Ignazio Visco: Retirement saving and the payout phase - how to get
there and how to get the most out of it
Keynote speech to the roundtable on "The impact of the payout phase on financial markets"
at the OECD conference "The payout phase of pensions, annuities and financial markets",
Paris, 12 November 2008.
I am greatly indebted to Giuseppe Grande and Pietro Tommasino for their help and many useful discussions.
* * *
The implications of population ageing for financial markets have long been a subject of
discussion for public authorities, financial intermediaries and academics. Over time we have
become aware that ageing has a deep impact on the structure of financial markets and, at
the same time, that this structure strongly affects the way in which demographic trends
spread through the real economy. A leading role in this process has been played by the
OECD.
1. Times are changing for pension funds
Retirement - related saving schemes offered by pension funds and other intermediaries
have developed considerably during the 1990s, as workers have relied increasingly on
capital markets to sustain their consumption in old age. By the early years of the current
decade some issues had reached the forefront of the policy debate, notably the importance
of aggregate longevity risk, the transfer of risk from governments and corporations to
households, the impact on financial markets of current and prospective reallocations of
pension fund portfolios, and the ability of the regulatory and supervisory framework to adapt
to the rapid changes in the supply of retirement saving schemes. These issues were
comprehensively analysed in a G10 Report on the implications of pension system reform for
financial markets, published in 2005.1 A wide range of policy options were drawn, along the
three directions of strengthening the risk management practices of providers of retirement
saving, promoting the supply of suitable financial instruments, and raising the standards of
investor protection and financial education.
Today, those policy conclusions are all the more significant. If anything, the current financial
crisis reinforces the need to develop effective ways of protecting retirement saving. However,
it may make it harder to adopt appropriate instruments to hedge the risks that may in the long
term affect the payout of pension benefits.
The severity of recent financial market developments certainly justifies the tendency to
concentrate on the short term. The crisis is especially costly for senior workers, whose
pension wealth, both inside and outside pension plans, has been dented by the sharp
decrease in asset prices. As in previous financial markets downturns, some of these workers
may react by postponing retirement. In certain cases this might not be enough, and an
argument could be made for public intervention (for instance, in the case of workers near to
retirement whose pension benefits would mostly derive from mandatory private pension
schemes). This situation also calls, however, for measures to improve the future working of
pension systems. The current crisis has only highlighted the urgent need for
betterfunctioning markets and better retirement products, if future retirees are to be guaranteed
adequate living standards.
We cannot regard the current events as just one more protracted period of high financial
market volatility, to be followed sooner or later by a return of investors' expectations and risk
premia to more comfortable levels. The financial crisis has already proved to be a watershed
for the international financial system and it is changing the attitude of public authorities
towards banking and capital market regulation. It might also deeply affect the propensity of
private investors to take risks. It will not be business as usual anymore.
The pension fund industry has already been hit very badly by the crisis. In the four quarters
ending in June 2008, in the United States the pool of assets managed by funded private and
public pension schemes has declined by more than 9 percentage points, or almost 900 billion
dollars. Since then losses have probably doubled, given the collapse of bond and stock
prices. Pension funds have also invested a huge amount of resources in troubled assets:
according to IMF estimates, potential write downs on US loans and securities range between
125 and 250 billion dollars.2
The current financial crisis raises several questions about the established practices of the
retirement saving industry. Consider, for instance, the major changes concerning credit rating
systems, which play a key role in the portfolio management of pension funds in every
country; or the uncertain perspectives of the investment banking industry, which provides
companies and investors with such essential services as securities underwriting and trading,
asset management, and M&A advice; or again the upsurge of counterparty risk on OTC
derivatives, which pension fund managers have used increasingly to try to improve portfolio
risk management. It is now difficult to figure out how financial intermediaries and markets will
adjust to these structural changes.
More importantly, the global banking crisis that still engulfs intermediaries and markets
threatens to cast a shadow on the very notion that financial markets could be a reliable
source of retirement income. More than the never-ending dispute of the pros and cons of
equities versus bonds, the focus is increasingly on the ability of financial markets to assure
workers a sufficient level of retirement income even over long-term investment periods.
