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# 3. REGULATION

This section assesses the main issues in pension fund regulation, comparing and contrasting the adopted solutions in the nine countries studied. It is suggested that whereas social security is the key determinant of total precautionary saving for retirement, it is the fiscal and regulatory environment that influences the use made of pension funds as a vehicle for such saving. An attempt is made to come to a view regarding "good regulatory practice".

# (a) Taxation

One of the main determinants of the scale of benefits and advantages of pension funds as a means of saving is exemption of contributions from taxatioq. As discussed in Johnson (1992), pensions may be taxed at three points, when money is contributed, when investment income is earned and when retirement benefits are paid to scheme members. _In_ general, taxing contributions only and benefits only are equivalent (except to the extent that progressive taxation may be lower on lower post-retirement income, and deferment itself means pretax rather than post tax income is available for investment and accumulation). These are expenditure tax regimes, where the post tax rate of return equals the pre tax rate, and the consumption/saving choice is not distorted; consumption is taxed at the same rate now and in the future.

In contrast, regimes where investment income is taxed as well as contributions or benefits are comprehensive income tax regimes (they tax income equally regardless of source). This reduces the incentive to save by driving post-tax rates of return below-the pre-tax rate. Note that if the distinction between- nominal and real returns is not made by the fiscal authorities (i;e., nominal returris are taxed) a comprehensive income tax also induces a growing distortion dependent on the rate of inflation. In general, pension funds are given expenditure tax treatment, while other forms of saving are not. There is thus a distortion between types of saving, encouraging accumulation' via pension funds.

Corresponding to this distortion, the growth of assets in long-term institutions in countries such as the United Kingdom and the United States as a proportion of personal portfolios has a counterpart in a continual reduction in direct personal equity holdings as a proportion of financial assets. This clearly partly results from the fact that direct equity holdings generally suffer from double taxation (purchases of securities are made from taxed income, and both dividends and capital gains are also taxed)."' However, in the longer term, this reduction may **also** result from an equalization of the income and wealth distribution, where only the wealthy could economically maintain equity portfolios with adequate risk diversification, although mutual funds overcome this problem. As a means of retirement provision, equity holdings also have the disadvantage of greater capital and income uncertainty than institutional iavestment and (particularly) defined benefit pension funds.

In other countries such as Denmark, supplementation of the state retirement schemes occurs via insurance schemes and bank investment products as well as through pension funds (given a more even tax treatment).

Reasons for taxing pensionr¢ relatively leniently include, first, the need to assist people to save enough to maintain post retirement living standards; second, a desire to encourage people to save and thus cut the cost to the state of meanstested social security benefits; and third, to raise the general level of saving.

The first is the most important, and is largely paternalistic. It suggests that people are generally myopic, and/or that there is a form of moral hazard, in that they assume they will be cared for by the state even if they do not save. That people do not save sufficiently is confirmed by US studies such as Diamond (1977), and recent evidence in New Zealand shows removal of tax exemption can cut retirement saving sharply. Of course, compulsion (as in Sweden and Switzerland') is an alternative way of ensuring adequate saving, but tax exemption mitigates the associated element of coercion. However, despite this argument, Munnell (1992) argues for taxation