Choice of the pension provider ...................................................................................................... 20 Issues posed by poor financial literacy and behavioural biases ..................................................... 20 Assessment of policies ................................................................................................................... 20
6. Choice of the investment strategy .................................................................................................. 24 Issues posed by poor financial literacy and behavioural biases ..................................................... 24 Assessment of policies ................................................................................................................... 26
7. Choice of the pay-out product........................................................................................................ 31 Issues posed by poor financial literacy and behavioural biases ..................................................... 31 Assessment of policies ................................................................................................................... 33
8. Conclusion ..................................................................................................................................... 36
References ............................................................................................................................................ 38
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Designing funded pension arrangements given the level of financial literacy
and behavioural biases: Background and assessment of policies
1. Introduction
1. The pensions' landscape has changed in recent decades, giving a greater role for
funded private defined contribution pension plans. Pension systems are still addressing
the challenges posed by population aging, the financial and economic crisis and the
economic environment of low growth and low interest rates. These challenges have led to
reforms that have increased the diversity of pension arrangements across OECD countries
and the importance of funded pension arrangements, especially defined contribution (DC)
ones (OECD, 2016a).
2. Defined contribution plans allow a direct link between pension contributions and
pension benefits but put most risks related to retirement saving (i.e. investment and
longevity) onto individuals. As DC pensions represent a growing share of total retirement
income, their design needs to be improved. In addition, OECD (2016a) compares
financial education needs across different types of pension arrangements and indicates
that the challenges people face in making decisions about their retirement are greater for
private pensions (as opposed to public pensions), personal plans (as opposed to
occupational plans) and DC plans (as opposed to defined benefit or DB plans). In DC
plans, people have to make many important decisions by themselves that will determine
how much they will get from their plan, such as how much to save, where to invest, when
to retire and how to allocate the assets accumulated when retiring. DC plans therefore
offer a greater amount of choice, but imply a greater amount of risk for individuals and
require more financial skills than DB plans.
3. However, people have difficulties in planning for retirement, determining their
retirement income needs and choosing retirement products. A combination of lack of
general financial knowledge and awareness of risk, poor pension-specific knowledge, as
well as behavioural and psychological biases undermines people's ability to make
appropriate decisions for their retirement. The potential mistakes that people can make
along the way therefore put at risk the ability of DC pension plans to deliver pension
benefits that people would consider adequate to finance retirement.
4. This document identifies the key decisions that people need to make for their
retirement at different stages of their lives in the context of DC pension plans. It is also a
first attempt to i) highlight the issues posed by low financial literacy levels and
behavioural biases and ii) assess experiments and policies implemented in different
OECD and non-OECD jurisdictions to improve the design of DC pension plans through
motivating or facilitating the appropriate behaviour by individuals, for each of the key
decisions that people need to make along the way. It emphasises the most recent
developments in design policies.
5. Policies aiming at improving the design of DC pension plans while addressing the
issues posed by low financial literacy levels and behavioural biases can be divided into
six broad categories. Default options are widely used to increase participation in and
contributions to DC pension arrangements (e.g. automatic enrolment), as well as to help
people who are unable or unwilling to choose a pension provider, an investment strategy
or a pay-out product. Simplification of information and choice is also a key policy
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measure to help people making decisions through a reduced set of options (e.g.
investment strategies), better disclosure of comparable information (e.g. cost information)
or facilitated comparison of options (e.g. a single internet platform to compare all pay-out
offers). More salient information can improve decision making. This information can be
conveyed through pension statements, financial education programmes and financial
advice. Tax and other types of financial incentives (e.g. matching contributions) are
widely used to promote private pension arrangements. Policy makers also introduce
product features that may help alleviate some of the fears that people may have when
locking in their money in private pension plans (e.g. investment return guarantees,
flexible annuity products). Finally, policies reducing costs are important to improve
retirement income outcomes.
6. The document starts with a background section highlighting the main reasons why
low levels of financial literacy and behavioural biases may have significant implications
for retirement income adequacy in the context of DC pension arrangements. The next
sections focus on each of the key decisions that people need to make when saving in a DC
pension plan: whether to participate in the plan (section 3), how much to contribute
(section 4), how to choose the pension provider (section 5), how to invest the
contributions (section 6) and how to allocate the accumulated savings when retiring
(section 7). Each section is structured in the same way: it first presents the issues posed
by poor financial literacy and behavioural biases and then assesses experiments and
policies implemented in different OECD and non-OECD jurisdictions to improve the
design of DC pension plans through motivating or facilitating the appropriate behaviour
by individuals. Finally, section 8 concludes. The Secretariat will share this document with
the OECD International Network on Financial Education.
7. This document lists and assesses the different experiments and policies that have
been implemented in different jurisdictions. It does not identify the most effective
policies to improve the design of DC pension plans. This will be the goal of a future
paper that will distil effective practices and policies on how to design DC pension plans
given the level of financial literacy and behavioural biases.
Delegates are kindly invited to:
help the Secretariat complement this document with any relevant policies that
have been implemented in their respective country to improve the design of DC
arrangements while accounting for low financial literacy levels and behavioural
biases
provide additional evidence on the cost and effectiveness of policies implemented
in their country to improve the design of DC pension plans (for example, whether
cost-reducing policies do not lower the quality of the services provided by
pension funds).
2. Why financial literacy levels and behavioural biases matter in the context of DC
pension arrangements?
8. This section presents how financial literacy levels and behavioural biases interact
with retirement decisions in the context of DC pension arrangements. Recent pension
reforms have reduced the role of pay-as-you-go (PAYG) public pensions by lowering
future pensions (OECD, 2015a). In parallel, funded pension arrangements have grown in
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importance, as a complement to public PAYG pensions. In addition, within funded
pensions, DC pension arrangements are becoming more prominent (OECD, 2016a).
9. DC pension arrangements provide a clear, straightforward link between pension
contributions and pension benefits, but put most risks onto individuals, making them
more responsible for managing their retirement. In DC pension arrangements, assets
accumulated at the end of one's working life (contributions plus investment income
earned on those contributions) are used to generate a stream of income, thereby directly
determining the amount of retirement income. However, individuals have to bear
investment and longevity risks. In addition, they have to make many important decisions
that will determine how much they will get from their plan, such as how much to save,
where to invest, when to retire and how to allocate the assets accumulated when retiring.
10. DC pension arrangements, unlike with PAYG and funded DB plans, require that
individuals understand the features of the different plans offered to them. However, most
individuals may not be able or prepared to assume this role, due to low levels of financial
literacy and behavioural biases.
11. Low levels of financial literacy are prevalent in many countries. The OECD
International Network on Financial Education (INFE) has defined financial literacy as
follows: "A combination of awareness, knowledge, skill, attitude and behaviour necessary
to make sound financial decisions and ultimately achieve individual financial wellbeing"
(OECD, 2016b). OECD (2016b) reports findings from 30 countries and economies that
participated in the OECD/INFE international survey of adult financial literacy
competencies and collected cross-comparable data. It shows that overall levels of
financial literacy, indicated by combining scores on knowledge, behaviour and attitudes
are relatively low, with an average score of 13.2 out of a maximum 21. On average, only
56% of adults achieve the minimum target score on financial knowledge, with large
differences by gender as 61% of men achieve the minimum target score against 51% for
women. The study identifies budgeting, planning ahead, choosing products and using
independent advice as weak areas of financial behaviour. The analysis also shows that
regarding attitudes, many people have a tendency towards short-termism (50% on
average). In addition, studies reviewed in Lusardi and Mitchell (2014) show that financial
knowledge is positively correlated with retirement planning, and that those who plan also
accumulate more wealth.
12. Behavioural biases are specific ways in which normal human thought
systematically departs from being fully rational. Biases can cause people to misjudge
important facts or to be inconsistent. Adapted from the list and classification of biases in
DellaVigna (2009), the Financial Conduct Authority (FCA) in the United Kingdom
categorises ten cognitive biases in retail financial services, according to which component
of a decision they affect: preferences, beliefs and decision-making processes (Table 1).
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Table 1. FCA's classification of behavioural biases in retail financial services
Category Bias Description
Preferences
Present bias People respond to urges for immediate gratification resulting in overvaluing the present over the future. As such, choices are regretted in the future. Present bias can lead to self-control problems such as procrastination.
Reference dependence and loss aversion
When evaluating a product or future prospects, people do not think of the choice or product in isolation. Instead they assess it with respect to changes relative to a reference point, thinking in terms of gains and losses from that reference point. Preferences may therefore change when the reference point changes. In addition, psychologically, losses are felt roughly twice as much as gains of the same magnitude. Loss aversion may lead to the endowment effect (valuing a good more just because the individual owns it), a preference for the status quo and distortions in attitudes to risk.
Regret and other emotions People avoid choice or are willing to pay for products just to avoid making a decision that they may come to regret. They may also shy away from ambiguity, uncertainty or stress even if making a choice is likely to result in a positive outcome for them. Their choices can also be distorted by temporary strong emotions (e.g. fear).
Beliefs
Overconfidence People can show overconfidence about the likelihood of good events occurring or their own ability and success at different tasks, including the accuracy of their judgements.
Over-extrapolation People often make predictions on the basis of only a few observations, when these observations are not representative. As a result, people also underestimate uncertainty.
Projection bias People expect their current tastes and preferences to continue in the future and underestimate the possibility of change.
Decision making
Mental accounting and narrow bracketing
Mental accounting describes how people treat money or assets differently according to the specific purpose that they have assigned to them, instead of treating all money as the same.
Narrow bracketing describes how people often consider the decisions they take in isolation, without integrating these decisions with other decisions that affect their overall wealth and level of risk they take on.
Framing, salience and limited attention
People may react differently to essentially the same choice situation because the problem is framed differently. Frames usually work by triggering a particular bias (e.g. loss aversion, reference dependence, regret, a rule of thumb), as certain information is made more salient and limited attention is paid to other factors.
Decision-making rules of thumb
Consumers simplify complex decision problems by adopting specific rules of thumb (heuristics). When choosing from a wide range of options, people may choose the most familiar, avoid the most ambiguous or uncertain, choose what draws attention most (e.g. the first option on a list), or avoid choice, including sticking to the status quo. When estimating unknown quantities, people may anchor estimates to some relevant or irrelevant figure and adjust from there.
Persuasion and social influence
Emotions and norms in social interactions are important: consumers may allow themselves to be persuaded to buy a product just because the sales person is 'likeable' and therefore trustworthy. Emphasising good personality traits or overemphasising bad personality traits may substitute for a reasoned judgement. Consumers may also be influenced by usage patterns without adequately considering whether those apply to their own circumstances.
Source: Erta et al. (2013).
13. Some of the behavioural biases described in Table 1 particularly affect
individuals' retirement planning. Present bias, framing, rules of thumb, persuasion,
overconfidence, over-extrapolation, loss aversion, and regret and other emotions are
specifically important when making decisions for retirement. First, present bias can be
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strong as saving for retirement is for the long term and may compete with other short-
term needs. Therefore, the combination of delayed benefits until retirement and small
short-term costs (e.g. transaction costs, paperwork) can be a real barrier to action,
including participation in retirement savings plans. Second, financial products, and in
particular retirement products, are complex. Individuals usually consider that making
financial decisions is hard, unpleasant and time-consuming. They often lack motivation to
invest time and effort to make informed decisions and, because of the complexity, cannot
easily evaluate some products at all. They are therefore more likely to rely on simple
rules of thumb and be sensitive to framing and persuasion. Third, effective retirement
decisions require sophisticated risk assessments (e.g. longevity and investment risks).
Most people lack the skills, practice or intuition to assess risk and uncertainty when
making important decisions. Overconfidence and over-extrapolation may therefore lead
individuals to underestimate uncertainty and risk. Fourth, many financial decisions are
emotional. Emotions, whether positive (like optimism or excitement) or negative (like
stress, anxiety, fear and regret), can drive decisions rather than logical cost/benefit
analyses. Finally, it can be difficult to improve one's ability to deal with retirement
products over time. Decisions related to retirement planning are made infrequently. The
consequences of these decisions are often only revealed long after the decision has been
made, with little opportunity to learn and correct past decisions. Because of loss aversion
and fear of regretting one's decisions later on, people may therefore fail to act.
