Friday, November 7, 2014

Investment Choice in Defined-Contribution Pension Schemes: International Experience and Policy Issues

RODRIGUEZ-MONTEMAYOR Eduardo
Read the working paper
INSEAD Working Paper 2014/60/EPS

Populations around the world are becoming older and countries are increasingly adopting defined contribution (DC) pension schemes to ensure adequate and sustainable retirement incomes for people. Such schemes typically give people the ability to exert choice in a series of key decisions in theadministration of their own retirement wealth. One of such decisions is how to allocate retirement assets across different investment options. This paper reviews how investment choice in DC pension schemes is regulated across different countries and also reviews actual country experiences in terms of individual active choice. The discussion of policy implications is supported by the current knowledge in the literature on behavioral economics and finance. How much freedom workers should have over the choice of a pension provider and the choice of investment portfolio is a key economic and policy question because academic literature shows that people’s behavior is often characterized by naïve decisions, inertia and switching and searching costs. What the evidence tells us, in general, is that the proportion of people that actively choose how to invest their pension contributions is low. People’s money is often invested in default investment funds. Therefore, policy intervention is usually desirable, particularly in the design of an optimal default policy. Our discussion suggests that an optimal regulation approach would move the basis of competition from short-term returns to long-term returns. One strategy is to set performance objectives for pension funds for outperforming a long-term benchmark fund (or funds) regulated by the government. Such funds could operate with life-cycle principles.