Investment Choice by Plan Members in OECD Countries with Selected Examples

1. Investment Choice by Plan Members in OECD Countrieswith Selected Examples “DevelopmentofSupplementaryRetirementProvisionintheEU and the Challenges to EU Accession Countries” Sofia, 12-13 October 2006

2. Origin(s) of member directed investment/portfolio choice in pension plans • Prudential regulation of plan member investment choice • Country examples • Selected OECD and pension reform countries • Policy issues

3. Origin(s) of member directed investment/portfolio choice in pension plans • Some kind of definition • The life-cycle model • Provides a model to explain saving/financial planning behaviour • There are better and better results testing the model on real data and including more and more variables • e.g. counting with investment decision variables changing with age • Labour flexibility and wealth are important factors, • but so as financial education and costs (of information, etc.) • There are variables which are in correlation with age, but it does not necessarily means causality • There are factors and groups that can not be captured by the model • There is a slight difference in consumption smoothing and wealth maximalization, zero, short, or long term optimalization • Pensions is only one source of savings in the model; Social Security and guarantees affect the outcome • Support side: • Liberalization and Development of financial markets and technology made possible new products – since the 1980’s • Competition among financial institutions and fund operators • Responsibility

4. Country examples • The U.S. • Canada • Australia and Switzerland • Examples of employer-based mandatory systems • The regulation is more general in Australia, and so as the experience • Sweden and Singapore* • Mandatory • Centralized collection and fund and portfolio management, decentralized asset management • Singapore: CPF manages wide range of life-time financing issues (social security) in the same framework • Chile • Other pension reform countries: Estonia and Hungary • Plans to implement from 2005 • Denmark: the Special Savings Pensions Scheme (SP) will offer choice from 2005 • Poland – similar to Chile before 2002 • Slovakia – similar to Estonia, plus scheduled withdraw of savings from risky funds as nearing retirement

5. Country examples – U.S. • Employers’ responsibility • Employees: diversify out of employer’s assets • Example: TIAA-CREF • Financial service provider to education, research, and healthcare professionals. • About US$290 billion in pension assets in trust for 3 million members • Members my choose from 10 funds in five categories, • Equity • Fixed Income • Money Market • Guaranteed Funds • Real Estate • TIAA Traditional Guaranteed Funds, • each fund including hundreds of securities • Fund management fees range from approximately 0.30% to 0.60% of assets. • Extensive research and education activity • Overall increase in equity; excluding the extreme cases the distribution is quite smooth; similar results from a life cycle model • TIAA-CREF membership: less labour uncertainty, and pensions from Social Security

6. Country examples - Canada • Regulation • Examples • The University Of Western Ontario Pension Plan • UWOPP allows members 15 investment options: • Diversified Equity or Bond or Long Term Bond Funds, Money Market Fund, Canadian Equity or Bond Funds, US Equity – Hedged or Unhedged Funds, Non-North American Equity Fund, Balanced Growth or Income, Target Date Funds* • Target Date Funds invest in Government of Canada Bonds, assuming the investments are held to their target dates – 2004, 2006, and 2008 – , while offering liquidity of the investments before maturity. • * t a: $59.20 p: 420 a/p: 67,735 c: 0.08% r4: 2.91% r6: 4.65% r8: 5.76% • Another university example: The McGill University Pension Plan • A defined contribution plan with a defined minimum benefit, even if the account was not invested in the default fund • Balanced Account; Equity Pool; Fixed Income Pool; Money Market Pool • A similar concept to the UWO Target Date Funds also implemented: the Money Market Pool is intended to protect from fluctuations in the market • The Balanced Account offers auto rebalancing, which might be better performed on fund rather than individual portfolio level • -------------- • Different portfolios offer really different risk-return for different cost • Matured systems: low number of changes

