sou · H7B344 · 2019-11-04 00:00:00 — (RiR 2014:13) and the report of the Inspectorate Choice of traditional insurance or fund insurance on retiring [Val av traditionell försäkring eller fondförsäkring vid pensionering] (ISF 2014:26). Individuals’ low level of financial literacy creates a market for both unprofessional and professional advice One area in behavioural economics, called financial literacy, examines the extent to which individuals are capable of making well-founded financial decisions. One central conclusion is that many adults have deficient knowledge of fundamental financial concepts and difficulty in performing simple calculations. One result is that many savers have considerable difficulty in understanding and assessing the impor- tance of fees and returns and that this has consequences for their ability to make rational choices. Without knowledge of the difference between equities and fixed income it is probably difficult for savers to compose an adapted portfolio and manage it efficiently for the rest of their lives. [the Swedish Financial Supervisory Authority] is doing mapping work on the financial literacy of Swedes in coopera- tion with external researchers. The results show that there are great differences in numeracy and financial skills in the Swedish adult population. Poorly educated people and low income-earners show weaker results.44 When individuals feel that they need to deal with their pension but realise, at the same time, that they do not have the ability to do so, a market comes into being to exploit this discrepancy. Since the introduction of the premium pension system an extensive advisory market has emerged. The first premium pension advisers, called the ‘asset management companies’, began to offer their services as early as 2005. This service meant that the companies took over asset management in return for a fee. The most expensive asset manage- ment services cost around 000 for one year’s management excluding the fund management fee; compared with which the default option, AP7 Såfa, costs an average of around per year.45 In 2011, as a commission from the Government, the stopped the ‘large-scale fund switching’ initiated by the asset management companies. After this intervention, the large asset management companies transferred savers’ assets to their own funds, 44The memorandum Numeracy and financial skills [Räknefärdighet och finansiell förmåga], , and (2015), annex to Finansinspek- tionen’s memorandum Half of consumers lack basic financial literacy [Hälften av konsumenterna saknar grundläggande finanskunskaper] (FI reg. no 151579). 45The average premium pension fee for savers with AP7 Såfa is currently around and the average fund management fee is around , source . which were specially created for the premium pension system. These funds were then often marketed through aggressive, and sometimes misleading, telemarketing. It was estimated that in 2016 around 440 000 pension savers, or just over a sixth of pension savers with their own portfolio, were using asset management services for the management of their premium pension funds.46 So these savers were paying someone else to manage their freedom of choice. International experience in line with ’s It is a global problem that, as buyers of financial products, savers are seldom knowledgeable about the goods – so high fees can be charged and extensive marketing put in place that generates switches from good and cheap products to worse and more expensive ones. The fact that savers are not knowledgeable about the goods is not only due to savers themselves but is also because the characteristics of the goods are not, and cannot be, well-defined and are, instead, only described on the basis of historical experience using statistics that are of unclear or, at any rate, uncertain importance for the future characteristics of the goods. A change of approach is under way in several other countries as part of various pension solutions – a change from a conviction about the possibilities and interest that individuals have in making choices to an understanding of how individuals actually behave in practice. Australia47 introduced a funded occupational pension scheme in the 1980s. The products offered quickly turned out to be both expensive and complicated. A supervisory authority was set up and tried to increase transparency about fees and returns and to permit switches between products. It was hoped that individuals’ rational behaviour would lead to them not choosing the bad products and that this would drive the market towards the best ones. But the switch rate was low. Instead an advisory industry emerged. In recent years the inability of the market to solve the problems has become 46Customer problems reported in the premium pension area [Rapporterade kundproblem inom premiepensionsområdet (PID156383)], 2017, p. 47The descriptions of , and the UK are partly taken from the Pilot study of possible structural changes for a more secure and more efficient premium pension system (2017/03516/SF). Many savers who have made a choice have made it on the recommendation of an adviser, and this led to a discussion about commissions – which have since been prohibited. The authorities have drawn the conclusion that further transparency and informa- tion will not lead to individuals being better able to make rational decisions about their pension saving. At present a policy discussion is under way about viewing occupational pensions as an institutional market rather than a consumer market. was one of the first countries to move from a defined- benefit to defined-contribution system, doing so in connection with the reform of its occupational pension system in 1982. Special com- mercial pension funds were created, known as AFPs (Administradoras de Fondos de Pensiones). They were only allowed to offer one product and there was clear detailed regulation. The assumption was that, with a standardised