14. The following sections focus on each of the key decisions that people need to
make for their retirement at different stages of their lives: whether to participate in the
plan, how much to contribute, how to choose the pension provider, how to invest and how
to allocate the accumulated savings when retiring. Poor financial literacy and behavioural
biases potentially affect those decisions in a different way. OECD and non-OECD
jurisdictions have implemented different policies to address the implications of poor
financial literacy and behavioural biases, improving as a result the design of DC pension
plans. These policies either simplify the decision-making process or harness the power of
behavioural biases to nudge people into acting in their own long-term interest.
3. Participation decision
Issues posed by poor financial literacy and behavioural biases
15. Present bias is the main behavioural bias affecting participation in private pension
arrangements. The complexity of retirement savings products also makes it difficult for
people to plan for retirement and properly assess how well prepared they may be for
retirement.
16. Because of present bias, individuals are bad at committing to save for retirement.
Procrastination, myopia and inertia lead many individuals to postpone or avoid making
the commitment to save for retirement even when they know that this is ultimately in
their best interest. In addition, retirement planning competes with other short-term needs,
especially at younger ages (e.g. buying a house, pay tuition fees, raising a family).
17. Saving for retirement is a complex financial decision. One potential consequence
of this complexity is that individuals put off confronting these decisions. For example,
Iyengar, Jiang and Huberman (2004) find that participation rates in 401(k) pension plans
in the United States decline as the number of fund option increases. Other things equal,
every ten options added was associated with 1.5% to 2% drop in participation rates.
Therefore, the complexity of the retirement savings decision, combined with low levels of
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financial literacy to appropriately assess the different options, discourages employees
from timely enrolment in private pension plans, even when they prefer participation to
non-participation.
18. It is also of concern that many people have a misperception of their retirement
preparedness, as they would fail to take action in case their future retirement income falls
short of their expectations. Munnell, Hou and Sanzenbacher (2017) show that 57% of
households in the United States have realistic expectations about their retirement
preparedness, with 33% recognising that they are at risk of being unable to maintain their
standard of living in retirement. Other households have a misperception of their
retirement readiness, with 24% of households reporting that they are inadequately
prepared while the index calculated by the authors says they are not at risk and 19% of
households being less worried than they should be about their retirement preparedness.
The key drivers of being in the "not worried enough" group are having a DC plan and
having high income. Households with a DC plan may indeed suffer from "wealth
illusion", not realising how much income can be derived from their DC balances. In
addition, high-income households may not properly assess how much wealth
accumulation is required to maintain their standard of living.
Assessment of policies
19. Policies aiming at increasing participation in DC pension plans fall into three
broad categories: policies related to the enrolment process, policies providing financial
incentives and policies increasing people's access to knowledge. Policies related to the
enrolment process include making participation compulsory, enrolling workers
automatically in pension plans, simplifying the choice for individuals and prompting an
active decision about participating in a private pension arrangement. Financial incentives
can help re-aligning people's wish to save for retirement with the action to join a private
pension plan. Historically, tax incentives have been the main type of financial incentives
to promote private pensions. Matching contributions and flat-rate subsidies are more
recent types of financial incentives. Finally, increasing people's knowledge about the
pension system and pension reforms, through better communication and financial
education, can help people realise about the importance of saving for retirement and
encourage them to take action.
Policies related to the enrolment process
20. Making enrolment into private pensions compulsory is ultimately the most
effective policy in reaching high and uniformly distributed coverage rates. As shown in
Figure 1, coverage rates are higher in countries having mandatory or quasi-mandatory
pension plans, usually at or above 70% of the working-age population. OECD (2012) also
shows that coverage is more evenly distributed across different socio-economic
characteristics in such systems, as compared to voluntary systems. Compulsory enrolment
addresses the behavioural biases identified above (procrastination, myopia and inertia),
ensuring that individuals save for retirement and start saving early in their career.
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Figure 1. Coverage of private pension systems
As a percentage of the woking-age population
Note: Coverage rates are provided with respect to the total working-age population (i.e. individual aged 15 to
64 years old) for all countries except Germany, Ireland, Sweden and the United Kingdom for which coverage
rates are provided with respect to total employment.
Source: OECD (2015a) and The Pensions Regulator (2016) for the United Kingdom.
21. One of the limits of compulsory enrolment is that it may not be necessary for all
individuals depending on the design of the overall pension system. Forcing low income
workers to contribute may lead them to become more indebted or divert funds from other
necessary expenses, such as children education or housing. When these workers can
already expect high replacement rates from the public pension system, making private
pension contributions compulsory for them may not be justified. Recognising this
problem, in Australia, only workers 18 years old or over and earning at least AUD 450 a
month are entitled to mandatory employer contributions to the superannuation system.
22. Another limit to compulsory enrolment is when the informal sector is large.
Workers outside the formal economy are not paying social security contributions, let
alone pension contributions. In Mexico for example, nearly 60% of all workers are
informal. In that country, informal workers are not only common among self-employed
workers and unpaid workers, but also among salaried workers (according to the National
Survey of Occupation and Employment, 45.5% of salaried workers were informal in the
third quarter of 2014). This explains why the mandatory private pension system only
covers around 60% of the working-age population (Figure 1).
23. As an alternative to compulsory enrolment, automatic enrolment has gained
popularity in the last decade. In some countries, compulsory enrolment would be difficult
to implement politically, because mandatory contributions to private pensions would be
perceived as another tax. Automatic enrolment involves signing up people automatically
to private pensions but giving them the option to opt out within specified timeframes and
conditions. The policy exploits individual behavioural traits such as inertia and
procrastination to make people engage in retirement and pension saving, while preserving
individual choice and responsibility for the decision about whether to participate in a
private pension arrangement. It is used in the context of occupational pension plans and
0.010.020.030.040.050.060.070.080.090.0
100.0
Mandatory/Quasi-mandatory Auto-enrolment Voluntary
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changes the default enrolment from "not participating" to "participating" in the employer-
sponsored pension plan. It is also associated with default options for the contribution rate
and the investment strategy to simplify the choice of individuals. The policy has been
introduced at the national level in Italy (2007), New Zealand (2007), Turkey (2017) and
the United Kingdom (2012), it is developed at the state level in the United States (2012)
and it is encouraged by regulation in Canada (2012) and the United States (2006). Table 2
provides a description of the different schemes.
Table 2. Description of automatic enrolment schemes
Country Description
Canada A Pooled Registered Pension Plan (PRPP) is a kind of multi-employer DC pension plan in which unrelated employers and self-employed
persons are eligible to participate. Where an employer elects to offer a PRPP, enrolment of employees would be automatic unless an
employee chooses to opt out. The PRPP framework, introduced in 2012 at the federal level, will be fully in place across Canada pending
provincial enabling legislation. So far, six provinces have introduced PRPP legislation. Italy Automatic enrolment was introduced in January 2007. For all private sector employees, it involved the payment into pension funds of the
future flow of the severance pay contributions (Trattamento di fine rapporto, TFR), set at 6.91% of salary. Individual workers were given
a period of six months in order to decide whether to opt out of this arrangement, keeping their rights regarding the TFR as in the past.
The same mechanism applies since then to all first-time private sector employees. New
Zealand
KiwiSaver was introduced on 1 July 2007. Employers must enrol new employees (i.e. those starting a new job) into the scheme and
individuals have 8 weeks to opt out. The minimum contribution is 3%, which is deducted from employee earnings, and an employer
contribution of 3% of salary is added. The government also contributes 50 cents for every dollar of member contribution annually up to
NZD 521.43. Existing employees not subject to the automatic enrolment rule can also join (opt in) the KiwiSaver plan on a voluntary
basis. The kick start payment of NZD 1 000 has been removed for contracts opened after 21 May 2015.
Turkey Since 1 January 2017, employers have to choose a private DC pension plan and automatically enrol employees younger than 45 into it.
Employees may choose to opt out of the system within the first two months following their automatic enrolment. Employers are not
required to contribute, while employees must contribute at least 3% of their gross income. The government matches 25% of an
employee's contributions and makes an additional one-time contribution of TRY 1,000 for those who do not opt out within the first two
months. The duty on employers is being staged in between January 2017 and January 2019, starting with the largest employers and the
public sector. United
Kingdom
Automatic enrolment has been introduced in 2012 for all those workers who are not already covered by a private pension arrangement.
Employers are required to automatically enrol their eligible jobholders (worker aged at least 22 but under State Pension Age, who earn
more than GBP 10,000 a year) into a qualifying workplace pension. Workers can opt out within one month, and if so, will be
automatically re-enrolled by their employer on a three-year cycle. Employer and employee contributions are being phased in from
October 2012 to a minimum total contribution of 8% of qualifying earnings by October 2018. The duty on employers is being staged in
between October 2012 and February 2018, starting with the largest employers. United
States
- Pension Protection Act:
Automatic enrolment in 401(k) pension plans was introduced in 1998 for newly hired employees. Since 2000, the automatic enrolment
was extended to current workers who were not enrolled in a pension scheme. In 2006, the adoption of the Pension Protection Act greatly
encouraged automatic enrolment by giving employers incentives to automatically enrol their employees into a retirement savings plan.
- Automatic IRA:
Since 2012, several states have created state-facilitated retirement savings plans following the "Automatic IRAs" model, which has been
proposed by the Obama Administration in 2009 but has never been enacted.
24. As detailed in OECD (2014), available evidence in the United States, New
Zealand and Italy shows that automatic enrolment has a positive impact on participation
in retirement savings plans. However, its impact on participation may be reduced when
other incentives compete and interact negatively with its introduction. Several studies in
the United States demonstrate that automatic enrolment is associated with significant
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increases in 401(k) plan participation.1 In terms of participation, the KiwiSaver scheme in
New Zealand is a real success with nearly 2.7 million people enrolled as at December
2016, of which 41% have been enrolled automatically. In addition, KiwiSaver members'
distribution by income is similar to the one of the eligible population, meaning that low-
income individuals are not disproportionately left out of the scheme (Inland Revenue,
2015). Finally, while the increase in pension fund coverage in Italy following the TFR
reform was significant, with 1.4 million additional workers enrolled in a pension fund
between 2006 and 2007, only around 5% of new members in that period were
automatically enrolled. As shown in Figure 1, private pensions covered less than 20% of
the working-age population at the end of 2013, six years after the TFR reform. Rinaldi
(2011) identifies structural and implementation factors to explain the relative failure of
the reform. Fornero and Monticone (2011) show that the lack of knowledge of basic
financial concepts among Italians may also have reduced the impact of automatic
enrolment. They find that financial literacy increases the probability of participating in a
pension fund, as well as the probability of transferring the TFR contributions to a pension
fund.
25. Despite the success of automatic enrolment at the company level in the United
States, membership in 401(k) plans has remained broadly constant at the national level
after the adoption of the Pension Protection Act in 2006, leading several states to take
further actions. According to data from the US Department of Labor, 401(k) coverage
increased from 27.5% of the working-age population in 2005 to 29.1% in 2006 and
stagnated at 29-30% thereafter. To further increase coverage, the US Administration
proposed in 2009 the "Automatic IRAs" programme, aiming at mandating employers not
offering an occupational pension plan to automatically enrol their employees in an
Individual Retirement Arrangement (IRA), with contributions deducted from the salary
and an opt-out option for the employee. Despite this, no legislation has been enacted at
the federal level yet. Several states have stepped in and created state-facilitated retirement
savings plans following the "Automatic IRAs" model (John & Antonelli, 2017; Munnell,
Belbase, & Sanzenbacher, 2016). According to the Georgetown Center for Retirement
Initiatives, since 2012, 40 states have considered to establish state-facilitated retirement
savings programmes. Seven states have already passed legislation (California,
Connecticut, Illinois, Maryland, New Jersey, Oregon and Washington). These plans use
private sector providers to manage investments and provide other services. By combining
state facilitation with private providers, they aim at allowing small employers to offer
simple, low-cost retirement savings plans to their employees.2
26. Automatic enrolment also has a positive impact on participation in the United
Kingdom and in Turkey. Cribb and Emmerson (2016) show that automatic enrolment in
the United Kingdom led to an increase of 37 percentage points in the probability of
participating in a workplace pension scheme for eligible private sector employees.