7. Country examples - Sweden • The new mandatory pension system in Sweden • NDC PAYGO (16 % contribution rate), and DC financial accounts, or FDC (2.5 % contribution rate) • In the FDC system individuals can choose between one and five funds from over 500 funds: 65% equity funds,15% fixed-income funds, and 20% mixed or life-cycle fundsIn addition; There is a publicly managed mutual fund as the default fund. • The Premium Pension Authority (PPM) administers the system • Contributions are collected by the National Tax Authority. Information on payments is transferred on an individual basis to the National Social Insurance Board (NSIB). Money from new contributions is transferred through the National Debt Office to the participating funds, following the an order from the PPM. For 18 months Contributions kept on an interim account at the National Debt Office, earning a bond rate of return. • The PPM is a clearinghouse for all fund transactions. Choices for new entrants and requests to buy and sell fund shares for all other participants are grouped together and executed jointly on each transaction day by the PPM. The PPM invests assets on behalf of participants, and is the sole client for any given fund. The PPM keeps the individual accounts of fund shares and values are computed for all trading days. • The PPM is also the sole provider of annuity products. • FDC Fund Participation Criteria:UCITS, plus additional disclosure and daily information to the PPM. PPM also negotiate fees on a market-share basis. • Fund Administration Costs: 1.11% for equity funds, 0.70% for mixed and life-cycle funds, and 0.60% for fixed-income funds, + PPM charge up to 0.3 %,total administration costs: 0.95 % • FDC Fund Choices • Initially 67 per cent of all participants made active choice; The number of active fund choices was a little over 10 million. Participants chose on average 3.4 funds. • Over 72% of those making active choices chose equity funds, and about 25% chose life-cycle funds. • Inflows of capital are – slightly – biased towards equity funds: 72% of invested capital, although the share of equity funds in the system is 68%. (see 1/n rule)

8. Country examples – Chile • The objectives of introduction of the multiple portfolio system was based on the life-cycle model, to increase the expected value of future pensions, by investing more efficiently during the active life with respect to age and risk-return profile. • From August 2002, the number of managed funds by APFs were increased to fiveThe multifunds are defined by minimum and maximum investment limits on equities.APFs are not obliged to establish Type A Fund (40%-80%), but Funds B – E (0%) must be created by all APFs.The definition of default selection also follows logic of the life-cycle model. • The earlier mechanism of minimum return guarantee has also been maintained • The basic rule for fund selection of members is free choice. However, older workers and pensioners, defined similarly as in the case to default fund selection, may invest only in less risky funds.Otherwise member may direct contributions in two different funds, and transfer assets into another Fund. • The experience of active fund selection (and redirection) in Chile seems to support the textbook case: • 42% of the contributors made active choice. • Participation in Fund A and Fund E (the two Funds that can be selected voluntarily) are significantly different in average age and accumulated funds, but not in average earnings. The difference might be explained by length of accumulation. This might support that young, high earning participants tend to choose the high risk fund, while retirees the low risk fund. • Women tend to be more risk-averse; while it seems to decrease by age. • Redirection of contributions show correlation with returns. The number of changes to Type A funds have always been the highest. Since March 2003 the gap in performance between Type A funds and Type E funds has increased, and the changes have followed the pattern. • The above results show that plan members seem to make well informed decisions. Further analysis would be needed to compare the number of changes between funds, plans/fund managers (APFs) before and after the introduction of the multifondos.

9. Country examples – other pension reform countries: Estonia • In Estonia pension fund asset managers may establish three type of funds: • Conservative: 100% in fixed income (6 funds) • Balanced: 75% in fixed income and up to 25% in equity (3 funds) • Progressive: 50% in fixed income and up to 50% in equity (6 funds) • Three fund operators offer 2 funds (conservative and balanced), and the other three offer all three options. Two operators offer balanced funds for voluntary contributions, one balanced with the same limits; and another all three strategy funds (with 100%, 70%, and 40% fixed income). The default option is the Conservative fund. In the mandatory system non-choosers were allocated to pension fund operators by drawing lots. • Ministry of Finance established a statutory limit on the fees: Unit issue fee – max. 3%, Unit redemption fee - max. 1%, Management fee - max. 2%. • The actual management fees range between 0.75%-2.0%, according to fund type. Issue fee Between 1%-3%, according to fund operator; redemption fee is 1% everywhere • Majority of the investors chose the maximum equity fund, though in other circumstances it would have also been titled as balanced. It is also true, that plan members are young, because of the provisions of the law. Figures show that the proportion of members than assets is slightly lower in conservative and balanced funds than in Progressive. At this stage it might be explained even by the difference in management fees.