Beyond the unresolved issue of aggregate longevity risk, we need to think whether workers
should be left alone to deal with financial markets tail risks (i.e. the fact that extreme losses
tend to be more frequent than it would be by chance in normal conditions).
Even the decision to join a pension fund (where private pension plans are not mandatory) is
likely to be seriously affected by the crisis. Investors' confidence in the soundness of financial
intermediaries and markets has been shaken and this may well spread disaffection among
workers, notably with respect to pension funds' defined contribution (DC) schemes. Workers
may feel less able than in the past to make difficult decisions about the appropriate level of
contributions and dependable asset allocation.
The phases of accumulation and decumulation are closely intertwined: the optimal design of
the former strongly depends on the latter and vice-versa. I will start from the accumulation
phase, because before dealing with the issues posed by the payment of pensions, we have
to be sure that workers will actually have something to decumulate when they retire.
2. The importance of pension funds has continued to grow
In this decade the pension fund industry has continued to expand relative to the size of the
economy, although at a slower pace than in the 1990s (Table 1). At the end of 2006 total
OECD funded pension assets (including occupational and personal arrangements) amounted
to about 24.6 trillion dollars, or 76 percent of GDP. Asset growth has differed considerably
across OECD countries, being stronger in those economies where pension funds are
welldeveloped (Figure 1).
There has also been a further move from defined benefit (DB) to DC schemes. Generally, the
latter have been adopted in countries where private pension schemes have been introduced
to complement and compensate the prospective downsizing of public pension systems.
However, available data also show that, in countries where DB and DC schemes coexist, the
latter have increased further as a share of total assets (Table 2).3 In particular, DB
occupational plans have continued to lose ground in the United States, where they have a
long tradition. According to the Employee Benefits Survey of the Department of Labor, the
percentage of private industry workers participating in defined contribution plans has
increased from 36 percent in 2000 to 43 percent in 2006. In the United Kingdom, too, there is
evidence of a further shift from DB to DC schemes, in line with the findings of the Turner
Report.4
Underlying these trends there are well-known structural factors, such as those reviewed in
the G10 Report. Ageing populations and the shrinking coverage provided by public pension
systems call for an increase in the pool of resources channelled to capital markets to provide
for retirement. In several countries changes in labour markets and concerns about future
pension liabilities are prompting employers to close DB plans and offer DC plans instead.
These profound structural changes in pension systems imply that the sources of retirement
income in the future will differ considerably from those of current retirees. This is highlighted
by a recent survey of US working-age and retired citizens (Table 3). While only one third of
retirees report that they also depend on some kind of retirement savings plan, workers'
expectations regarding the future sources of retirement income show a much greater role of
both funded pension schemes (such as 401(k) plans and Individual Retirement Accounts)
and other forms of personal saving. This evidence provides further indication that future
retirees will depend heavily on savings as a source of retirement income, and specifically on
DC pension schemes.
3. Retirement saving should increase further
The present crisis creates problems for DB pension plan sponsors (which are the residual
risk bearers of the plan) as falling asset prices reduce asset/liability ratios and might
ultimately require higher contributions. Partial relief is provided by the increase in yields on
corporate bonds, which are used in several countries to discount pension fund liabilities.