product, competition between AFPs would lead to lower costs and better quality for savers. the next 20 years, AFPs did not compete on price but by offering savers gifts (such as toasters, trainers and bicycles). Fees and costs for savers were high: in 1994 they amounted to 10 percent of annual premium payments. Critics argued that the costs of freedom of choice – between pro- viders of what was in practice a standardised product – had become too high, partly because competition based on price did not work. If the AFPs were allowed to offer more than one product, competition would increase and the costs of the system decrease. In 2002 the system was reformed, giving AFPs the right to offer five generation fund profiles that individuals could choose between. The increase in freedom of choice turned out not to solve the basic problem of high fees. To improve competition, an auction was introduced in 2008, with the various AFPs having to submit bids. The winner of the auction received all premiums from new savers over a two-year period, but the fee level also had to be offered to existing . The auction mechanism resulted in lower prices, but 80 percent of savers still chose to stay with their original AFP, paying a higher price than necessary. Only one AFP participated in the most recent auction in 2016. Recently a state-owned AFP was proposed. ’s experience shows that despite a standardised product offer- ing and a large difference in price, many people still chose not to engage with the system. failed to appear, and market forces did not succeed in giving individuals an attractive price for a standardised product. In 2008 the UK introduced a statutory occupational pension reform known as auto-enrolment, which meant that employers had to offer employees an occupational pension that the employee could then opt out of. The funding of the system is favourably structured, so that it is normally rational for employees to opt for an occupational pension. The default option is to have an occupational pension, i.e. individuals must actively decide to opt out. This has led to a very large share of employees now saving for an occupational pension. The share actively opting out of saving for an occupational pension is around 5 per cent. The freedom of choice in the system lies with the employers, who procure the pension provider they want. The () is a state-financed provider that is obliged to accept all employers that want to become . In other respects, competes with other operators in the auto-enrolment market. Because the State introduced a low-price operator in the market, the general price level for occupational pensions has fallen. Previous insurance solutions in the UK often had large fund marketplaces. Distribution took place via independent financial advisers, who used the fund marketplace to compose portfolios for their . Since the auto-enrolment reform was introduced, the market has moved in the direction of being simpler for , and this has eliminated the need for advice and reduced costs. The ban on commission-based sales has also had an impact. The new providers in the occupational pension market offer much simpler products. offers no fund marketplace; instead, it has a default option, which contains 98 percent of the savings capital, and a few optional off-the-shelf package solutions. There is also a commercial provider that only offers a default option without any selectable options. In the US the national pension, , is an income- related defined-benefit pension. In addition, there is voluntary occupa- tional pension saving offered via employers. The majority of these plans are defined-contribution plans and are called 401(k) plans. Per- sonal accounts are linked to them, and both the employer and the employee can make deposits in the accounts. There is no real equivalent of collective bargaining agreements, and deposits are made on a voluntary basis. The most common model is for the employer to match the sum deposited by the employee. than half of all employers in the US make provisions to some form of occupational pension. Employees can deposit a maximum of around 25 per cent of their income in this pension saving. For employers the defined-contribution 401(k) plans are cheaper than defined-benefit plans. The plans play an important role in a changed labour market in which employees are more mobile and have more employers. Furthermore, they give employees a sense of being in control of their pension saving, and the possibility of invest- ing some of their pension assets in the capital market. However, the 401(k)-plans in the US have been criticised because the system requires pension savers to take far too difficult and com- plicated decisions: about whether, and how much, money to deposit, about how to invest the assets, about how to view their old plan when they change jobs and about how much money to draw and how to manage it during the payment period.48 Fund managers have also been accused of not primarily looking to the best interests of savers and of instead using the pension plan as a marketing and distribution channel for their own, often under- performing, funds. Fund managers tend to make decisions that have an adverse impact on savers’ pensions at the same time as savers do not behave as well-informed consumers by choosing not to join these managers’ funds.49 When it comes to how administrators of fund marketplaces select funds for 401(k) plans, these administrators have been criticised because the funds selected perform worse than their index, at the same time as fund switches in the fund marketplace seldom generate a better return since selection tends to be based on historical returns. Pension savers’ own investment strategies very rarely provide any added value.50 Employers who offer 401(k) plans have to administer the plans “solely in the interest of the participants and beneficiaries”.51 This 48Coming Up Short. of 401(k) Plans, . Munnell and , 2004. 