10. Country examples – other pension reform countries: Hungary • Voluntary • The main emphasis of regulation was on coherence with the investment regulation (limits and SIP), expensing and disclosure.The rules of operating multiple portfolio system in the pension plan must be approved by the General Assembly and licensed by the HFSA. • All portfolios should adhere to the global limitations of the investment regulation, which allows maximum 60% shares and 30% foreign investment.The used benchmarks are short and long term, and composite Hungarian Government Bond indexes, BUX and MSCI World equity indexes, with respect to the asset composition of the portfolio • Out of 82 voluntary pension plans 5 have multiple portfolios, covering 17% of total membership.Two plans have insurer as background organisation, two other are multi-employer plans and one is an open fund of a bank. • The participating plans offer five (1), four (2) or three (2) portfolios. All funds have a default portfolio, which is not always the least risky.One plan applies a default/technical/temporary fund of 100% Hungarian Government bonds, similarly as in the Swedish system. • The initial portfolio selection and switching from a terminating portfolio is free of charges. Two funds charge fixed amount (€8, €10), with explicit reference to the actual real costs. Another one uses this condition, with 0.2% of assets plus €2, but maximum €40, but refundable on actual calculations by the end of the year. One fund charges simply 0.1% of assets. • The plans disclose basic information about the portfolios on the internet, three revealing rules and fees, and two publishing also performance data, additionally to the required disclosure. In one plan the members are asked about their portfolio preference annually. In this plan the rate of answers with active selection is around 15%, and increasing, although about 50% of the choices select the suggested/default portfolio. Another fund offers a risk-tolerance assessment questionnaire.

11. Country examples –pension reform countries • Active choice is high in a new, immature system • Familiarity (known, domestic providers), education, costs, marital status, gender all influenced initial decision

12. Policy issues • Applicability of the life-cycle model: is it demand or supply – are we rational? • Complexity, familiarity, financial education • Applicability of portfolio selection • In Voluntary systems: • Events that trigger change of portfolio • Occupational pensions: part of compensation scheme, members may expect the assets to be invested by professionals – and it is not necessarily a problem • In Mandatory systems: • DC mandatory • Effect of guarantees • Funds really differ in returns and fees • The adequacy of information and professional advise that is provided • System/Plan design issues – adequacy to the participants/members – default options • Regulation: technically 

13. The U.S.: ERISA Section 404(c) (1992) Canada: Guidelines for Capital Accumulation Plans, Joint Forum of Financial Market Regulators (2004) Australia: APRA regulation on Managing Investments and Investment Choice (1999) Hungary: Amendments to investment regulation (2001) OECD Guidelines for the Protection of Rights of Members and Beneficiaries in Occupational Pension Plans (2003) Prudential governance and management is the same as in the case of a stand-alone fund But there are additional tasks because of multiplicity: Definition of complementing portfolios with different strategies Maintaining a default fund Support plan members’ decision making Information provision Changing and termination of a portfolio, internal transfers Complex administration, IT Costs Prudential regulation of plan member investment choice

14. …The tendency in the last several years has been to offer participants in self-directed retirement plans more and more investment options. Economists generally believe that people are made better off when offered more choices, as long as they can always choose what they had before. But when people do not have the knowledge to make choices that are in their own best interests, increasing the number of choices does not necessarily make them better off. In fact, it may make them more vulnerable to exploitation by opportunistic salespeople or by well-intentioned but unqualified professionals. … For better or for worse, these developments mean that people are being given more individual choice over their own asset accumulation and drawdown processes. .. From a social-welfare perspective, this development might actually be a step backward. Risk is being transferred to those who are least qualified to manage it. Zvi Bodie

15. Thank you for your attention! Comments and further information are welcome. Please send to Parniczky.Tibor@chello.hu