Several observers have raised concerns about the generalized adoption of market-based,
fair value accounting principles. The new accounting standards undoubtedly improve balance
sheet transparency and comparability by limiting sponsor companies' discretion in pension
fund accounting practices. However, this may well have intensified the pro-cyclicality of
financial market trends, given the importance of pension funds in many countries and their
unique role as long-term investors, and may have encouraged pension fund managers to
focus on short-term trading.5
Even more importantly, the crisis may make DC plan members less confident about taking
complex decisions. DC plans require workers to make a number of difficult choices, such as
whether or not to enrol, how much money to contribute, how to invest it and when to
rebalance the portfolio. A serious risk that DC plan members face is not saving enough for
their old age. Contributions to DC plans tend to be low.6 Many factors may account for
workers' tendency to under-save:
• Left alone to decide how much to contribute, people seem short-sighted and may
lack willpower. Recent survey evidence on a representative sample of 51-years old
or older US citizens has shown that almost 30 percent of respondents have never
thought about a saving plan for retirement. Moreover, only 60 percent of the
"planners" were able to stick to the plan.7
• Workers are also very poorly aware of the degree of coverage provided by their
retirement income sources. In Italy, for instance, ten years after three reforms that
dramatically reduced the prospective replacement rates of public pension (i.e. the
ratio between pension benefit and last pay at retirement) for many workers,
adjustment to the new conditions is far from complete and is proving slower for the
cohorts and employment groups most affected by the reforms. For example,
middleaged and young self-employed workers expect a replacement rate of about 60
percent, which is 20 percentage points higher than the rate consistent with current
legislation.8 This is also true for the funded component of pension wealth, as US
surveys tend to find that employees are very poorly aware of the characteristics of
the plan they are enrolled in (e.g. whether it is DB, DC, or mixed).9
•
What is worse is the fact that DC plan members are likely not even to consider the
problem of setting a target replacement rate for their accumulation plan. This is
especially worrying as decisions about contribution rates and asset allocation
depend very much on key forward-looking parameters, such as the foreseeable
trend of labour income, the planned retirement date, the target pattern of retirement
income, and the intensity of the bequest motive. Without a target replacement rate,
workers might become aware they have saved too little only when they retire and
are no longer in a position to increase the pool of assets available to fund their
consumption in old age. The lack of retirement goals may also reflect the poor
incentives of selling agents, who have no contractual obligation to deliver any
particular fund size on the retirement date10: in order to persuade workers to enrol
they may allow them to choose contribution rates that are too low.
•
Finally, it is often argued that another reason why the risk of inadequate savings is
serious is that DC plan members tend to choose a fairly conservative asset
allocation. In order to accumulate a sufficient pool of funds, they should save
relatively more compared with more equity-oriented long-term investors.11 At the
same time equity-oriented portfolios may expose investors to huge investment risks
(see below).
6
See, for instance, Choi et al (2004), Pensions Commission (2005), Olsen and Whitman (2007) and Blake,
Cairns and Dowd (2008).
7
Lusardi and Mitchell (2006).
8
The level of awareness about public pension provision is low, especially among the self-employed, public
sector employees, and younger workers. Presumably this information shortfall also reflects the general
uncertainty caused by the protracted reform process, which has made more difficult and burdensome for
savers to obtain information on how the new pension system works. See Cesari, Grande and Panetta (2008),
updating the estimates in Bottazzi, Jappelli and Padula (2006).
9
Gustman and Steinmeier (2004).
10
Blake, Cairns and Dowd (2008).
11
Choi et al (2004).
BIS Review 137/2008
Two widely used instruments to increase pension fund enrolments and contributions are
fiscal incentives and employer-matching contributions. Both are effective means of boosting
pension fund returns and greatly increase the convenience of joining a funded retirement
scheme.12 Both have drawbacks, however. Fiscal incentives are usually expensive,
regressive, and possibly prone to time inconsistency, especially when tax advantages apply
to the payout phase. Employers' contributions might be offset by a reduction in net wages
and not necessarily produce an increase in the worker's total wealth. Moreover, as they are
typically the result of agreements between employers and trade unions, their portability
across different retirement schemes may be far from seamless. In any case, workers seem
to exploit fiscal incentives and employers' contributions only partially. For example, a recent
study of a sample of DC plan members in the United States finds that each year between 20
and 60 percent of these workers contribute below the threshold (even if they could make
penalty-free withdrawals), losing as much as 6 percent of their annual pay - a free lunch left
on the table.13
A factor discouraging workers from increasing pension fund contributions is the relative
illiquidity of their net equity in pension funds. DC pension schemes usually grant workers the
possibility to withdraw their balances some time before they retire only under special
circumstances. Any option to grant higher flexibility of early withdrawals (maybe to those
categories of workers, such as young and low-paid workers, that are more likely to be
liquidity-constrained) has to be carefully weighted against the risk that short-sighted and
time-inconsistent workers might withdraw too much too early, against their own long-term
interest.