According to The Pensions Regulator (2016), as at March 2016, 66% of all employees
were active members of a pension scheme (Figure 1), compared with just 47% in 2012.
Only 4.5 months after the introduction of the new system in Turkey (as at 19 May 2017),
1 See Madrian and Shea (2001), Choi et al. (2001), Choi et al. (2004), Beshears et al. (2009) and Butrica and
Karamcheva (2015).
2 It is not clear what will happen to these plans already stablished in seven states after the Senate, in May 2017,
voted to reverse the policy. States may still be able to set up plans as long as they comply with ERISA
rules (therefore excluding the use of IRAs).
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nearly 2.9 million employees had already been automatically enrolled. As a comparison,
the individual voluntary system was introduced in 2003 and covered 5.6 million
individuals at the end of 2015.
27. Other forms of enrolments have been tested voluntarily by employers in the
United States. As an alternative to traditional opt-in programmes (employees are not
enrolled in the 401(k) plan unless they make an affirmative election) and to automatic
enrolment (employees are automatically enrolled and can opt out), Choi, Laibson and
Madrian (2009) and Beshears et al. (2013) studied the effects of Quick Enrollment™.
This programme gives workers the option of enrolling in the 401(k) plan provided by
their employer by opting into a pre-set default contribution rate and asset allocation. The
goal of this policy is to reduce complexity. Instead of evaluating all possible contribution
rate and asset allocation options, employees just face a binary choice between
participating based on the default options provided by the programme and non-
participating. The authors find that Quick Enrollment resulted in substantial 401(k)
participation increases, although typically smaller than automatic enrolment: it increased
the participation among new hires by 16 percentage points after three months of tenure
(relative to a standard enrolment mechanism in which employees must actively select
both a contribution rate and an asset allocation); and it prompted 10% to 20% of
previously hired employees who were not participating in their 401(k) plan to enrol in the
plan. They also find that the participation increases produced by Quick Enrollment are
durable and that employees who join the pension plan in this way often remain at the
default contribution rate and asset allocation for years.
28. Automatic enrolment and Quick Enrollment involve default options, but defaults
may not be suitable when they apply to a large number of people with heterogeneous
needs and preferences. Studies show that most participants enrolled under those
arrangements stick to both the default contribution rate and the default asset allocation for
long periods. For example, KiwiSaver members tend to retain the default contribution
rate they have been assigned to when joining the system. Inland Revenue statistics show
that as of 30 June 2011, 80% of people who joined KiwiSaver after April 2009
contributed 2% (the default between April 2009 and April 2013), while 62% of those who
joined before that date were still contributing 4% (the default before April 2009).
However, even well-chosen defaults may not be optimal when they apply to individuals
with highly heterogeneous situations. For example, in a company whose workforce
includes both financially constraint young parents and older employees who need to save
for their retirement, a single contribution rate to the occupational pension plan may not be
appropriate. Default contribution rates and investment strategies could vary according to
some observable demographic characteristics such as age, but unobserved employee
heterogeneity may limit the usefulness of such employee-specific defaults and the
practical implementation may be difficult (in particular from a legal perspective as not all
employees would be treated equally).
29. An alternative to default mechanisms is to force people to take active decisions
about their participation in a pension plan. Carroll et al. (2009) compare two kinds of
401(k) enrolment: standard enrolment (i.e. the default is not to participate) and active
decisions (i.e. there is no default but rather a compulsory choice between participating or
not). On the one hand, the active decision mechanism encourages individuals to think
about an important decision and avoid procrastinating. On the other hand, an active
decision mechanism requires individuals to deal with a potentially time-consuming and
complex issue and then explicitly express their decision at a time which may be
inconvenient. The authors describe a natural experiment at one firm and find that
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compelling new hires to make active decisions about 401(k) participation raises
participation by 28 percentage points relative to a standard opt-in enrolment procedure
after three months of tenure. In addition, contribution rates in the active decision cohort
reach levels that would take 30 months to achieve under standard enrolment, i.e.
employees immediately choose a contribution rate that is similar on average to what they
would take up to 30 months to attain under standard enrolment.
Providing financial incentives
30. Historically, tax incentives (tax exemptions, tax deductions, tax credits or rate
reliefs) have been the main type of financial incentives provided by governments to
promote private pensions. DAF/AS/PEN/WD(2017)2 shows that tax incentives,
especially tax deductions, encourage participation in private pension plans. The impact of
tax deductions on participation increases with income, as high-income individuals usually
face higher marginal tax rates. Individuals also respond to changes in tax incentives (e.g.
tax reforms, changes in contribution limits) by adjusting their participation in private
pension arrangements.
31. The evidence on the impact of rate reliefs on private pension participation is less
conclusive. For example, Feng (2014) fails to demonstrate a positive impact of a reduced
flat tax rate on contributions on participation in salary sacrifice arrangements in Australia.
A salary sacrifice arrangement is where employees agree contractually and voluntarily to
give up part of the remuneration that they would otherwise receive as salary or wages, in
return for their employer providing contributions to a superannuation fund of the same
amount. Salary sacrifice contributions attract a favourable tax treatment, being taxed at a
fixed rate of 15% (same as for mandatory employer contributions), rather than at the
marginal income tax rate. Using data from wave 10 of the Household Income and Labour
Dynamic in Australia survey, the author determines the effect of higher tax incentives on
the participation in salary sacrifice arrangements at two marginal tax rate jump points of
the personal income tax system, from 15% to 30% and from 30% to 38%.3 The results
indicate that tax incentives lead to a small but insignificant increase in participation in
salary sacrifice arrangements. The author explains that this result is likely due to the
complexity of the incentive schemes and competing demands for long-term savings. In
addition, the name of the arrangement, "salary sacrifice", is framed as a loss which may
discourage participation.
32. Tax incentives can be complemented by other types of financial incentives to
encourage participation in private pension, such as matching contributions (from the state
or from the employer) and state flat-rate subsidies. These incentives are provided to
eligible individuals who actually participate or make voluntary contributions to the
private pension system. Both matching contributions and state subsidies are paid in the
pension account, thus increasing the assets accumulated to finance retirement.
33. After tax incentives, matching contributions are the most common type of
financial incentive used by OECD and EU countries to promote private pensions (OECD,
2015b). Usually, the matching contribution is conditional on the individual contributing
and corresponds to a certain proportion of the individual's own contribution, up to a
maximum amount. The generosity of the match rate varies greatly across countries, from
3 The higher the marginal tax rate, the higher the drop in the tax rate on contributions and therefore the higher the
incentive to contribute.
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3% in Austria (paid by the state) to 325% in Mexico (paid by the state for civil servants).
A match rate of 50% can be found in Australia (paid by the state), Iceland (paid by the
employer) and New Zealand (paid by the state). Matching contributions usually apply to
all workers, but can also be targeted to specific groups, such as young workers (as in
Chile) or low-income individuals (as in Australia).
34. Empirical evidence from a large body of the literature in the United States
suggests that matching contributions increase participation in private pension plans. Choi
(2015) and Madrian (2013) review the rich literature in the United States regarding the
effect of matching contributions on participation and conclude that matching
contributions increase participation. Madrian (2013) however qualifies the quantitative
impact as small. This statement relies on a study by Engelhardt and Kumar (2007).
Indeed, using a nationally representative random sample of individuals aged 51 to 61 and
their spouses from the Health and Retirement Survey, they find that increasing the match
rate by 25 percentage points (for example, from 25 cents per dollar of employee
contribution to 50 cents) raises 401(k) participation by 5 percentage points. Choi (2015)
reports that an increase of 10 percentage points in the match rate increases the
participation rate in a range from 2.5 percentage points to 6.3 percentage points,
depending on the study.
35. Flat-rate subsidies paid by the state into pension accounts can be found in Chile,
Germany, Lithuania and Mexico. They are designed to attract low-income individuals, as
the fixed subsidy represents a higher share of their income. In Germany, financial
institutions can offer so-called Riester pension plans since 2002. The state encourages
people to contribute to a Riester plan via two types of incentives: tax exemptions and flat-
rate subsidies. Flat-rate subsidies are particularly valuable for low-income individuals,
while tax deductions attract more high-income individuals. There are three types of flat-
rate subsidies: a basic subsidy of EUR 154 per year and per person, a child subsidy of
EUR 300 per year and per child and a young worker subsidy of EUR 200 granted once at
the age of 25. In order to receive the maximum subsidy, the sum of the member's
contributions and the subsidy must be at least equal to 4% of his/her previous year's
annual income. Only very low-income households can get the full subsidy without
investing 4% of their income if they contribute at least EUR 60 annually. In 2012, 44% of
eligible households were covered by the Riester scheme (Börsch-Supan et al., 2016).
36. Evidence related to the introduction of the Riester pension scheme in Germany
shows that subsidies are effective in attracting families with children and low-income
earners. Indeed, Pfarr and Schneider (2013) find that child subsidies have an impact on
the take up of Riester plans. In addition, Börsch-Supan, Coppola and Reil-Held (2012)
and OECD (2012) show that despite the fact that coverage rates of Riester pensions
increase with income, Riester pensions are more equally distributed by income than
occupational pensions and unsubsidised private pension plans. For example, in 2009, only
around 19% of households in the lowest income bracket had taken up Riester pension
plans, while almost a half of those in the two upper income brackets participated in the
scheme. However, the distribution of participation is even more skewed towards high-
income individuals for occupational pension plans and other private pension plans, which
cover only around 5% of households in the lowest income bracket. Therefore, among
low-income households, Riester pensions are much more common than any other form of
private pension provision. As a result, Riester pensions are more equally distributed by
income than occupational pensions or unsubsidised private pension schemes.
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Increasing access to information, knowledge and skills
37. Policy makers increasingly recognise the role of financial education in supporting
individuals to plan for their retirement. OECD (2016a) summarises the different financial
education tools used in different jurisdictions to address various financial education needs
in relation to retirement planning. These can be split into three broad categories:
Providing information on retirement options and increasing awareness of
retirement issues: this includes general information through websites, awareness
campaigns covering retirement issues, comparison tools presenting plan features
in a standardised way, personalised pension statements, access to personal
information online, as well as calculators and simulators;
Instruction: this takes the form of seminars and workshops about retirement
planning, helping participants acquire financial knowledge and skills relevant for
retirement, explaining the risks that individuals may be exposed to and suggesting
how to manage them, and helping individuals estimate their retirement income
needs, with the ultimate goal to help them taking decisions about their pensions;
Advice: this ranges from factual information to fully personalised advice.
38. Evidence on the effectiveness of financial education for retirement is currently
limited but suggests that workplace financial education can be effective in increasing
enrolment in occupational pension plans (Atkinson, Messy, Rabinovich, & Yoong, 2015).
Workplace financial education initiatives that are efficient in increasing participation in
private pension arrangements include seminars and workshops and online courses. For
instance, Duflo and Saez (2003) studied a university that encouraged a random sample of
its employees to attend to an annual event providing information on benefits, including an
occupational pension plan. They found that 5 to 11 months after the event, plan
participation was higher in treated departments (i.e. those where a random sample of
employees received an invitation letter promising a reward for attending the event) than
in control departments. Collins and Urban (2016) show that online financial education
courses offered to employees increases self-reported IRA participation by six percentage
points.
39. In addition, providing more information on the employer's pension plan and how
to join it can also increase participation. Clark, Maki and Morrill (2014) find that young
employees (18 to 24 years old) who received a flyer containing information about their
employer's 401(k) plan and the value of contributions compounding over a career, were
more likely to begin contributing to the plan compared to workers of a similar age that
did not receive the flyer. Lusardi, Keller and Keller (2009) study the impact of helping
employees form and implement a savings plan through the provision of a planning aid
that (a) encourages individuals to set aside a specific time for enrolling in their savings
plan, (b) outlines the steps involved in enrolling in the plan (e.g., choosing a contribution
rate and an asset allocation), (c) gives an approximation of the time each step will take,
and (d) provides tips on what to do if individuals get stuck. This planning aid increased
enrolment in the studied occupational pension plan by 12 to 21 percentage points for
newly hired employees.
