Background on the Swedish Reform

Transcription

1 Presentation at Penge- og Pensionspanelet Conference Copenhagen, Denmark, October 30, 2012 Design Choices in Privatized Social Security Systems: Learning from the Swedish Experience Henrik Cronqvist Robert Day School of Economics and Finance Claremont McKenna College Claremont, California, USA Background on the Swedish Reform In 2000, Sweden launched the Premium Pension System ( a partial privatization of the public pension system. A national defined contribution (DC) plan. 2.5% payroll tax contributed by workers to individual accounts in which they then completely control the fund allocations. 1

2 Important Design Details 1. Participants were allowed to construct their own portfolios by choosing up to 5 funds from an approved list. 2. One fund was chosen (with some care) to be a default fund for anyone who, for whatever reason, did not make an active choice. 3. Participants were encouraged (via an enormous advertising campaign) not to choose the default fund, but rather construct their own portfolio. 4. Both balances and future contributions can be changed at any time (for free), but unless some action is taken, the initial allocation determines all future contribution flows. Plan Details, Cont. 5. Any fund fulfilling certain fiduciary standards was allowed to enter the system. Thus, market forces determined the mix of funds participants could choose from. As a result of this process, there were 456 funds to choose from. 6. Funds set their own fees, except managers included in the default fund, whose fees were negotiated. 7. Funds were allowed to advertise to attract money. 8. Information about the funds, including fees, past performance, risk, etc., was provided in book form to all participants. 2

3 Analysis of Plan Details Every design choice was consistent with standard neoclassical economic principles pro choice. Alternative approach: libertarian paternalism (Thaler and Sunstein, 2003) design plan to improve the outcomes of unsophisticated participants, while maintaining the freedom of choice for more sophisticated participants. 3

4 The Default Fund For many reasons, if a fund is designated as the default fund, many participants will end up choosing it. Reasons include: Status quo bias (Samuelson and Zeckhauser, 1988) Procrastination Implicit endorsement by plan designers (possibly unintended). In 401(k) plans in the U.S., when participants are automatically enrolled into the plan, the vast majority select the default fund (e.g., Madrian and Shea, 2001). Possible Default Fund Options A. Participants are not given any choice: The default fund is the only fund offered B. A default is designated, but its selection is discouraged. C. A default is designated, and its selection is encouraged. D. A default is designated, and its selection is neither encouraged nor discouraged. E. There is no default option; participants must make an active choice or they forfeit their contributions. The Swedish plan designers adopted option B, and spent millions of dollars on an advertising campaign encouraging participants to choose their own portfolio. 4

5 Other Default Options If the plan designers think that participants will generally do well choosing for themselves, then perhaps E (no default & forced choice) should be preferred to B. Alternatively, if the planner thinks that participants would generally be better off with the default than with their own mix, then C (encourage the default) or even A (only the default) might be better. Effective Lobbying for Active Choice The advertising/information campaigns to encourage active choice worked: 66.9% constructed their own portfolio. 5

6 Extensive Fund Advertising According to the Premium Pension Authority in Sweden, the coverage of the pension reform in media in Sweden in 2000, was significantly larger than the coverage of the Sydney Olympics the same year! Advertising Fee-advertising, 7.9% Non-informative advertising, 62.1% Performanceadvertising, 30.0% 6

7 Post-Launch Sign-Up Experience As new participants enroll (mostly younger workers) they go through the same process, but without the advertising to encourage active choice: In the original sign-up period, 56.7% of those under 22 made an active choice, but only 8.4% of those joining in 2003 did so. 80.0% 70.0% 66.9% 60.0% 56.7% 50.0% 40.0% 30.0% 20.0% 10.0% 18.0% 14.1% 8.4% 0.0% 2000 (population) 2000 (age <= 22 years) Equity Allocations in the Default Fund and Mean Chosen Funds Asset Allocation Default Fund Mean Chosen Funds Equities 90% 96.2% Sweden 17% 48.2% Americas 35% 23.1% Europe 20% 18.2% Asia 10% 6.7% Hedge Funds 4% 0% Private Equity 4% 0% 7

8 Other Portfolio Characteristics Default Fund Mean Chosen Fund Fixed Income 10% 3.8% Indexed 60% 4.1% Average Fee 0.16% 0.77% Ex Post (3 year) Performance -29.9% -39.6% Chasing Recent Past Returns The largest market share (aside from the default fund) went to Robur Contura which received 4.2 percent of the investment allocations. This fund invested primarily in technology (e.g., dot-coms ) in Sweden and elsewhere. Its performance over the five year period leading up to the choice was 534%, the best of the 456 funds in the menu to choose from. In the three years after the reform, it lost 69.5% of its value. 8

9 Long Lasting Effects Although the initial account balances were small (average was about $1,500), the welfare costs can be very large if participants (i) choose mean-variance inefficient portfolios and (ii) do not make changes. In the first three years after the pension reform, the percentage of participants who made no changes to their portfolio during the year was 98.3%, 97.3%, and 96.9%, respectively. Conclusions for Pension Reform If any choice is given, it might be better to just have a small number (3-5) well-diversified (index) funds with varying risk and negotiated fees. Even just one fund is probably OK. People can adjust their portfolios elsewhere. 9

10 Swedish Model: Great in Principle Market-oriented and pro choice for individuals. Competition: Any fund which met EU s fiduciary standards for funds was allowed to participate. Information: Educate the (unsophisticated) participants and encourage them to seek relevant information in the market, i.e., from funds themselves, Morningstar, etc. Investor heterogeneity: Encourage each investor to construct a portfolio that is efficient for him/her because one (default) fund doesn t fit all. Maintain safety net with a reasonable default fund. But Not Without Problems Many participants, particularly the youngest, probably failed to realize the importance of the decision (e.g., $500 in initial account looks like peanuts ). But if no rebalancing, they effectively make decisions for the present value of all lifetime contributions. Competition created lots of choices for investors, but confusing to choose among as many as 456 funds. Unsophisticated investors became (surprisingly) active, but failed to become informed. Collecting relevant information can be very costly (e.g., meeting with independent financial advisor). An advertising-based choice is so much more convenient. 10

11 Problems, Cont d Profit-maximizing funds have strong incentives to attract and lock in fund flows (=fees), but no incentives to educate the general public unless it pays off for the fund itself. Politicians and policy-makers should not be naïve about this! The timing: The end of the dot-com bubble. Ex post, this was disastrous, but pension reforms are most likely for political reasons to take place in boom times (not busts). When people see 5-year past return numbers of 534%, many go for such funds even if the government and funds must state past performance is no guarantee of future results. It s in our genes to exhibit such performance chasing behavior. General Conclusion Economists often believe that the biases observed in psychologist and economist laboratories will be eradicated in open markets. The Swedish experience shows how just the opposite may take place! Markets, in combination with advertising, reinforced individual biases: Invest in home market (familiarity) Chase recent past returns (extrapolation) Active fund management (overconfidence) 11

12 Suggested Readings Cronqvist & Thaler: Design Choices in Privatized Social Security Systems: Learning from the Swedish Experience, American Economic Review, Thaler & Sunstein: Nudge, Chapter 9 ( Privatizing Social Security: Smorgasbord Style ), Cronqvist: Advertising and Portfolio Choice, Working Paper, Cronqvist & Siegel: Why Do Individuals Exhibit Investment Biases?, Working Paper, henrik.cronqvist@cmc.edu Thanks! 12