This naturally leads us to underline the importance of providing DC plan members with good
investment returns, as this would be the main way to alleviate the relative illiquidity of
investments in pension funds and improve the trade-off between liquidity and pension fund
returns. In this respect, it is essential to keep total costs to savers low; otherwise, the
advantages of pension funds (investing retirement saving in financial instruments as well as
enjoying employer contributions and tax incentives) will be seen mainly in the financial
accounts of the intermediaries running the funds, rather than in better living standards for
pensioners. Indeed, charges may have a major impact on the final balance accrued to
workers over an extended period of time.14 The importance of keeping pension funds' total
costs low has been emphasized, among others, by the Turner Report, which argues that,
against reasonable expectations of long-term returns, annual charges of 1.5 percent (not at
all uncommon in many countries) are high enough to represent a rational disincentive to
12
According to simulations carried out by Cesari, Grande and Panetta (2008) for Italian DC pension funds, the
benefit of the employer's contribution provided by the recent pension fund law is substantial: over a 30-year
accumulation period, even on the most unfavourable assumptions, the return obtained by a pension fund
member each year is at least 0.6 percentage pointshigher, and his final accrued balance more than 6 percent
higher, than that obtained by a non-member. Tax advantages are also very large: after 30 contribution years
the final balance accrued to a younger worker joining a pension fund would be almost 24 percent greater than
that accrued to a worker who invests directly in financial assets; more than half of the advantage would be due
to the deductibility of contributions and another third to the preferential taxation of benefits.
13
Choi, Laibson and Madrian (2005).
14
Even small variations in charges lead to big difference in the final balance assigned to workers on retirement.
After 30 years, workers who can invest at an annual cost of 0.5 percent per annum could, for the same
savings level, enjoy a final accrued balance more than 30 percent higher than that enjoyed by workers facing
an annual cost of 1.5 percent. For a detailed analysis of the impact of pension fund costs on workers' gains
from joining a pension fund (based on the parameters of the Italian DC pension funds), see Cesari, Grande
and Panetta (2008).
BIS Review 137/2008
voluntary private savings and undermine the case for providing earnings-related pensions in
a funded rather than a PAYG form.15
Cost reductions can come not only from increasing the volume of assets under management,
with consequent economies of scale, but also from stimulating competition among pension
schemes. This may call for several measures including educating consumers about the effect
of charges on pension fund returns; assuring a high degree of transparency and
comparability of charges between different schemes; easing the transferability of employer
contributions across different schemes, especially for people with term jobs and interrupted
careers; and intensifying competition among intermediaries offering pension fund asset
management services.
Moreover, in all countries public authorities have a powerful (and relatively inexpensive)
instrument for boosting pension fund contributions - namely, the provision of information.
The better workers are informed, the quicker they revise their expectations and adjust their
saving patterns.16 Workers should be given systematic, timely and clear information to help
them make reliable estimates of replacement ratios, taking into account both mandatory
retirement programmes and supplementary pension plans. Specifically, for funded defined
contribution schemes, either the public authorities or the plan sponsors and financial
intermediaries could provide workers with an estimate of the pension scheme's net benefits,
based on reasonable, transparent and standardized assumptions regarding contributions
rates, the growth rate of earnings for groups of workers, the growth rate of benefits, the
probability of survival, and the expected returns on pension fund assets. Regular
assessments should provide an indication of the contribution rates that would be consistent
with the updated scenario. The same should be done on a regular basis by the Social
Security Department, for the first-pillar pension wealth (as happens, for example, in Sweden).
Another powerful instrument in the hands of both employers and policymakers is the design
of retirement plans in terms of enrolment, contribution, investment and withdrawal options. In
defining default options, there seems to be consensus on a few general criteria such as17
avoiding opt-in clauses (which imply that the worker is not enrolled unless he or she asks)
and relying instead on opt-out clauses or some kind of more active decision-making; offering
only a small number of basic investment choices, while being ready to offer a wider choice to
those workers that ask for it; and setting employee contribution rates that rise slowly over
time. All these solutions are meant to encourage long-lasting changes in behaviour and to
overcome inconsistencies in individual decision-making arising due to short-sightedness,
inertia, procrastination or lack of willpower.
4. Should we move from unprotected to protected DC schemes?
A cursory look at financial market data (Figure 2) shows that over long periods of
accumulation higher risks have on average been associated with higher returns.
Accumulated returns are lowest for investment strategies that merely track consumer prices,
highest for equities, and somewhere in-between for nominal government bond portfolios.