40. The take up of financial advice may be increased by facilitating the payment for
advice. For example, the United Kingdom has introduced a pension advice allowance to
enable people to withdraw money from their DC pension plan to access pension and
retirement advice. Since April 2017, pension providers are able to offer the allowance to
their members. Individual members and beneficiaries can, at any age, withdraw GBP 500
tax free, no more than once in a tax year, and up to a maximum of three times in total.
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Payment of the allowance must be made directly from the pension scheme to the financial
adviser and is only available for regulated financial advice, including "robo advice" as
well as traditional face-to-face advice.
41. Finally, not all type of information may contribute to increasing participation in
retirement savings plans. For example, Beshears et al. (2015) show that information about
peers' saving behaviour may discourage participation by generating "oppositional
reaction". The authors conducted a field experiment to assess the impact on retirement
savings choices of disseminating information about what a target population's peer
usually do. The expectation was that individuals may realise that participating in their
employer's 401(k) plan is more common than they had previously believed among their
co-workers, and thereby that social influence would motivate them to enrol in the plan.
On the contrary, the results show that the presence of peer information decreased the
likelihood of subsequently enrolling in the plan by approximately one-third from 9.9% to
6.3%. The authors find that the oppositional reaction is concentrated among employees
with relatively lower income. This result suggests that information about peers' savings
choices may discourage low-income employees by making their relative economic status
more salient, reducing their motivation to increase their retirement savings.
4. How much to contribute
Issues posed by poor financial literacy and behavioural biases
42. People need to decide how much money they may need for retirement and how
much they need to put aside to cover those needs. Determining the appropriate
contribution rate is difficult in both mandatory and voluntary private pension systems.
High enough contribution rates paid for long periods are necessary to improve people's
chances to achieve an adequate retirement income (OECD, 2012). In mandatory systems,
the contribution rate is determined by regulation but people need to assess whether they
need to complement it with voluntary contributions. In voluntary systems, people can
usually choose how much they want to contribute, although some minimum may be
prescribed by law. In any case, people need the numeracy and financial skills to assess
whether their contributions will translate into an income that will cover their needs in
retirement. That assessment should be done given the level of retirement income that may
be expected from the public pension system, which requires a good level of
understanding of the rules used to compute public pension benefits.
43. The main behavioural biases affecting how much people contribute in DC pension
arrangements are self-control, use of simple heuristics, projection bias and loss aversion.
44. Saving for retirement requires self-control. When surveyed about their low
savings rates, many households report that they would like to save more but lack the
willpower. For example, Choi et al. (2001) report that 67.7% of their sample of 401(k)
participants think that their contribution rate is “too low.” However, procrastination
makes them postpone action to increase their contribution rate. Among self-reported
under-savers, 35% expressed an intention to increase their contribution rate in the next
few months, but only 14% of this subgroup actually increased their contribution rate in
the four months following the survey. People tend not to follow through on their good
intentions. For the same reason, people automatically enrolled tend to stick to the default
contribution rate for long periods, even when this default is not the optimal rate for them.
45. There are no satisfactory heuristics that could help people approximate a good
contribution rate. The most common heuristics in place appear to be to save the maximum
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allowed by law to get tax incentives or to save the minimum necessary to receive the full
matching contribution offered by the employer or the state. Neither of these amounts
however was most likely computed to be the most appropriate contribution rate for
everyone.
46. Projection bias may also interfere with the contribution rate level chosen by
individuals. People may indeed underestimate how much income they will need during
retirement if they base their assessment on their current needs and preferences or if they
underestimate their life expectancy. They may underestimate the fact that their
preferences and circumstances may change when they get older and therefore fail to save
enough for retirement.
47. Finally, loss aversion affects savings. Many studies show that people have the
tendency to weigh losses significantly more heavily than gains. Estimates of loss aversion
are typically close to 2. Losses hurt roughly twice as much as gains yield pleasure. Once
people get used to a particular level of disposable income, they tend to view reductions in
that level as a loss. Thus people may be reluctant to increase their contributions to their
private pension plan because they do not want to experience a cut in take-home pay.
Assessment of policies
48. This section assesses policies that automatically increase contribution rates over
time or that aims at increasing savings rates through the provision of information about
retirement and expected benefits. It also looks at how automatic enrolment and matching
contributions interact with contribution levels.
Automatic escalation of contributions
49. To help individuals eventually save enough to reach their target retirement
income, several policies establish plans with automatic increases in contribution rates.
Individuals at early stages of their working life have generally less income and greater
consumption needs (e.g. housing, tuition) than later in their careers, making it harder to
save for retirement. In this context, it may be appropriate to have contribution rates
increasing as people age (Blake, Wright, & Zhang, 2014). However, one needs to be
careful about the potential time inconsistency of contribution rates as contribution rates
may need to reach extremely high levels at the end of one's career in order to attain the
same target retirement income (OECD, 2012). Two initiatives have been tested in the
United States to help people save more over time: Save More Tomorrow™ (SMarT
programme) and Easy Escalation™.
50. Thaler and Benartzi (2004) describe the SMarT programme and argue that it
successfully increased the contribution rate of participants. The goal of the programme is
to help employees who would like to save more but lack the willpower to act on this
desire. The programme therefore gives workers the option of committing themselves now
to increasing their contribution rate later. The increase in the contribution level happens
each time the individual gets a salary increase. This feature mitigates the perceived loss
aversion of a cut in take-home pay. The contribution rate continues to increase on each
scheduled salary increase until the contribution rate reaches a pre-set maximum. In this
way, inertia and status quo bias work towards keeping people in the plan. The employee
can opt out of the plan at any time. Knowledge of this feature also makes employees more
comfortable about joining. The initial experience with the SMarT plan took place in 1998
in a midsize manufacturing company. Most of the individuals who were previously
participating in their employer pension plan and were offered the plan elected to use it
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(78%) and a majority of those who joined the SMarT plan remained with it through four
salary increases (80%). Results show that SMarT participants almost quadrupled their
contribution rates: the average contribution rates for SMarT participants increased from
3.5% to 13.6% over the course of 40 months.
51. Easy Escalation allows employees already participating in a pension plan to
increase their contribution rate to a pre-selected level. Beshears et al. (2013) evaluate the
implementation of the Easy Escalation plan in one company. In January 2004 and
February 2005, that company sent Easy Escalation forms to employees already
participating in the company pension plan whose contribution rate was below 6%. These
forms allowed employees to tick a box to increase their total contribution rate to the 6%
threshold. The authors find that about 15% of low contributors who received an Easy
Escalation form raised their contribution rate to the pre-selected threshold. In comparison,
only about 1% of low contributors on average increased their contribution rate to 6%
outside the months during which Easy Escalation forms were sent.
52. Some countries set the default or mandatory contribution rate to the private
pension system below the level desired initially and raise it afterwards. For mandatory
pension schemes, this may be a way to make it easier for people to accept the policy and
adjust to it. For automatic enrolment schemes, the main goal is to minimise opt-out rates,
as too high contribution rates may reverse the effectiveness of automatic enrolment by
increasing the feeling of a loss on take-home pay. Ideally, this increase in the contribution
rate could be done in an automatic manner according to a set calendar. For example, in
Australia, the mandatory contribution rate was set at 3% initially and is being raised
gradually to 12% by 2025. In the United Kingdom, minimum contribution levels for
automatic enrolment schemes are being phased in to help both employers and individuals
adjust gradually to the additional costs of the reform. Between October 2012 and October
2018, the minimum total contribution rate will rise from 2% to 8% on a band of
qualifying earnings, while the minimum employer contribution rate will rise from 1% to
3%.
Provision of information
53. Salient information about retirement and expected benefits can also increase
contributions to private pension arrangements. Dolls et al. (2016) use a reform in
Germany that increased the information about future pension payments and made the
issue of retirement more salient to individuals to assess the impact of information letters
on retirement savings. Since 2004, the German pension authority sends out annual letters
which provide detailed and clear information about the pension system in general and
individual expected pension payments. The letters also highlight the importance of
additional voluntary retirement savings. Using tax return data from administrative
records, the authors find that receiving the letter increases contributions to a Riester
pension plan (excluding subsidies).
54. Personalised information, as opposed to general information, can better encourage
people to increase contributions. Fuentes et al. (2017) shows the results of randomly
giving low- to middle-income workers in Chile either personalised or generalised
information regarding their pension savings. Individuals in the treatment group received a
personalised estimate of their expected pension under different scenarios: status quo,
increasing the contribution density, increasing voluntary savings, and delaying retirement
by one year. Individuals in the control group received comparable general information
and recommendations on how to improve their future pensions (including by increasing
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their contribution density, by increasing voluntary savings and by postponing retirement
age) but without any reference to their individual situation. The authors find that
voluntary savings increased by about 10-15% for the treatment group compared to the
control group.
55. Finally, calculators and simulators can facilitate the estimation of the contribution
rate needed to cover people's needs in retirement and reduce the difficulties related to lack
of numeracy. By providing forward-looking information under different scenarios, they
make the long-term benefit of saving more salient and improve awareness of the link
between contributions and retirement income (OECD, 2016a). In addition, they usually
allow users to assess how their retirement income would change if they change their
expectation regarding the retirement age or the contribution rate for example, of if
external parameters (e.g. rate of return, inflation) change. Moreover, by combining
information about the different sources of retirement income (e.g., public and private),
simulators and calculators help people realise whether their overall target replacement
rate can realistically be achieved given their current saving behaviour. Such calculators
are available for instance in Chile, Latvia, the Netherlands and the United Kingdom.
Impact of automatic enrolment and matching contributions on contribution levels
56. While automatic enrolment increase participation in private pension
arrangements, evidence on its impact on contribution rates is mixed. In the United States,
Butrica and Karamcheva (2015) show that the total (employee plus employer)
contribution rate is 1.6 percentage points lower for automatically enrolled workers
compared to workers who opted in voluntarily, mostly due to lower employee
contributions. Soto and Butrica (2009) also show that employers adjust their 401(k)
match rate downwards in response to automatic enrolment. Evidence in the United
Kingdom however leads to opposite results, with automatic enrolment resulting in higher
total contribution rates (Cribb & Emmerson, 2016). The authors argue that this is partly
due to some employers contributing above the long-run minimum contribution rate
mandated by the government. For example, automatic enrolment is associated with a
4.1% percentage point increase in the proportion of employees receiving an employer
contribution above 5% (the minimum employer contribution rate will be 3% as of
October 2018).
57. The impact of matching contribution on total contributions is also unclear. Choi
(2015) and Madrian (2013) both show that the empirical evidence in the United States on
the impact of matching on total contributions is mixed: some studies find a positive
relationship between matching and contributions, others find no relationship and yet other
studies find a negative relationship. Choi et al. (2001) show however that the rate of
employee contribution up to which the employer offers the match (i.e. the match
threshold) has an impact on employee contributions. They study a company with a 50%
match rate that increased its match threshold from 5% to 7% of income for union workers
and from 6% to 8% of income for management employees. They observe an immediate
change in the distribution of employee contribution rates towards an increase in the
proportion of participants contributing between 7% and 8%. Finally, OECD (2012) also
shows that matching contributions targeted at low-income individuals may encourage
higher contribution rates for that sub-group. Indeed, in Australia, low-income individuals
are encouraged to make voluntary contributions to the pension system through a dollar-
for-dollar government matching contribution (up to a ceiling). Data show that among
individuals making voluntary contributions, low-income individuals have a higher
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contribution rate than other income groups, as taking advantage of the maximum
matching requires a larger contribution effort.
5. Choice of the pension provider
Issues posed by poor financial literacy and behavioural biases
58. Participants in private pensions are expected to choose among pension providers
the one that best fits their needs. This choice should be driven, among others, by
comparing the services offered, the long-term performance, and the fees charged.
Unfortunately, comparing pension providers takes time and effort. In addition, low
financial literacy and behavioural biases affect how people choose, which could lead to
lower competition between pension providers and ultimately increase costs and fees.
59. People may lack the skills to compare pension providers and choose the best one
for them, in particular when many providers are available (choice overload) and pricing
practices are complex. For example, when pension providers use different fee structures,
it becomes difficult for individuals to compare pension plans. This is the case in Latvia,
where voluntary private pension funds can use a mix of asset-based and contribution-
based fees.
