Report Argues for Mandatory Participation in a Small Number of Pension Funds

Authors: Tito Boeri (Bocconi University, Fondazione Rodolfo Debenedetti and CEPR), Lans Bovenberg (Netspar and Tilburg University), Benoît Coeuré (Ecole Polytechnique) and Andrew Roberts (Merrill Lynch International)

Pension funds are becoming the largest institutional investors in global financial markets. They help individuals save for their old age and protect the value of their pensions. However, pension funds operate in an environment characterised by a number of serious market imperfections - poor financial education of investors and managers, informational asymmetries, labour, product and capital markets imperfections. In the eighth CEPR\ICMB Geneva Report on the World Economy Report 'Dealing With the New Giants: Rethinking the Role of Pension Funds' the authors take a stance on a number of controversial issues concerning the future of pension funds:

• Reforms involving a higher retirement age and lower pension benefits face serious political obstacles. The authors therefore favour automatic adjustments in PAYG pensions, such as indexing pension benefits and the retirement age to the evolution of longevity. Notionally Defined Contribution (NDC) systems incorporating such adjustments are being gradually introduced in Italy, Latvia, Sweden and Poland. They offer a blueprint for other countries. The explicit risk-sharing agreements in these NDC systems alleviate political risks and facilitate planning for retirement
• Households lack the basic financial knowledge and computational ability to implement complex financial knowledge over the life cycle. Individual pension plans also involve high costs and a substantial risk of misselling. Mandatory participation in collective pension plans offering a limited number of default choices can avoid this.
• The Report therefore argues for limited freedom of choice for individual participants, but substantial competition for various asset management and other services that pension funds can contract out, taking advantage of an integrated market for financial services. Competition would therefore occur at the wholesale rather than the retail level.
• Occupational pension schemes in which corporate sponsors guarantee pensions to their employees are being increasingly replaced by stand-alone pension funds in which participants share risks among themselves and on capital markets. The authors of the Report welcome this development. Capital markets increasingly allow workers and retirees to diversify financial risks so that they become less dependent on the firm they work for.
• The Report also argues in favour of hybrid pension systems in which participants transform their risky, defined-contribution type, claims into guaranteed defined-benefit type claims as they grow older. By exploiting the longer horizon of younger participants to buffer shocks, pension funds can indeed alleviate the tension between facilitating macroeconomic stabilization and enforcing the market discipline associated with mark-to-market valuation.
• The authors argue for harmonisation of accounting standards based on mark-to-market principles and better reporting to individuals about their accumulated pension rights, on the basis of the Swedish "orange envelope" system.
• Aging calls for more accumulation, better maintenance and more intense use of human capital and entrepreneurship in addition to fiscal discipline and additional private saving. A higher effective retirement age raises the return on human capital by lengthening the horizon for investments in human capital. More flexible labour markets for elderly workers should allow the speed and extent of phased retirement to act as a buffer for absorbing aggregate financial market and aggregate longevity risks.

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