However, as we move from the least to most rewarding investment strategy, return variability
escalates as well, and in certain periods a pure equity strategy may be overtaken by a bond
strategy. Moreover, holding period returns clearly indicate that even over long-term
accumulation periods the returns from a pure equity strategy may be subject to large drops,
as may happen when the holding period includes the first ten months of 2008. This bird's eye
view of financial market returns also shows that by holding a balanced portfolio of stocks and
fixed-income instruments, long-term investors may try to increase expected portfolio returns,
while keeping return volatility moderate.
What I would like to emphasize, however, is that basing asset allocation on the past
properties of asset returns may still leave the investor considerably exposed to investment
risk, for at least two reasons:
•
First, past realizations may come from different underlying economic regimes or
conceal structural breaks, so that care should be taken when using observed returns
to estimate expected returns.18 It is generally agreed, for example, that around the
turn of the century the equity premium declined somewhat; the term premia on
longterm interest rates may also have recorded a lasting decrease in this decade. This
may again reverse in the near future.
•
Second, even if expected returns on equities are higher than those on bonds in the
long term, actual returns on equities may turn out to be sharply negative. The
probability of large drops in asset prices may be substantially higher than it is
assumed in standard mean-variance frameworks. Indeed, there is evidence that the
distribution of many asset prices has fatter tails than the normal distribution (possibly
signalling the unexpected occurrence of very large shocks that may be at odds with
standard applications of the central limit theorem).
The investment risk can be dealt with, to some extent, by relying on market-based
instruments. DC plan members could invest a large share of their funds in risky assets at the
beginning of their accumulation period and gradually increase the percentage of cash and
government bonds as they approach retirement19. One difficulty of this life-cycle investment
strategy is that individuals may find it a daunting task to change the asset allocation as they
age (as well as to anticipate trends in the prices of risky assets). A solution is provided by
accumulation schemes that automatically adjust risk as an investor ages ("life-cycle funds").
This kind of solution has been increasingly adopted for DC pension plans in a number of
countries.
Financial markets also offer strategies that drastically reduce the exposure to investment
risk. One possibility is to restrict portfolio choices to fixed-income instruments, especially
index-linked bonds, or to use options. Then there is recourse to rate-of-return guarantees
provided by third parties (an insurance company, the sponsor or a central reserve fund). A
DC pension fund may also maintain a reserve to smooth returns over time: in good
investment years part of the fund's returns are placed in the reserve, which can be drawn on
when they fall below a certain threshold.
While financial markets offer different ways of introducing minimum return guarantees, it is
clear that the hedging of financial market risks does not come without cost. A higher
incidence of fixed-income instruments may take its toll on portfolio returns; the use of
derivatives or third-parties guarantees implies the payment of fees. With intertemporal
smoothing of returns, good investment years subsidize bad investment periods, with a
potential redistribution of investment income across plan members. Therefore, all these
forms of protection from investment risks may result in lower net-of-fees returns. If these are
not offset by higher contributions during the accumulation phase, they lead to a lower
pension during the decumulation stage - i.e. lower returns imply lower consumption, either
during working age or in retirement or both.
More importantly, market-based solutions cannot protect investors from strong aggregate
shocks hitting several asset classes and economic sectors at the same time. In such an
event, aggregate wealth is not only redistributed across individuals and sectors, but it is also
destroyed.
One might argue that in such exceptional circumstances there is a straightforward solution: a
public rescue of pension funds by the government (especially when enrolment is mandatory
rather than voluntary). A bail-out of pension fund members would always be an available
policy option, provided that it were limited to workers who are close to retirement and unable
to take advantage of a possible recovery of asset prices over medium- to long-term horizons.
However, a bail-out of pension fund members should always remain the last option for two
well-known reasons: it is costly to taxpayers and it may encourage opportunistic behaviour
by pension funds in the future.
A more sustainable and efficient form of protection could come from some kind of collective
inter-generational arrangement. One possibility is that of hybrid pension plans, such as those
previously mentioned, in which participants transform their risky claims into guaranteed
claims as they become older.20 In practice, younger workers would partly insure the pension
rights of older workers, by accepting to pay higher contributions in periods of adverse
financial market shocks. In some countries (for example the Netherlands) these investment
vehicles already exist.