60. Behavioural biases may create or strengthen market power in what would
otherwise be a competitive market (Erta et al., 2013). Because of procrastination and
inertia, pension plan members tend to stick with their existing plans, do not shop around,
do not compare plans based on their most critical characteristics, and do not switch to
better plans. For example, in Mexico weak member engagement and understanding
reduced the effectiveness of two traditional competition policies, increasing the number
of providers and allowing people to switch between providers. These policies have
actually led to higher costs and less competition. The annuity market in the United
Kingdom illustrates the potential consequences of inertia on competition. Before the
pension freedoms reform in 2015, individuals were basically required to buy an annuity
in the United Kingdom. The Financial Conduct Authority reports that, in 2012, 60% of
individuals purchased an annuity with their existing provider, even though an estimated
80% of these individuals could have gotten a better deal elsewhere (Financial Conduct
Authority, 2014).
61. Finally, framing, persuasion and simplistic rules of thumb may guide individuals'
choice of the pension provider rather than thorough analyses of plan characteristics.
Individuals may not choose the appropriate pension plan if they focus on the salient
information provided by pension providers and underweight or ignore the non-salient, but
potentially important, pieces of information. In addition, individuals may choose a
specific plan because they know the brand name of the management company, because
the sales person was nice to them, or because that plan was first in the list of options.
Assessment of policies
62. Most policies implemented in OECD and non-OECD jurisdictions, to help people
with the choice of their pension provider, focus on the demand side. Because of poor
financial literacy and behavioural biases, competition between pension providers may not
be effective. One solution could be to default people into low-cost providers.
Alternatively, policy makers may want to implement measures to strengthen competitive
pressures through disclosure-based initiatives that ensure that members receive timely
information on the fees they pay and can compare them across providers. These
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initiatives need to be complemented by measures improving efficiency in the pension
industry, so that individuals can expect good value for money independently of the choice
of the provider. These include transparency measures, pricing regulations and structural
solutions. DAF/AS/PEN/WD(2017)5 provides some more details on these measures.
Default providers
63. Low-cost providers with high quality standards can be introduced as a default. In
the case of New Zealand, default KiwiSaver providers are intended to be temporary,
managing assets following a conservative approach while members consider the best
provider for them. Default providers have a special contract with the government that
requires them to meet additional reporting requirements. Their activities and default
investment funds are closely monitored. Nine default KiwiSaver providers have been
appointed by the government for a seven year term starting 1 July 2014. If a member does
not choose a scheme, and his/her employer does not have a chosen scheme, then Inland
Revenue allocates that person to one of the default providers. By June 2016, 21% of
KiwiSaver members were with a default provider, 8% were with the provider chosen by
their employer and a vast majority (71%) were with a provider they had actively chosen.
The Chilean auction process (described later on) that assigns new entrants to the labour
market to the provider offering the lower fees could also be considered as an approach to
appoint default providers.
Disclosure-based initiatives
64. Enhanced disclosure primarily aims at encouraging plan participants to react to
differences in cost and fee levels. The Danish government-backed site
www.pensionsinfo.dk provides individuals with comprehensive information on their own
pension accounts including direct and indirect administration and investment costs, and
past returns. The 2015 Communications Act in the Netherlands requires schemes to
provide standardised information to their members. Individual pension statements in
Mexico include information on fees paid by the worker and compare net-of-fees returns
across pension funds. In the United States, participant disclosure regulation 404(a)
requires plan sponsors to ensure that participants and beneficiaries receive sufficient
information on fees, expenses and performance to make informed investment decisions.
As argued in OECD (2014), pension statements should ideally combine all sources of
retirement income and include accurate and standardised information, in as simple
language as possible.
65. The main limitation of disclosure-based initiatives is that pension statements and
information websites do not always succeed in prompting members' action regarding their
retirement savings. This is particularly the case for people with low financial knowledge.
Indeed, as people do not always have a good understanding of the effect of compounding,
they may not realise that small differences in fees (a few basis points) may translate into
large differences in assets at the end of the accumulation period. In addition, while greater
transparency and more straightforward comparisons should make it easier for plan
participants to switch providers, switches may not always occur in the intended direction.
Calderón-Colín, Domínguez and Schwartz (2008) indeed show that in Mexico, instead of
strengthening competition through lower fees and higher returns for the workers,
switching resulted in lower pensions for more than half of workers. Between 2001 and
2014, the majority of the workers who switched did so to a pension fund providing a
lower net return (negative switch). In addition, pension funds actually increase their
market share through larger marketing costs and a greater number of sales agents that try
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to convince workers to switch (OECD, 2016c). The regulator is therefore considering
extending the period during which workers cannot switch from one to three years, with
the possibility to switch after one year only if the pension fund receiving the account
offers better returns and better services.
Transparency measures
66. In some countries, transparency is seen as a key element to encourage competition
and aims at changing the behaviour of pension plan providers. This includes measures to
improve reporting, communication and benchmarking of investment costs and plan fees.
In the Netherlands and Denmark for example, pension plans are required to provide
granular information on administration and investment costs. This has led to greater cost
awareness, resulting in better outcomes for members. Table 3 indicates that pension
providers in the Netherlands had an incomplete picture of their costs before reporting
requirements were introduced in 2011: ABP and PMT for example significantly
understated their 2010 costs. The data also show that pension funds were able to take
action on the basis of the new information, as PME and PMT both reduced their costs
over the period 2011-2013. Other funds took similar action but made other changes that
mean that overall costs did not decline.
Table 3. Asset management costs in selected Dutch pension funds, 2010-2013
In basis points of assets under management
Pension fund 2010 2011 2012 2013
ABP* 39 64 73 76 PFZW 48 55 57 61 PMT 17 62 54 40 BPF Bouw 52 46 50 58 PME 70 53 37 29
Note: ABP restated the 2010 figure to 70 basis points.
Source: Pension Federation (2016), "Recommendations on Administrative Costs", revised version.
Pricing regulations
67. Changing the charge structure can facilitate comparisons between pension
providers. Some countries replaced their mixed fee structures (usually with fees on both
assets and contributions) with a single, asset-based fee. This is the case for example in
Mexico (2008) and Costa Rica (2011). Avoiding mixed fee structures can contribute to
disclosure efforts by making it easier for participants to understand what services they are
paying for and exactly how much they are paying. In Latvia, investment management
companies can only charge fees on assets, but voluntary private pension funds can still
use a mix of asset-based and contribution-based fees, making it difficult for participants
to compare across pension funds.
68. As a complement to a single charge structure, some countries have introduced
more direct controls over pricing, such as caps on fees. This measure is useful when
competition is not sufficient by itself to bring down prices. The United Kingdom
introduced a cap on fees of 0.75% of assets under management that applies to workplace
default funds since April 2015. The cap includes all direct and indirect administration and
investment costs, but does not include transaction costs. In Turkey, fees in the new
automatic enrolment system have been capped at 0.85% of assets under management a
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year (compared with 1.7% a year in the individual voluntary system). Poland has
successfully used price caps to lower fees. In 2004, the regulator capped the management
fee at 7% of contributions. In 2010, a new legal limit of 3.5% was introduced. Under the
2014 pension reform law, the maximum fee fell again to 1.75%. In Costa Rica, the fee
was initially capped at 1.1% of assets and will be reduced to 0.35% by 2020, so that
members share in the benefits from economies of scale. Finally, Hong Kong (China)
introduced a new Default Investment Strategy in April 2017 for mandatory pension funds,
with a cap on management fees of 0.75% of the net asset value of the funds per year, and
a cap on recurrent out-of-pocket expenses of 0.2%.
69. Caps set a clear and simple standard for member fees but can have unintended
consequences. First, if the cap is set too high, fees tend to rise to the level of the cap. For
example, when stakeholder pensions were introduced in the United Kingdom in 2001
with a maximum fee of 1%, this limit became the market price for all similar retirement
savings products. In a similar manner, the German government estimated that Riester
products could run with a total fee of 10% of assets and this has become the de facto
standard fee. The cap is probably also too high in Latvia, as all investment management
companies charge the maximum fee allowed by regulation (1% fixed fee and 0.5% to 1%
performance-based fee depending on the investment plan). Second, if the cap is set too
low, plan providers may try to cut costs by offering lower-quality plans or by reducing
the number of transactions they undertake, even when the trades would be in the best
interests of members. Third, if the cap does not include all costs, providers may have an
incentive to exaggerate uncapped costs in order to compensate for any lost profits in areas
that do fall within the scope of the cap. This is a concern in the United Kingdom, as the
new 0.75% cap does not cover transaction costs.
Structural solutions
70. Structural solutions entail an intervention in the structure of the market. These can
include measures to strengthen competition. Where enhanced market mechanisms are not
sufficient to control fees charged to members, policy makers may consider measures to
influence the operational set-up of pension providers or the organisational set-up of the
market in which they operate.
71. In order to strengthen competition, Chile introduced an auction process in 2008.
The auction applies to the fees charged for the management of the individual accounts for
new members. New members are automatically enrolled in the pension fund which
charges the lowest fees and they are required to remain in this pension fund for at least 24
months. The fees cover administration costs and internal investment costs. There have
been three auctions since the reform was enacted. The first auction took place in 2010 and
it allowed a new pension fund to enter the market starting from August of that year,
offering the minimum fee of the system equal to 1.14% of salary. The same pension fund
won the second auction in January 2012, decreasing the fee offered to 0.77% of salary.
As a result, another pension fund decided to lower its fees from June 2012, the first
reduction by any of the incumbents since 2009. During the third auction, carried out in
January 2014, the pension fund previously with the highest fee won the auction by
lowering it to 0.47% of salary.
72. Policy makers in several jurisdictions are encouraging the development of bigger
and more efficient plans through mergers or other organisational changes in order to
benefit from economies of scale. Fund mergers can be mandatory, as in Sweden, or a
voluntary response to other regulatory pressures such as increased scrutiny of costs, as in
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the Netherlands and Switzerland. The Pooled Registered Pension Plan (PRPP) framework
in Canada is designed to pool individual accounts in order to benefit from economies of
scale. Total costs charged to PRPP members cannot be higher than those incurred by the
members of DC plans that provide investment options to groups of 500 or more members.
Since 2013, Australian superannuation funds are required to determine each year whether
their MySuper product has access to sufficient scale, with respect to both assets and
number of members. This requirement seeks to ensure that members of a particular
MySuper product are not disadvantaged in comparison to members of other MySuper
products.
73. Another structural solution may involve the establishment of a new, centralised
institution. Centralised institutions can help to control member fees in a number of ways:
Provide additional competition to plan providers: e.g. NEST in the United
Kingdom competes with other providers for automatic enrolment business.
Offer low-cost solutions directly to underserved populations: e.g. NEST has an
obligation to take on smaller accounts.
Ensure that economies of scale are available to all participants: e.g. the PPM
clearinghouse in Sweden offers a platform to negotiate better terms (lower fees)
on behalf of plan members.
74. This policy solution can be very effective in achieving low fees as it ensures
economies of scale and can avoid the marketing expenses of the retail model. However, it
could be argued that centralised institutions have an unfair marketing advantage and can
price in economies of scale before they are realised thanks to government support. A
centralised institution can also raise governance challenges that call for effective and
strong independent oversight.
75. Finally, reduced costs can be implemented via the use of passive investment
strategies or the introduction of simple, low-cost pension products, for example MySuper
in Australia and MyRA in the United States. MySuper was introduced in 2012 in
Australia. It offers lower fees (with restrictions on the type of fees that can be charged)
and simple features (e.g. MySuper products offer a single diversified investment option or
a lifecycle investment option). All superannuation funds can apply to offer a MySuper
product. Since 1 January 2014, only funds offering a MySuper product are eligible to be
the default fund for new employees. From 1 July 2017, all member accounts in default
investment options will be required to be transferred to MySuper products. Since
November 2015, Americans having an annual earned income below USD 132 000 (or
USD 194 000 if married filing jointly) can start saving for their retirement in a MyRA
account. myRA is a public-managed Roth IRA that invests in United States Treasury
savings bond and guarantees the capital. myRA accounts cost nothing to open, have no
fees, and do not require a minimum amount of savings. Once the account reaches 30
years or a maximum balance of USD 15 000 (whichever comes first), the balance in the
account must be transferred into a privately-managed Roth IRA. In that sense, it is a
product to help people who do not have access to occupational pension plans to start
saving for retirement in an easy, safe and costless way.
