Rational Pension Products for Irrational People

1. Rational Pension Products for Irrational People Zvi BodieNorman and Adele Barron Professor of Management, Boston University, USHenriëtte PrastRabo and Netspar Professor of Personal Finance, Tilburg University Member of the Scientific Council for Government Policy, The Netherlands

2. Purpose of paper • How to redesign pension schemes in order to make them state-of-the-art taking account of • Behavioral insights • Next generation financial technology

3. Paul Samuelson (2006) “God must love those common folk that behavioral scientists write about, because She created so many of them”

4. Zvi Bodie • Finance is like medicine • People do not like it • They rely on expert advice • They view choice as a mixed blessing

5. Robert C. Merton New tchnology and deregulation have left households with the responsibility for making important and technically complex micro financial decisions involving risk….that they did not have to make in the past, are not trained to make in the present, and are unlikely to execute efficiently in the future, even with attempts at education”

6. First pillar in Europe • Major differences across countries • Example: • Netherlands: 650 euro per month at 65+ • Italy: amount depends on labour history

7. Second pillar in Europe • Major differences across countries • Example • Netherlands: automatic and mandatory at firm level; assets exceed gdp; 95% participate • Italy: not automatic, not mandatory; assets less than 5% of gdp

8. Common challenges • Aging of the population • Risk shift towards employee • Decrease in replacement ratio

9. Behavioral insights • Even if people know what is good for them, they do not always act on it • Lack of self control • Procrastination • Status quo bias • Extremeness aversion

10. Pension irrationality • Amount saved for retirement: too low • Portfolio choice: inconsistent, suboptimal • Default sensitivity • Decumulation: take the money and run (Huebner and Teppa)

11. Current policy, NL • Uniform Pension Overview (UPO) • 4 page overview + 3 page explanation….. • Indexation label

12. Indexation label

13. Best intentions… • But does it work……?

16. Pension preferences • People are interested in pension income, not portfolio • People want guaranteed real living standard in retirement

17. Products • Real living standard oriented • Semi-tailored • Rational, using next generation technology

18. Institutional design • Semi-tailored set as default; limited additional choice • Useful information and meaningful choice • Marketed through a trusted institution • Employer • Pension fund • Trade Union

19. Role for the government • Complete markets by issuing long-dated inflation-indexed debt/consumption-indexed bonds (Merton, 2000)

20. Different applications • In some countries, RPPIP will have a modest role, supplementing current 2nd pillar systems (NL) • In others, they will replace current 3rd pillar arrangements (IT) • In some, they will be the core of a new system

21. Conclusions (1) • Policy focus on transparency and education may be counterproductive: “comply and do not innovate” • Financial customers need education in understanding their pension preferences

22. Conclusions (2) • People should be supplied paternalistically with pension products that deliver the output they prefer • These products should be rational from the perspective of science