49Are 401(k) Investment Menus for Plan Participants? Pool, and , 2015. 50How Do Employers’ 401(k) Selections Affect Performance? . , . and . , 2013. 51United State Code 29 § 1104 (a) (1). definition has been the subject of a large number of lawsuits in recent years that have dealt with unjustifiably high costs and inappropriate investment arrangements. The key issue has often been whether the plan has been enough in its investment decisions. The legal proceedings have led to some self-regulation with more cheap index funds and other ways of reducing costs. There is, however, criticism that the litigation inhibits innovation and product development. One of the largest 401(k) plans is the federal employees’ Thrift Sav- ings Plan (TSP) with some 5 million savers and over billion in assets. TSP pension savers can choose between six different funds: a Lifecycle fund, a fund (Treasury bills and bonds issued by the federal government), a Fixed Income Index fund (mixed bonds), a Common Stock Index fund, a Small Capitalisation Stock Index fund and an International Stock Index fund. Summing up, it can be concluded that the pension systems of the countries described above have a different design from the Swedish system and function in a different environment and culture. There are, however, distinct similarities concerning experience of how indi- viduals behave, or do not behave, and of how the advisory market grows when the system becomes too complicated. The Inquiry can conclude that neither information, transparency nor standardisation is of any help if the product sold is too complex for most individuals. Choice architecture is the key to a well-functioning premium pension system The Inquiry’s proposal: The choice architecture of the premium pension system should encourage pension savers to make informed and considered choices about how to invest their premium pension assets. The Inquiry’s assessment: The premium pension system should be designed and administered in such a way that only savers who want to and can compile their own fund portfolios in the fund marketplace do so. A well-considered and well-maintained choice architecture, which provides support and guidance, is crucial in ensuring that this will come about. The selection of funds in the way done by insurance providers in, for instance, the occupational pension system counters some of the problems faced by individuals when choosing funds in the premium pension system. Reasons for the Inquiry’s proposal and assessment The Inquiry’s terms of reference state that the starting point for the reformed premium pension system should be the default option. They also state that, in addition to the default option, there should continue to be a fund marketplace for the premium pension with funds that have different investment approaches and risk profiles. The fund marketplace should offer real freedom of choice and make it possible for savers to take on responsibility for the management of their assets. Furthermore, the Pension Agreement and the state- ment of the remit of the review of the default option says that it should be possible to adjust risk upwards or downwards as part of the default option.52 Our terms of reference and the Pension Agreement note that the present design of the fund marketplace makes the choice situation difficult for most savers and risks leading to irrational choices that do not benefit savers. They also say that the State should take more responsibility for designing the premium pension system on the basis of how people actually behave and not of how it is considered they ought to behave. The starting point of the reformed pension system should be the default option and it should be a cost-efficient, secure and stable pension insurance that does not require deep knowledge or any action on the part of pension savers. As regards the transition from the default option to the fund marketplace our terms of reference state that pension savers who choose to invest their premium pension assets in one or more funds in the fund marketplace should be informed that, by doing so, they take over the responsibility for choices and the maintenance of choices. should take more responsibility than it currently 52Fi2019/00913/FPM. does for the choice environment offered being comprehensible, reli- able and secure. Our terms of reference also state that funds in the fund market- place should be procured on the basis of principles of freedom of choice, sustainability and controllability. The funds should be of good quality and the range of funds should be sufficient to maintain real freedom of choice. Lessons from behavioural economics One prominent conclusion of behavioural economics research is that individuals seldom behave in a rational way in the type of decision situation that arises in pension saving. This is why designing a well- considered choice architecture is a central task for insurers providing pension insurance. One starting point is that even relatively small changes in the decision situation can make it simpler for individuals to make decisions that promote their own welfare, and sometimes also collective welfare, without limiting their own freedom of choice. This corresponds to what is called ‘libertarian paternalism’ or, put simply, nudges53 or behavioural insights (BI)54. As early as a couple of years after the introduction of the premium pension system it was noted that pension savers faced considerable difficulties in choosing from the large range in the fund marketplace. In the report Difficult to navigate? Premium pension savings on the right course the inquiry chair argued for dividing savers into three categories: 1.Savers who cannot or do not want to choose. These savers should have the default option. 2.Savers who want to but cannot choose. These savers need deci- sion support. 3.Savers who want to and can choose. These savers are able to cope with the fund marketplace by themselves. 