6. Choice of the investment strategy
Issues posed by poor financial literacy and behavioural biases
76. In DC pension arrangements, participants usually bear the risks and consequences
of their investment decisions. If participants behave as predicted by economic theory,
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such responsibility would be welfare-enhancing as members would invest and hold a
portfolio of financial assets with a risk-return combination consistent with their
investment horizon, degree of risk aversion and the portfolio of other assets they hold.
This assumes that members have the knowledge to exercise choice and that their choice is
not distorted by behavioural biases.
77. However, individuals lack good financial knowledge and are prone to various
behavioural biases that can have an impact on investment choice (Tapia & Yermo, 2007),
including:
Choice and information overload:
Contrary to popular belief, more choice is not always better. Individuals can be prone to
choice overload and therefore fail to act. For example, Iyengar, Jiang and Huberman
(2004) find that participation rates in 401(k) pension plans decline as the number of fund
option increases.
Time-inconsistent preferences:
Risk aversion and preferences vary over time, complicating optimal investment plan
design. In addition, inertia (keeping things as they are) and procrastination (put the
decision off until tomorrow) affect individuals' decisions, leading to sub-optimal choices.
For example, Benartzi and Thaler (2002) show that plan participants rarely rebalance
their investment portfolios after joining plans and have relatively week preferences for
the portfolio they elect.
Heuristic decision making:
When making investment decisions, people are confronted with a complex sequence of
choices. To start with, they have to decide whether to invest in the default option. If not,
they then have to decide in how many funds to invest, in which funds to invest and finally
what percentage to invest in each fund.
Faced with complex decisions, people rely on simple rules of thumb or heuristics, that
serve to reduce the complexity of the options to be assessed. Benartzi and Thaler (2001)
show evidence that participants make decisions that seem to be based on naive notions of
diversification, such as the "1/n heuristic". The rule simply divides contributions evenly
among the n options offered in the retirement savings plan. There is nothing wrong a
priori with this allocation per se, but the authors show that the complete reliance on the
l/n heuristic could be costly. For example, individuals who are using this rule and are
enrolled in plans with predominantly stock funds will find themselves owning mostly
stocks, while those in plans that have mostly fixed income funds will own mostly bonds.
The empirical evidence in Benartzi and Thaler (2001) confirms that the array of funds
being offered affects the resulting asset allocation: the proportion invested in stocks
depends strongly on the proportion of stock funds in the plan.
Framing effects:
Another bias in decision-making is a result of the fact that many participants are
influenced by the way in which saving and investment issues are presented or "framed".
In addition, if a number of different investment options are presented, issues such as
numbering and the order in which they appear will affect choice, as people may not
bother going through the whole list.
For instance, a recent study by Bateman et al. (2016) shows that individuals are more
influenced by asset allocation information than risk and return information when
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comparing different investment options. The authors conduct an experiment in Australia
to see how university students and staff participating in the university retirement plan
choose retirement savings investment options using a new short-form product disclosure
statement prescribed by the regulator. The prescribed information includes expected
return, risk, percentage allocations between risky and risk-free assets, minimum
suggested time frame for investment, and textual risk label. They find that asset allocation
information had the largest impact on choices. Participants preferred investment options
with more, and more evenly weighted, asset classes. Individuals appear to focus on asset
allocation information at the expense of risk and return information. When asset
allocation information is not shown to participants, they revert to a risk-return trade-off.
Overconfidence and over-extrapolation:
A large experimental literature finds that individuals are usually overconfident (Tapia &
Yermo, 2007). Overconfidence is the tendency for people to overestimate their
knowledge, abilities and the precision of their information. Over-extrapolation occurs
when people make projections on the basis of only a few observations, implicitly
believing that these observations suggest real patterns or trends (e.g. using the past year's
return to guess on the future performance of an investment strategy). These biases mean
that investment decisions may become based on conjectures rather than fundamental
value.
Loss aversion:
People often strongly prefer avoiding losses to acquiring gains. This may result in under-
diversified portfolios with an over-reliance on fixed income.
78. Overall, women, as well as older, low-income and less educated individuals are
more likely to make portfolio "mistakes". Hung and Yoong (2013) diagnose portfolio
mistakes based on commonly accepted principles of investment, mainly avoiding overly
conservative portfolios (no equity exposure or less than 40% in equities), overly
aggressive portfolios (more than 95% in equities) and under-diversified portfolios (100%
in a single asset class). Based on a sample of 401(k) plan participants from a nationally
representative household survey, they find that more than half (56%) of respondents'
portfolios have at least one mistake. Women tend to be more conservative in general,
being more prone to having too few equities: 42.2% have too conservative portfolios, as
opposed to 26.2% for men. As a result they also tend to be under-diversified overall.
Similarly, individuals older than 45, those earning less than USD 50 000 and individuals
without college degree are also more likely to be holding no stocks.
Assessment of policies
79. In order to account for the implications of low financial literacy and behavioural
biases on investment decisions, policy makers have focused on three key aspects of
pension plan design: the range of investment options, the design of the default investment
strategy and the opportunity to offer investment return guarantees.
Investment options
80. In DC pension arrangements, policy makers need to find the appropriate balance
between a wide range of individual choices on the one hand, allowing people to take into
consideration their individual risk profiles and preferences, and the simplicity of a
restricted menu of choices on the other.
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81. Some countries, such as Sweden and Australia, give priority to individual choice
and allow a large number of investment options. These are complemented with default
strategies for those unwilling or unable to choose. For example, in Sweden, individuals
can choose up to five funds from the 830 registered with the Swedish Pensions Agency at
the end of 2015. If an individual decides not to choose his/her own funds, the
contributions go to the publicly-managed fund AP7. According to the Swedish
Investment Fund Association (2013), 63% of Swedes like having fund choice within the
premium pension system. The share of individuals appreciating this choice is even greater
(71%) for the youngest age group (aged 18 to 42). By the end of 2016, just over 2.8
million workers had chosen their own funds, representing 50% of all active members
(The Swedish Pensions Agency, 2016).
82. At the other extreme, many countries in Latin America and Central and Eastern
Europe (CEE) allow participants to choose only from a restricted number of investment
options. In Mexico for example, each asset manager has to propose four pension funds,
which by default are targeted to people of different age groups (up to 36 years old, 37 to
45 years old, 46 to 59 years old, and from 60 years old). As members get older, their
pension assets are invested in a more conservative investment strategy, with a lower
exposure to equities and a greater proportion of fixed-income instruments. Nonetheless,
members can opt to invest their assets in a more conservative fund than the default
option. In Chile, the multi-fund system is composed of five different funds, named A, B,
C, D and E according to the level of risk (fund A being the most risky). Members can
freely choose any fund, except pensioners, men over 55 years old and women over 50
years old. Older members are not allowed to choose the most risky fund (A), while
pensioners are not allowed to choose the two most risky funds (A and B) (see Table 4).
The reason for these restrictions is to prevent pensioners or members approaching
retirement age from taking high risks on investments, since a shock in financial markets
for these members may produce irreversible damage to the amount of their pensions and
the level of solidarity pension paid by the state. In CEE countries, funds are usually
named by their risk level. For example, in Estonia, members can choose from four funds:
conservative, balanced, progressive and aggressive. In Latvia, members can only choose
from three funds: conservative, balanced and active. In both cases, the funds are
differentiated mainly by the proportion of each fund invested in equities.
Table 4. Chile multi-fund system
Type of fund Up to 35 years old Men: 36 to 55 years old
Women: 36 to 50 years old
Men: over 56 years old
Women: over 50 years old Pensioners
Fund A - Most risky
Fund B - Risky Default
Fund C - Intermediate Default
Fund D - Conservative Default Default
Fund E - Most conservative
Note: Green cells represent funds that members can choose from.
83. Reducing and simplifying investment options can improve members' outcomes.
Keim and Mitchell (2016) examine how employees in a large U.S. firm changed their
fund allocations when the employer streamlined its pension fund menu and deleted nearly
half of the offered funds. The authors examine plan participants' investment choices prior
to and after the streamlining event and evaluate what happened to participant fund
allocations, risk exposure, and costs as a result of the change. Participants holding the
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deleted funds could either i) reallocate their money to funds kept in the list in advance of
the deadline, or ii) be defaulted into the age-appropriate target date fund. Post-
streamlining, participants who held the deleted funds adjusted their portfolio, ending up
with fewer funds, significantly lower within-fund turnover rates, and lower expense
ratios. The authors estimate that these portfolio adjustments could lead to potential
accumulated savings for these participants over a 20-year period of more than USD 9,400
per participant.
84. Finally, financial advice should help members tailor their investment strategy to
their needs but may be ineffective when it is unsolicited. In a randomised experiment,
Hung and Yoong (2013) ask individuals to allocate a hypothetical portfolio between six
different mutual funds, with different fees and past performances. They identify four
portfolio "mistakes", which are having (i) no equity exposure, (ii) an overly conservative
strategy (less than 40% in equities), (iii) an overly aggressive strategy (more than 95% in
equities), and (iv) an undiversified strategy (100% in a single asset class). Individuals in
the control group do not receive any advice, those in the "default treatment group" all
receive the same financial advice and those in the "affirmative decision group" are given
the choice of whether or not to receive the advice. The results show that individuals who
receive unsolicited advice disregard it almost completely, they are not doing any better
than those not receiving advice. When individuals can choose whether or not to receive
financial advice, those with low financial literacy are more likely to take it. In spite of this
negative selection on financial literacy, individuals who actively solicit advice perform
better, making fewer portfolio mistakes.
Design of the default investment strategy
85. Default investment strategies are necessary because some people lack the
knowledge and the commitment to design and manage their own portfolio, while others
have the commitment to design and manage their own fund portfolio, but lack sufficient
knowledge to do so.
86. There may be several reasons why default options work. The first reason is that
many people do not want to choose and therefore inertia will lead them to remain in the
default. In addition, people may treat defaults as a form of advice. People may perceive
the default option as the one endorsed by the authority that determines the default.
Defaults may also act as a signal as to the choices made by others, leading people to be
drawn towards them through behavioural convergence. In other cases, defaults might
serve as a psychological reference point, against which other options are judged.
87. The default investment strategy may be designed according to a balanced
investment strategy that keeps the same asset allocation throughout the investment period
or following a life-cycle strategy. In Australia, providers of the new default product can
choose between a single diversified investment strategy and a lifecycle investment
strategy. According to the Australian Prudential Regulation Authority (Quarterly
MySuper Statistics), at the end of 2016, of the AUD 533 909 assets managed by MySuper
products, 34% were invested in a life-cycle strategy. Other countries usually choose one
of the two designs for their default investment strategy.
88. In some countries, such as Estonia and Latvia, all contributions are invested in the
most conservative strategy (no equity exposure) until the participant designates an
alternative pension fund. The reasoning for such regulations may be that those unable to
make choice may also be the most risk averse. It also gives members time to think about
the strategy that best fits their needs. Thus, pension funds invest contributions in a fixed
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income portfolio under the expectation that at some point in the future, participant will
make their own appropriate investment choice.
89. The drawback with such a strategy is that it could be inconsistent with two
financial principles if people stick to it until retirement. Indeed, conservative investment
strategies account neither for the existence of an equity risk premium, nor for the
principle that younger individuals are able to assume greater risk than older individuals
because the former have more time to recover from periods of low returns and have more
human capital. However, people are prone to inertia and procrastination. If members are
passive decision makers, the default option selected by policy makers or employers
becomes the de facto member's choice. For example, Choi et al. (2004) find that about
45% of workers automatically enrolled in their employer pension plan still save at the
default contribution rate and invest exclusively in the default conservative investment
strategy three years after enrolment. Some people may therefore remain with a
conservative investment strategy for the entire accumulation period. This fear may not be
valid in every country however. For example, most participants in the Latvian mandatory
funded pension scheme make an active investment choice getting out of the default
conservative plan.
