On the Choice Between Group-Based and Individual-Based Pensions--The Role of Financial Education

1. On the Choice Between Group-Based and Individual-Based Pensions--The Role of Financial Education Dean M. Maki Vice President and Economist Putnam Investments Presentation to Contractual Savings Conference at the World Bank, April 30, 2002

2. The Choice Between Group and Individual-based Pensions • What should be the goals of policy? • Ensuring adequacy of retirement living standards • Encouraging saving? • Increasing welfare of population • Should these goals be met through group or individual-based pension schemes?

3. Retirement Saving, Asset Allocation Decisions are Difficult • Individual or group must decide: • Amount of saving needed • Allocation among investment types • Individual must also decide: • Individual security vs. mutual fund vs. variable annuity • Active vs. passively managed fund

4. Probability distribution of: Rate of return on stocks, bonds, cash, home prices Income growth Inflation Investor for a group may have informational advantage on these items Individual-specific items Desired retirement age Desired bequest Expected lifespan Expected time path of health Risk aversion Discount rate Individual has informational advantage on these items To Make Optimal Saving and Asset Allocation Decisions, Investors Must Assume:

5. Strengths of Group-based Systems • Professional managers generally more knowledgeable about financial topics than individuals • Economies of scale; lower transaction costs • Greater certainty of nominal benefit payouts • May encourage development of more efficient capital markets

6. Weaknesses of Group-based Systems • Not necessarily a match between individual goals and benefit payout formula • Diversification, economies of scale can be achieved through voluntary mutual fund saving • What is the market failure that a mandatory group-based system is meant to fix?

7. Strengths of Individual-based Systems • Can map individual goals into saving rates, asset allocation • Individual may buy annuity to match group-based outcome--though adverse selection may prevent this • Individuals appear to “re-optimize” quickly in other complicated decisions, e.g. tax law changes, response to mortgage interest rates. • Why is the retirement decision different?

8. Weaknesses of Individual-based Systems • Individuals are often ill-informed about financial topics, how can they make good decisions without knowing basic facts? • Only 52% of US households could name the security class with the highest return over the last twenty years. (Maki, Brookings volume, 2001) • The answer has been the same for over 55 years

9. Weaknesses of Individual-based Systems • Individuals may not save “enough” for retirement • Why? • Lack of knowledge, information • Discount rate that is “too” high • The answer to this question is likely to define the optimal structure of a group-based system

10. Should Policy-makers Encourage Group or Individual-based Plans? • The “optimal” retirement system is likely a hybrid of group- and individual-based plans • The optimal mix offers a retirement income floor; individuals take responsibility for generating income above that floor • Optimal mix is a complicated function of societal preferences for equality vs. efficiency, state of financial development

11. The Role of Financial Education • Financial education may mitigate some weaknesses of systems that are partly individual-based • My research suggests financial education makes individuals more knowledgeable and changes their behavior

12. Types of Financial Education • Workplace Financial Education • Written materials, seminars, workshops • Asset allocation, retirement income needs • Often related to 401(k) plans

13. Types of Financial Education • High School Financial Education • Budgeting, money management, credit, and saving and investing • Saving and investing may cover financial instruments, risk & return, and diversification

14. Financial Education and Financial Knowledge • Maki (Brookings volume, 2001) • 1995 survey of households, estimate probit models • Dependent variables measure knowledge of: • Historical relative asset returns • Pension plan features (matching provisions, match rate, loan option)

15. Financial Education and Financial Knowledge • Results • Financial education is correlated with knowledge of relative asset returns • Respondents with workplace education 10% more likely to answer correctly • Respondents with high school education 14.5% more likely to answer correctly

16. Financial Education and Financial Knowledge Results • Results • Workplace education reduces ignorance by 20% • High school education reduces ignorance by 11% • Financial education appears to increase knowledge, does this translate into changes in behavior?

17. High School Financial Education & Saving • Bernheim, Garrett & Maki (Journal of Public Economics, June 2001) • State-level mandates passed in 1970s • Household survey in 1995 • Compare saving among households in “mandate” and “non-mandate” states

18. High School Financial Education & Saving • Results • Financial education increases saving • Saving rate 1.5% higher among those exposed to a mandate in effect for five years • Effect is greater among respondents whose parents were poor savers

19. High School Financial Education & Saving • Results • Financial education increases wealth • Wealth higher among those exposed to a mandate by one year’s worth of earnings • Effect is greater among respondents whose parents were poor savers

20. Policy Implications • Financial education increases financial knowledge • Increases savings and wealth • Shouldn’t rely solely on models of fully rational & informed agents to assess possible changes to saving policy

21. Policy Implications • Stimulating saving through tax incentives is controversial • Substitution for other saving? • Regressive • Financial education has neither of these possible downsides and is relatively inexpensive

22. Policy Implications • Financial education may have other important effects • Even for an individual who does not save more, asset mix may change (Muller, 2000) • Financial literacy correlated with lower number of personal bankruptcies (Mandell, 1998) • Generous provision and support of financial education should attract little controversy