For Official Use DAF/AS/PEN/WD(2017)3

Organisation de Coopération et de Développement Économiques

Organisation for Economic Co-operation and Development

13 June 2017

English - Or. English

DIRECTORATE FOR FINANCIAL AND ENTERPRISE AFFAIRS

INSURANCE AND PRIVATE PENSIONS COMMITTEE

Working Party on Private Pensions

Designing funded pension arrangements given the level of financial literacy and

behavioural biases

Background and assessment of policies

19-20 June 2017

This document is circulated for discussion under the agenda of the WPPP meeting

For further information, please contact Ms. Stéphanie Payet [Tel: +33 1 45 24 15 24; Email:

stephanie.payet@oecd.org] or Mr. Pablo Antolin [Tel: +33 1 45 24 90 86; email:

Pablo.antolin@oecd.org]

JT03415950

This document, as well as any data and map included herein, are without prejudice to the status of or sovereignty over any territory, to the

delimitation of international frontiers and boundaries and to the name of any territory, city or area.

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Table of Contents

Designing funded pension arrangements given the level of financial literacy and behavioural

biases: Background and assessment of policies .................................................................................. 3

1. Introduction ...................................................................................................................................... 3 2. Why financial literacy levels and behavioural biases matter in the context of DC pension

arrangements? ...................................................................................................................................... 4 3. Participation decision ....................................................................................................................... 7

Issues posed by poor financial literacy and behavioural biases ....................................................... 7 Assessment of policies ..................................................................................................................... 8

4. How much to contribute................................................................................................................. 16 Issues posed by poor financial literacy and behavioural biases ..................................................... 16 Assessment of policies ................................................................................................................... 17

5. Choice of the pension provider ...................................................................................................... 20 Issues posed by poor financial literacy and behavioural biases ..................................................... 20 Assessment of policies ................................................................................................................... 20

6. Choice of the investment strategy .................................................................................................. 24 Issues posed by poor financial literacy and behavioural biases ..................................................... 24 Assessment of policies ................................................................................................................... 26

7. Choice of the pay-out product........................................................................................................ 31 Issues posed by poor financial literacy and behavioural biases ..................................................... 31 Assessment of policies ................................................................................................................... 33

8. Conclusion ..................................................................................................................................... 36

References ............................................................................................................................................ 38

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Designing funded pension arrangements given the level of financial literacy

and behavioural biases: Background and assessment of policies

1. Introduction

1. The pensions' landscape has changed in recent decades, giving a greater role for

funded private defined contribution pension plans. Pension systems are still addressing

the challenges posed by population aging, the financial and economic crisis and the

economic environment of low growth and low interest rates. These challenges have led to

reforms that have increased the diversity of pension arrangements across OECD countries

and the importance of funded pension arrangements, especially defined contribution (DC)

ones (OECD, 2016a).

2. Defined contribution plans allow a direct link between pension contributions and

pension benefits but put most risks related to retirement saving (i.e. investment and

longevity) onto individuals. As DC pensions represent a growing share of total retirement

income, their design needs to be improved. In addition, OECD (2016a) compares

financial education needs across different types of pension arrangements and indicates

that the challenges people face in making decisions about their retirement are greater for

private pensions (as opposed to public pensions), personal plans (as opposed to

occupational plans) and DC plans (as opposed to defined benefit or DB plans). In DC

plans, people have to make many important decisions by themselves that will determine

how much they will get from their plan, such as how much to save, where to invest, when

to retire and how to allocate the assets accumulated when retiring. DC plans therefore

offer a greater amount of choice, but imply a greater amount of risk for individuals and

require more financial skills than DB plans.

3. However, people have difficulties in planning for retirement, determining their

retirement income needs and choosing retirement products. A combination of lack of

general financial knowledge and awareness of risk, poor pension-specific knowledge, as

well as behavioural and psychological biases undermines people's ability to make

appropriate decisions for their retirement. The potential mistakes that people can make

along the way therefore put at risk the ability of DC pension plans to deliver pension

benefits that people would consider adequate to finance retirement.

4. This document identifies the key decisions that people need to make for their

retirement at different stages of their lives in the context of DC pension plans. It is also a

first attempt to i) highlight the issues posed by low financial literacy levels and

behavioural biases and ii) assess experiments and policies implemented in different

OECD and non-OECD jurisdictions to improve the design of DC pension plans through

motivating or facilitating the appropriate behaviour by individuals, for each of the key

decisions that people need to make along the way. It emphasises the most recent

developments in design policies.