90. The main trend in recent years is to establish a life-cycle strategy as the default
investment strategy to allow younger individuals to take more risk and reduce risk as
people age. As members get older, their pension assets are invested in a more
conservative investment strategy, reducing the risk of large losses in their account as the
retirement age approaches. Several Latin American countries follow a multi-fund system,
with members assigned to one of the funds by default according to their age (e.g. Chile
and Mexico). Members' assets are transferred from one fund to the next when they hit the
age thresholds.4 The age thresholds are determined considering the investment horizons
of members, that is, the time remaining until they reach the retirement age, and their
likelihood of recovering from periods of low returns.
91. In some countries, like Hong Kong (China) and Sweden, the default life-cycle
investment strategy uses a mix of funds, the proportions of which evolve as members
reach a certain age. Effective 1 April 2017, Hong Kong (China) introduced the Default
Investment Strategy (DIS) for members of the Mandatory Provident Fund (MPF) who do
not select an investment strategy for their account.5 The DIS uses two mixed assets funds,
the "Core Accumulation Fund" (CAF) and the "Age 65 Plus Fund" (A65F). The new
legislation requires 60% of the CAF to be invested in assets with higher risk, mainly
global equities, and 40% in assets with lower risk, mainly global bonds. The A65F holds
80% in lower risk assets and 20% in higher risk ones. When members are younger than
50, all of their MPF is invested in the CAF; once they turn 50, their portfolio is
automatically adjusted every year to reduce their investment in the CAF and increase that
in the A65F; when they turn 64, all of their MPF is invested in the A65F. In the case of
the Swedish default fund AP7, the cut-off age between the Equity Fund and the Fixed
4 The transition from one fund to the next can also be smoothed out over several years. For instance, in Chile, 20%
of the balance is transferred at the time of the age change, and then 20% per year over a four-year period
until all resources are transferred.
5 The DIS is a long-term retirement investment solution that has been designed with reference to advice from the
OECD Secretariat and input from other overseas experience.
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Income Fund is 55 and the adjustment is made up to age 75, at which time two thirds of
the capital is invested in the Fixed Income Fund and one third in the Equity Fund.
92. In the United States, the use of target date funds is also growing in 401(k) plans.6
According to Vanguard (2016), 90% of employers using Vanguard DC plans offered a
target date fund in 2015, up from 43% of employers in 2006. In 2015, nearly all
Vanguard participants were in plans offering target date funds (98%) and 69% of them
used target data funds (up from 10% in 2006).
Investment return guarantees
93. Investment return guarantees alleviate the impact of market risk on retirement
income by setting a floor on the value of accumulated assets at retirement, either in
nominal or real terms. They provide some predictability in the savings phase with respect
to future pension benefits. They may increase the attractiveness of saving for retirement
in DC pension plans as they overcome people's fear of losing the nominal value of their
contributions.
94. Investment return guarantees enter into two main categories. Absolute return
guarantees are set against a pre-specified return (e.g. 0% nominal annually for Riester
plans in Germany). Relative return guarantees are set in relation to a market benchmark
(e.g. government bonds in Slovenia), a synthetic investment portfolio or the average
performance of pension funds in the industry (e.g. Chile). Only absolute return guarantees
pre-determine the minimum value of the accumulated assets. The minimum value of
accumulated assets under a relative guarantee will vary with market performance.
95. Investment return guarantees have to be paid for, and this cost reduces the
expected value of benefits from DC plans relative to a situation where there are no
guarantees (OECD, 2012). The cost of the capital guarantee, that makes sure that people
will get back at least their contributions (in nominal terms), is affordable for long enough
contribution periods. Guarantees above the capital guarantee may be too costly however.
96. In addition, the assessment of whether to introduce investment return guarantees
needs to be done in the context of the overall pension system. Investment return
guarantees may not always be the best way to provide a floor or minimum income at
retirement to prevent people from having inadequate pensions. In many OECD countries,
public pensions' automatic stabilisers and old-age safety nets already provide such a floor.
These forms of public protection may be more valuable than investment return
guarantees, as they guarantee a minimum level of income throughout retirement rather
than a minimum value for the assets accumulated at retirement. In addition, if DC
pensions are just a voluntary complement to public pensions (and occupational DB plans)
that already provide sufficient guaranteed retirement income, investment return
guarantees in DC plans may lose some of their purpose.
97. Some countries are moving away from investment return guarantees, such as the
Czech Republic, Denmark and Germany for example. Since November 2012, transformed
pension funds in the Czech Republic are closed to new members and replaced by
participation funds. While transformed funds offered a capital guarantee on a yearly
6 Target date funds base portfolio allocations on an expected retirement date, with allocations growing more
conservative as the participant approaches the fund's target date. The glide path is usually smoother than
with multi-fund life-cycle funds.
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basis, participation funds offer no guarantees but provide different risk profiles and
investment strategies. To cope with the new environment of low interest rates and longer
life expectancies, pension companies in Denmark have developed pension products with
lower or even no guarantees. Products with guarantees require higher technical
provisions, meaning that the investment opportunities of the pension companies are
limited to investment products with lower risk and thereby lower expected returns. Lower
risk eases the pressure on solvency, but eventually, lower expected returns can make it
difficult for pension companies to generate returns that are sufficient to meet their
guarantees. Consequently, developments in recent years have resulted in even more non-
guaranteed pension products. Thus, the percentage of technical provisions for market
return products, which are generally non-guaranteed, relative to total technical provisions
has increased from around 4% in 2003 to around 37% in 2015. In Germany, a new law
introducing DC pension plans without guarantees is currently under discussion in the
parliament.
7. Choice of the pay-out product
Issues posed by poor financial literacy and behavioural biases
98. One of the key goals of pensions is to provide a stream of income for life after
retirement. In DC pension arrangements, life annuities are the easiest way to achieve that
goal. The biggest risk people face during retirement is to run out of money while they are
still alive. Unlike lump sums and programmed withdrawals, life annuities guarantee a
payment for the entire lifetime of the retiree and therefore protect retirees from longevity
risk. Low financial literacy and behavioural biases however affect how people perceive
annuities. They also affect the way in which people may draw down their savings when
choosing programmed withdrawals as an alternative to annuities to get an income stream
during retirement.
99. The effect of financial knowledge on annuity demand is unclear (Brown J. ,
2009). For example, Agnew et al. (2008) find that, conditional on education, individuals
with high levels of financial knowledge are significantly less likely to choose annuities.
This may be due to the fact that more financially knowledgeable individuals are over-
confident in their investment skills, perhaps leading them to believe that they can "do
better" than an annuity by investing on their own. Brown, Casey and Mitchell (2008) find
that more highly educated individuals are less likely to annuitise. However, conditional
on education, they find that more financially knowledgeable individuals are more likely
to choose an annuity. In both studies, financial knowledge is measured based on the
capacity to correctly answer three basic questions on interest compounding, inflation and
risk diversification. However, the decision to annuitise may be linked to other types of
financial knowledge, such as understanding the implications of longevity on retirement
outcomes.
100. Because of loss aversion, people tend to dislike annuities. Indeed, people do not
like to give away large amounts of money (annuity premiums are large one-off payments)
for a small amount (payments are relatively smaller). Moreover, people tend to view
annuity providers as institutions taking their money away. It is indeed important to
individuals to keep control over their assets and investment strategies, in part because of
fears of illiquidity. In addition, people feel that they lose money if they die early. Finally,
there is also the issue of insolvency risk. People wonder whether the institutions taking
their money now for promised pension payments in 20-30 years will still be around over
that time.
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101. Improving individuals' awareness of the risk of living to an old age does not
necessarily increase the preference for annuities. While the expectation of a longer life
has been shown to be related to the increased preference for annuities, individuals also
tend to underestimate their expected survival. Mosher (2015) assessed whether improving
individuals' awareness of the risk of living to an old age could improve these estimates
and lead to a higher preference for annuities. Results showed that while subjective life
expectancies may be influenced by this information, it does not affect the preference for
life annuities and may even reduce the take up of annuities. A potential explanation for
these results is that individuals having higher subjective life expectancies also have a
higher risk tolerance because they have a longer investment horizon. In addition,
increasing individuals' awareness of longevity risk may also increase their perceived need
for liquidity for future healthcare costs, reducing their preference for illiquid life
annuities.
102. Framing also influences demand for annuities. Brown et al. (2013) argue that life
annuities are more attractive when presented in a "consumption frame" than in an
"investment frame". The two alternative frames, which are just two representations of the
same financial choice, may lead to different perceptions of gains and losses. The
consumption frame presents financial products by highlighting consequences for
consumption over the lifecycle. The investment frame focuses instead on the risk and
return features of the financial products. In an experiment, the authors randomly assigned
people over the age of 50 to choose between different financial products using the
consumption or investment frame. The financial products include life annuities, savings
accounts, bonds and period annuities (i.e. annuities paying a fixed number of
instalments). The results show that life annuities are preferred when financial products are
presented in a consumption frame. On the contrary, when these same products are
presented in an investment frame, savings accounts and other financial products are
strongly preferred to annuities.
103. Programmed withdrawals are an alternative to annuities to get an income stream
during retirement. However, as they do not provide full longevity cover, choosing the
right withdrawal rate becomes crucial but is difficult. On the one hand, withdrawing too
much and too early causes individuals to face an increased risk of outliving their pension
assets. On the other hand, withdrawing too little may lead people to reduce the standard
of living that they can enjoy in retirement. In Australia for example, plan members can
choose to receive their pension assets as a lump sum or as programmed withdrawals.
With programmed withdrawals, a minimum amount is required to be paid each year, from
4% under age 65 to 5% between 65 and 74 years old and up to 14% of assets at age 95
and older. According to the Australian Government (2016), a majority of individuals
draw down account-based pensions at or close to the minimum rates. This reduces the
risk of outliving one's pension wealth, but it also reduces the standard of living that
individuals can enjoy in retirement. Individuals are self-insuring against longevity risk,
but in an expensive way measured in terms of forgone income.
104. There are three traditional rules of thumb to draw down pension assets in
programmed withdrawals, but according to Sun and Webb (2012), none of them are
optimal. People adopt rules of thumb for drawing down their assets because rules are
relatively simple to follow. Some retirees use the straightforward strategy of leaving the
principal in their retirement accounts untouched and spending only the investment
income. This strategy may be desirable for those who want to leave a bequest but it
reduces retirement consumption. A second draw-down strategy is to divide each year all
financial assets by the remaining life expectancy, as predicted by life tables. However,
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33
people living beyond their cohort's life expectancy will outlive their resources. A third
strategy is the so-called 4-percent rule advocated by some financial planners, under which
the retiree each year withdraws 4% of the initial amount of assets accumulated at
retirement.7 However, this strategy lacks flexibility, as the withdrawn amounts do not
adjust to the performance of the portfolio. Sun and Webb (2012) compare these three
strategies to an optimal draw-down pattern that maximizes the expected utility of
consumption. The three strategies underperform the optimal strategy, with the life
expectancy strategy being the closest and the 4-percent rule the farthest from the optimal.
Assessment of policies
105. Policy options to help individuals transforming the assets accumulated in their
pension account into a retirement income range from giving complete freedom on how to
allocate their assets in retirement, to promoting annuities without making them mandatory
and to mandating life annuities.
Freedom of choice
106. The design of the pay-out option needs to be determined in coherence with the
overall structure of the pension system. The need to annuitize DC pension pots depend on
how much is already received as an annuity from funded and PAYG DB plans. In
addition, the design of the accumulation and pay-out phases needs to be internally
coherent, for example, flexibility in the pay-out phase makes sense if the accumulation is
flexible (e.g. voluntary).
107. In some countries, pension funds only offer lump sum and programmed
withdrawal options to their members. In turn, the lump sum may be used to cover
expenses or reimburse debt. The money can also be invested or used to buy a life annuity
with a life insurance company. Therefore, individuals have complete freedom on how to
allocate their resources during retirement, but they also have the responsibility of dealing
with the risk of outliving these resources. This is the case for example in Hong Kong
(China) and Australia.