53Nudge, Improving Decisions about Health, Wealth and Happiness, and , 2008. 54OECD (2019), Tools and Ethics for Applied Behavioral Insights: The BASIC Toolkit, , . The Inquiry considers that the overall experience gained in recent years and the compilation made of behavioural economics research above show that the needs analysis made in the report Difficult to navigate? Premium pension savings on the right course is no longer fully relevant. Relatively deep knowledge and continuous engage- ment are required to be able to make long-term financial decisions about pensions. A reasonable starting point regarding what know- ledge should be assumed for anyone choosing funds in the fund marketplace is that they have the ability to: •assess their individual risk preference •assess their ability to withstand losses •assess what knowledge and engagement different funds require over time •evaluate and maintain their choices throughout their saving period on the basis of the composition of their portfolio. Many pension savers do not have this knowledge and these abilities. is it reasonable, as part of a compulsory social insurance system, to demand such knowledge and abilities, or to build the design of the system on the basis that savers have this knowledge or these abilities. The experience of the system up to now also shows that, in practice, it is not possible to supply such knowledge and abilities for a broader group of pension savers through decision support or finan- cial education of the population. People who cannot compose and manage a well-diversified portfolio should therefore not do so either. They should even less be encouraged to do so, either directly or indirectly. Behavioural economics research indicates that these people should stay in the default option. Moreover, the conclusions of behavioural economics and the experience from the premium pensions system so far gained point to a considerable imbalance between those faced with choosing a financial product (pension savers) and those supplying the product (fund managers) in terms of knowledge and information. This is probably at least part of the reason why almost all insurers in the occupational pension system apply a selection procedure. The selec- tion procedure means that funds judged to be less well-placed than others to give a good return are weeded out or, as is most common, the funds judged to be best placed to give good returns are selected (see section 6.5). Viewed in the light of the experience of the pre- mium pension so far and of the conclusions of behavioural economics, the Inquiry sees no reasons why the State as an insurance provider should act differently. The Inquiry considers that the premium pension system should be designed and administered in such a way that only individuals who both want to and can compose appropriate portfolios for pen- sion saving do so. It is, of course, not possible to guarantee that this will happen in every instance, but the system should be designed and administered in such a way that it happens as far as possible. A well- considered and well-maintained choice architecture is the most important instrument to ensure that savers who do not want to choose funds, or who lack the knowledge to do so, save in the default option instead, while those who both want to and are able to choose funds themselves do so in the fund marketplace. So, only savers who have sufficient knowledge ought to choose funds in the fund marketplace, but this does not mean that these savers should be left to do so without support and good tools for choosing funds. In the view of the Inquiry, a well-considered and well-maintained choice architecture should supply relevant informa- tion based on the needs of the target group and build on modern information technology. features of a new choice environment The Inquiry’s proposal: The definition of choice architecture in the premium pension system should be the structure of choices that a pension saver is faced with and the support and information that is given when a pension saver chooses how their pension assets will be managed. The choice architecture in the premium pension system should be designed to make the default option the starting point for all pension savers. For those who want to make their own choices there should be a possibility of choosing a risk level in the first place. After that, it should be possible to choose between different fund categories. Finally, it should be possible to choose between procured funds in the fund marketplace. A choice of risk level, fund category and fund in the fund marketplace should be preceded by the saver being given written information about the meaning of the choice. The saver should also confirm in writing that they have read this information. A request to switch funds should, as at present, be made elec- tronically in the first place. The choice architecture should be developed continuously. The new agency should be able to issue more detailed regula- tions about the choice architecture. Reasons for the Inquiry’s proposals Behavioural economics research shows that economic theories about individuals making rational choices in well-functioning markets do not stand up in practice in many industries. This applies to pension saving in particular since it involves complicated products and very long-time horizons for the individual. The demands made on the ability of individuals to compile an efficient and well-diversified invest- ment portfolio also exceed most individuals’ knowledge for and interest in this matter. This has also created an advisory market, which was not the intention of the freedom of choice in the premium pension system. Therefore, an appropriate choice architecture needs to be intro- duced for the premium pension system. Choice architecture means a logical structure of the choices a pension saver is faced with when the pension saver is to choose how to invest their pension assets.