While any initiatives to improve the financial literacy and understanding of pension fund members are laudable, at best, they are long-term initiatives. This market failure calls for more attention in the provision of default options, such that individuals with limited financial education might be guided towards the right strategies.<sup>25</sup>

# **_Aligning Incentives – Use of Benchmarks_**

The failure to measure pension risk is a function of a lack of benchmarks, against which it can be measured, which, in turn, is due to the failure to quantify the pension objective. In other words, it is not possible to answer the question of “will I have enough?” unless there is a quantification of “enough”.

Can the attention of pension supervisors be focused back towards to core goal of delivering an adequate pension income and mitigating pension risk?

This paper argues that benchmarking portfolios of pension funds is the most strategic way of applying the pillar three concept to RBS of pension funds. In order to be meaningful, rates of returns need to be compared against something. Consequently, it is essential to measure performance against benchmarks built with the objective of optimizing the contributors’ pensions at retirement age.<sup>26</sup> In the absence of explicit targets related to the expected value of pensions at retirement age, the introduction of RBS does not guarantee that the expected value of pensions at retirement age will adequate. In other words, if RBS is to be more meaningful, it needs also to supervise investment risks, and assess those risks against benchmarks derived from quantifiable targets.

The proper approach to pension design, including for DC schemes, is to start calculating back from a desired/required pension level and setting a long term investment strategy adequate to reach this goal. Given, say, a 66 percent replacement rate target at the age of 65 and a contribution rate of 8 percent, one needs to calculate expected annuity prices based on mortality data and estimates about improvements, and then use asset return and wage curve modeling to see what sort of investment performance and portfolio may be necessary to reach the pension capital required. It may turn out that the set of replacement rate – retirement age – contribution rate does not allow for an investment performance which is realistic in which case one or more of those parameters may have to be adjusted or the expectations of a future replacement rate lowered.

This approach is fundamentally different from the standard one of ‘contributions are defined and benefits will be as much as investment strategies succeed in delivering’. From day one a long term investment strategy and portfolio must be utilized, whose only objective is to lead to adequate pensions.

Given this goal, an alternative approach to controlling investment risk is required. The best way to align regulation with the long-term goal of delivering adequate pension income is through the use of benchmarks or reference portfolios. These are designed to deliver a

> 25 See Lusardi and Mitchell (2014) and Poterba (2014).

> 26 The discussion of how to build benchmarks is beyond the scope of this paper. Rudolph and others (2010), Rudolph (2013) and Stewart (2014) provide some discussions on the topic.

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