Another possibility would be a more active role of the State in providing insurance against
grave systemic risks. Tail risk in financial markets is similar to what is called aggregate
longevity risk, i.e. the risk of a whole cohort living longer than expected. Aggregate longevity
risk must be kept distinct from idiosyncratic longevity risk, i.e. the risk of an individual living
longer than his or her cohort's average (a risk that the market can easily insure away). I will
elaborate on these risks in the next section.
Of course, providing insurance against catastrophic events destroying financial wealth was
the reason why PAYG social security systems were introduced, most of them in the
aftermath of the Great Depression and of the hyper-inflation following WWII.21 However,
social security systems came under strain in most developed countries for several
wellknown reasons. In particular, the sizeable (and largely unexpected) increases in longevity,
coupled with a substantial fall in fertility rates, put the financial sustainability of traditional
PAYG schemes under question in many countries, unless substantial cuts in benefits and
increases in payroll contributions were introduced (and the effective retirement age
increased).
Yet, there are other ways to provide workers with a collective protection against financial
market risks. One example, is the plan put forward by Franco Modigliani and co-authors in
various contributions.22 While it is similar in spirit to inter-generational arrangements, it
includes the whole national community in the risk-sharing scheme. Basically, the proposal is
to introduce a single funded DC pension scheme which would enter in a swap arrangement
with the Treasury each year so that the risky pension fund returns are exchanged with a
guaranteed rate of return.
With respect to the original proposal, the swap arrangements may involve more than one
pension fund, and the swap guarantee may be partial, at a price that in normal times should
compensate the Treasury for the risks it undertakes. In this case, it would be especially
important to keep pension fund fees and other expenses low, as mentioned earlier.
One merit of the Modigliani proposal is that workers with similar characteristics would be
granted similar rates of return on their savings. On fairness grounds, it seems disputable that
workers with equal pension contributions and in equal in all other relevant respects should
end up with very different retirement wealth, due to the evolution of financial markets.
Finally, while the feasibility of such a scheme needs to be studied in relation to the various
existing national pension systems, it is worth noting not only that it might provide the needed
smoothing of pension funds returns, but, more importantly, that the scheme would also put
the burden of aggregate financial risks due to events that cannot be hedged at a cohort level
within a truly intergenerational exchange framework. Obviously, this would call for the
introduction of measures to limit the burden on future generations caused by high and rising
levels of public debt.
5. We need cheaper and safer pay-out products
An adequate level of pension wealth at retirement is necessary but not sufficient to
guarantee adequate living standards during the retirement years. Indeed, it is important to
ensure that such wealth is properly decumulated. Therefore, the most important choice is the
extent of annuitization.
It is difficult not to agree that annuitization of a significant fraction of private pension wealth is
highly advisable. It is indeed advisable both for the individual and for the government:
•
At retirement, workers have to choose the level of consumption for the subsequent
years, given the wealth accumulated over their working lives. Without annuities, they
would be exposed to longevity risk: if they live longer than expected, they could
outlive their resources; if on the contrary their lifespan turns out to be shorter than
expected, a fraction of resources would be wasted. By buying an annuity, both risks
would be shifted onto the insurance company.
•
As companies have a wide pool of clients, they can diversify away the idiosyncratic
component of the longevity risk. Therefore, they can offer annuities at convenient
prices for the investors. However, companies have to bear the aggregate
component of the longevity risk, i.e. the risk of unpredicted changes in the average
lifespan. To cover this risk, they could ask for a premium that may substantially raise
the overall cost of the annuity scheme.
•
A high degree of annuitization would also work to protect public finances from
opportunistic behaviour: individuals may indeed have an incentive to consume
resources early after retirement, and to rely on the publicly-financed safety net in the
following years.
At the moment, annuity markets around the world are rather thin, except in a handful of
countries in which private pensions are more developed (such as in the United Kingdom,
Switzerland and Chile). This may be due to a wide range of demand and supply factors, such
as opaque and inefficient pricing policies by insurance companies, a lack of products which
meet the tastes and needs of investors, and the presence of still substantial annuitized
benefits provided by pub