108. There is popular demand for flexibly accessing pension assets, as demonstrated by
the pension freedoms reform in the United Kingdom. Since April 2015, individuals aged
55 and over can access their DC pension savings as they wish, subject to their marginal
rate of income tax. Before this reform, people withdrawing the whole pot from a DC plan
were charged a 55% rate. According to HMRC’s latest statistics, GBP 6.45 billion was
withdrawn from pension funds in the financial year 2016-17, up from GBP 4.35 billion
the previous year. Payments were made to 393 000 individuals, up from 232 000 in 2015-
16. In addition, according to FCA statistics, based on a sample of firms covering
approximately 95% of DC contract-based pension schemes assets, between April 2015
and September 2016, 972 703 pension pots have been accessed for the first time and full
cash withdrawals were the most used product for consumers accessing their pension pots
(55% of the total) (Financial Conduct Authority, 2017). These numbers demonstrate that
there is popular demand for the increased flexibility brought about by the reform.
7 This rule originates from a study by Bengen (1994) who looked at the spending rate that would allow a pension
pot to survive exactly 30 years of retirement.
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109. However, individuals may not fully understand the consequences of such
withdrawals in terms of taxes paid. The Treasury indeed increased its forecasts of tax
revenues from the pension reform. The measure was initially estimated to raise around
GBP 0.3 billion in 2015-16 and GBP 0.6 billion in 2016-17, but it has actually raised far
more than anticipated: GBP 1.5 billion in 2015-16, while the latest estimate for 2016-17
is GBP 1.1 billion. The Treasury now expects the measure to bring in GBP 1.6 billion in
2017-18. The difference between the initial estimates and the reality stems from the fact
that individuals spread their withdrawals over a shorter period than the anticipated four
years. In addition, some individuals are taking larger amounts than they would have been
able to purchase through an annuity, thereby creating a higher tax liability.
110. The United Kingdom is also introducing new rules to encourage shopping around
in the annuity market. While the number of members purchasing annuities has decreased
following the introduction of the pension freedoms, the market for annuities remains
significant in the United Kingdom, with around 80 000 plan members purchasing
annuities each year. In addition, FCA's data suggest that around 60% of annuity sales are
still being made to firms' existing members (Financial Conduct Authority, 2017). In order
to improve competition in this market, the FCA introduced new rules requiring providers
to give members information to encourage shopping around in the annuity market. From
1 March 2018, firms will be required to provide information about the amount used to
purchase the proposed annuity, whether the annuity is single or joint life, whether
payment is in advance or in arrears of the start date, whether the income paid by the
annuity is guaranteed for any period and whether the income will increase in line with
inflation or some other specified rate. The document will also give the provider's own
quote and explain how to shop around, encouraging use of the Money Advice service.
111. In order to help people compare different pay-out options, one could introduce a
system where plan members can see the bids from all insurance companies and pension
funds in one place. The Online Pension Consultation and Bidding System (Sistema de
Consultas y Ofertas de Montos de Pensión, or SCOMP) in Chile does this. Upon
retirement, people can choose from four different options: programmed withdrawal, life
annuity, programmed withdrawal with immediate life annuity and programmed
withdrawal with deferred life annuity. In order to make that choice, all members must
consult the SCOMP. Life insurance companies and pension funds respectively transmit
bids for life annuities and pension payments under the programmed withdrawal option. In
this way, members simultaneous receive and compare all available retirement bids.
Consultation with this system is mandatory for any member wishing to choose a life
annuity and receive a pension, as well as for all pensioners in the programmed withdrawal
option who wish to switch pension options. The mandatory consultation of the bids is
used here as an alternative to defaulting people into a specific pay-out option. However,
this consultation system is only informative. Indeed, there is no restriction in terms of the
bids that members may choose, or any obligation to accept any of them. Once they review
the bids, members have five options: accepting one of them, submitting a new
consultation, requesting external bids (i.e. bids from an insurance company outside of the
consultation system), requesting an auction on the system (i.e. ask at least three insurance
companies to present bids), desisting from retirement, or switching pension options.
Promote the demand for annuities
112. When mandating annuities is not an option, the role of annuities in the pension
system may still be strengthen to help people cope with longevity risk by making
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annuities an explicit option for retirement, providing tax incentives and fostering product
design innovation.
113. Policy makers may wish to make annuity products a more explicit option within
their pension system. For example, in Australia, superannuation funds currently only
offer lump sums or programmed withdrawals. However, from 1 July 2017, the
government will extend the tax exemption on earnings in the retirement phase to
innovative products, such as deferred lifetime annuities and group self- annuitization
products. The goal is to encourage the development of new retirement income products
and provide greater choice and flexibility for retirees to manage the risk of outliving their
retirement savings. In addition, the government is currently consulting on the
development of a framework for Comprehensive Income Products for Retirement
(CIPRs). The CIPRs framework would aim to facilitate the development and take-up of
products that better manage longevity risk through risk pooling. Upon retirement,
individuals would however still be free to accept the offered product, modify the product
to reflect their individual needs, or take their pension benefits in any other way.
114. Tax incentives can also be used to encourage individuals to purchase annuities.
Both the Czech Republic and Estonia incentivise people to annuitize their pension income
through a more favourable tax treatment for annuities as compared to programmed
withdrawals (OECD, 2015b). Annuities can also be indirectly incentivised by taxing less
favourably other pay-out options. For example, in Denmark, a tax reform in 1999 reduced
the deduction that high-income workers could take for contributions to "capital" pension
accounts, which are accounts that provide lump-sum payments at retirement. That reform
however left unchanged the treatment of contributions to accounts that provide annuity
payments. Chetty et al (2014) show that individuals in the top income tax bracket reduced
significantly their contributions to capital pensions following the reform, redirecting
nearly all that saving to annuity pension plans and other savings accounts.
115. Product design innovations try to overcome the low levels of demand for
traditional annuity products. OECD (2016d) provides an overview of the different types
of annuity products, describing the guarantees that they offer. It shows that there is a
trend towards more flexibility and risk-sharing in the design of annuity products. For
example, variable annuities provide flexibility in the sense that, although a minimum rate
at which the accumulated funds can be converted into an annuity is guaranteed at issue,
annuitization is not mandatory and the policy may be surrendered instead. Risk-sharing
features can be found in participating life annuities for instance. These annuity products
generally offer a minimum guaranteed level of income to the annuitant, but give
additional bonus payments depending on actual return or profit measure.
116. Another way to strike a balance between flexibility and protection from longevity
risk is to combine programmed withdrawals with a deferred life annuity bought at the
time of retirement that starts paying at old ages (e.g. 80-85).8 This combination could be
an appropriate default option as it achieves a balance between protection from longevity
risk (through the annuity), as well as flexibility, liquidity, possibility of bequest and
access to portfolio gains (through the programmed withdrawals). This option exists in
Chile. NEST in the United Kingdom also explores the possibility for its members to be
able to make small payments from an income drawdown fund to gradually buy a deferred
life annuity (NEST, 2015).
8 This combined arrangement is advocated in the OECD Roadmap for the Good Design of DC Pension Plans.
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Mandatory annuitization
117. While annuities are usually mandatory with occupational funded DB plans, this is
much less common with funded occupational DC plans and personal plans. The
institution responsible for paying annuity income can be the pension fund that managed
the assets during the accumulation phase (e.g. occupational pension plans in Iceland and
the Netherlands), a life insurance company (e.g. the mandatory funded pension scheme in
Latvia) or a centralised public institution (e.g. Sweden and Singapore).
118. A centralised public institution providing annuities ensures that economies of
scale are available to all participants. It can be more effective in achieving low costs than
with competing private providers. However, it can also raise governance issues, such that
costs need to be closely monitored.
119. In Sweden, two types of annuity products are provided by the Premium Pension
Authority or PPM. The PPM is the clearinghouse for fund transactions, keeps individual
accounts, collects and provides (daily) information on participating funds, provides
information services to participants and is the unique annuity provider for the mandatory
funded pension system (Premium Pension System or PPS). The possible annuity products
are specified in the law regulating the PPS. Accordingly, participants can choose between
single and joint life annuities, and between fixed or variable rate annuities. A fixed
annuity is purchased from the PPM and entails moving fund assets to the PPM. The PPM
is then responsible for investing the funds. Alternatively, the participant can leave his/her
money in investment funds and receive annuity payments that vary on an annual basis.
This is the variable rate annuity. The annuity is recalculated each year based on the
amount of money remaining on the individual account and life expectancy for the
individual's birth cohort at that year.
120. In Singapore, the mandatory annuity scheme offers some flexibility. In 2009,
Singapore introduced mandatory annuitization in the Central Provident Fund (CPF). All
CPF members must set aside a retirement sum in their retirement account to finance their
future retirement income. They must join the CPF Lifelong Income For the Elderly (CPF
LIFE) scheme, which is provided by the CPF Board, as long as their retirement account
balance is at least SGD 60 000 six months before reaching the eligibility age (currently
65). CPF LIFE monthly pension payments can be deferred up to age 70, thereby
increasing future pension payments. Under the CPF LIFE plans, all unused annuity
premium (without interest) and retirement account savings, if any, are paid to the
member's beneficiaries after his/her death. CPF members not automatically placed on
CPF LIFE can still apply to join the scheme voluntarily anytime between age 60 and 80,
or remain on the Retirement Sum Scheme, which a programmed withdrawal scheme
paying monthly payments for about 20 years.
8. Conclusion
121. Given the growing importance of DC pensions in people's future retirement
income in many countries, policy makers increasingly recognise the need to improve the
design of these arrangements. Several factors need to be taken into consideration when
implementing policies to improve the design of DC pension arrangements, such as the
structure of the overall pension system and political constraints, but also the level of
financial literacy of the population and the existence of behavioural biases when people
have to take decisions.
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37
122. This document has argued that low financial literacy levels and behavioural biases
can undermine people's ability to take action and make appropriate decisions in the
context of DC pension arrangements. It has then assessed experiments and policies
implemented in different OECD and non-OECD jurisdictions to improve the design of
DC pension plans through motivating or facilitating the appropriate behaviour by
individuals.
123. The policies can be divided into six broad categories: default options,
simplification of information and choice, salient information, financial incentives,
product features and cost-reducing policies.
124. Defaults are widely used to increase participation in and contributions to DC
pension arrangements (e.g. automatic enrolment and automatic escalation of
contributions). In this case, the policy harnesses the power of inertia to keep people in the
plan. Default options also help people who are unable or unwilling to choose a pension
provider (e.g. KiwiSaver default schemes in New Zealand), an investment strategy (e.g.
the Default Investment Strategy in Hong Kong, China) or a pay-out product (e.g.
mandatory annuitization in Sweden). The default option usually implies lower risks for
individuals. However, default options may not be suitable for everyone failing to make a
choice given different needs and preferences.
125. People can make better choices if the decision-making process is simplified. This
can be achieved through the provision of a reduced set of options (e.g. investment
strategies), better disclosure of comparable information (e.g. cost information) or
facilitated comparison of options (e.g. the SCOMP platform in Chile that allows people to
compare all pay-out offers from pension funds and insurance companies).
126. People tend to focus on salient information. Making sure that important
information related to retirement saving is emphasised can therefore improve decision
making. This information can be conveyed through pension statements, financial
education programmes and financial advice.
127. Matching contributions and flat-rate subsidies are increasingly used to promote
private pension arrangements, as a complement or as a substitute to tax incentives. These
financial incentives intend to realign people's intentions (they know that saving for
retirement in their best interest) with their actual behaviour (procrastination and status
quo biases are barriers to action).
128. Policy makers also introduce product features that may help alleviate some of the
fears that people have when locking in their money in private pension plans. For example,
investment return guarantees albeit they cost, alleviate the impact of market risk on
retirement income, while innovative annuity products provide access to the underlying
capital.
129. Finally, policies reducing costs are important to improve retirement income
outcomes. Pricing regulation and structural solutions help containing costs during the
accumulation and pay-out phases.
130. The next steps of this project are to share the paper with the OECD INFE and get
their comments. The OECD Secretariat will prepare an additional paper distilling
effective practices and policies on how to design DC pension plans given the level of
financial literacy and behavioural biases.
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38
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