5. Policies aiming at improving the design of DC pension plans while addressing the

issues posed by low financial literacy levels and behavioural biases can be divided into

six broad categories. Default options are widely used to increase participation in and

contributions to DC pension arrangements (e.g. automatic enrolment), as well as to help

people who are unable or unwilling to choose a pension provider, an investment strategy

or a pay-out product. Simplification of information and choice is also a key policy

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measure to help people making decisions through a reduced set of options (e.g.

investment strategies), better disclosure of comparable information (e.g. cost information)

or facilitated comparison of options (e.g. a single internet platform to compare all pay-out

offers). More salient information can improve decision making. This information can be

conveyed through pension statements, financial education programmes and financial

advice. Tax and other types of financial incentives (e.g. matching contributions) are

widely used to promote private pension arrangements. Policy makers also introduce

product features that may help alleviate some of the fears that people may have when

locking in their money in private pension plans (e.g. investment return guarantees,

flexible annuity products). Finally, policies reducing costs are important to improve

retirement income outcomes.

6. The document starts with a background section highlighting the main reasons why

low levels of financial literacy and behavioural biases may have significant implications

for retirement income adequacy in the context of DC pension arrangements. The next

sections focus on each of the key decisions that people need to make when saving in a DC

pension plan: whether to participate in the plan (section 3), how much to contribute

(section 4), how to choose the pension provider (section 5), how to invest the

contributions (section 6) and how to allocate the accumulated savings when retiring

(section 7). Each section is structured in the same way: it first presents the issues posed

by poor financial literacy and behavioural biases and then assesses experiments and

policies implemented in different OECD and non-OECD jurisdictions to improve the

design of DC pension plans through motivating or facilitating the appropriate behaviour

by individuals. Finally, section 8 concludes. The Secretariat will share this document with

the OECD International Network on Financial Education.

7. This document lists and assesses the different experiments and policies that have

been implemented in different jurisdictions. It does not identify the most effective

policies to improve the design of DC pension plans. This will be the goal of a future

paper that will distil effective practices and policies on how to design DC pension plans

given the level of financial literacy and behavioural biases.

Delegates are kindly invited to:

help the Secretariat complement this document with any relevant policies that

have been implemented in their respective country to improve the design of DC

arrangements while accounting for low financial literacy levels and behavioural

biases

provide additional evidence on the cost and effectiveness of policies implemented

in their country to improve the design of DC pension plans (for example, whether

cost-reducing policies do not lower the quality of the services provided by

pension funds).

2. Why financial literacy levels and behavioural biases matter in the context of DC

pension arrangements?

8. This section presents how financial literacy levels and behavioural biases interact

with retirement decisions in the context of DC pension arrangements. Recent pension

reforms have reduced the role of pay-as-you-go (PAYG) public pensions by lowering

future pensions (OECD, 2015a). In parallel, funded pension arrangements have grown in

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importance, as a complement to public PAYG pensions. In addition, within funded

pensions, DC pension arrangements are becoming more prominent (OECD, 2016a).

9. DC pension arrangements provide a clear, straightforward link between pension

contributions and pension benefits, but put most risks onto individuals, making them

more responsible for managing their retirement. In DC pension arrangements, assets

accumulated at the end of one's working life (contributions plus investment income

earned on those contributions) are used to generate a stream of income, thereby directly

determining the amount of retirement income. However, individuals have to bear

investment and longevity risks. In addition, they have to make many important decisions

that will determine how much they will get from their plan, such as how much to save,

where to invest, when to retire and how to allocate the assets accumulated when retiring.

10. DC pension arrangements, unlike with PAYG and funded DB plans, require that

individuals understand the features of the different plans offered to them. However, most

individuals may not be able or prepared to assume this role, due to low levels of financial

literacy and behavioural biases.

11. Low levels of financial literacy are prevalent in many countries. The OECD

International Network on Financial Education (INFE) has defined financial literacy as

follows: "A combination of awareness, knowledge, skill, attitude and behaviour necessary

to make sound financial decisions and ultimately achieve individual financial wellbeing"

(OECD, 2016b). OECD (2016b) reports findings from 30 countries and economies that

participated in the OECD/INFE international survey of adult financial literacy

competencies and collected cross-comparable data. It shows that overall levels of

financial literacy, indicated by combining scores on knowledge, behaviour and attitudes

are relatively low, with an average score of 13.2 out of a maximum 21. On average, only

56% of adults achieve the minimum target score on financial knowledge, with large

differences by gender as 61% of men achieve the minimum target score against 51% for

women. The study identifies budgeting, planning ahead, choosing products and using

independent advice as weak areas of financial behaviour. The analysis also shows that

regarding attitudes, many people have a tendency towards short-termism (50% on

average). In addition, studies reviewed in Lusardi and Mitchell (2014) show that financial

knowledge is positively correlated with retirement planning, and that those who plan also

accumulate more wealth.

12. Behavioural biases are specific ways in which normal human thought

systematically departs from being fully rational. Biases can cause people to misjudge

important facts or to be inconsistent. Adapted from the list and classification of biases in

DellaVigna (2009), the Financial Conduct Authority (FCA) in the United Kingdom

categorises ten cognitive biases in retail financial services, according to which component

of a decision they affect: preferences, beliefs and decision-making processes (Table 1).

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Table 1. FCA's classification of behavioural biases in retail financial services

Category Bias Description

Preferences

Present bias People respond to urges for immediate gratification resulting in overvaluing the present over the future. As such, choices are regretted in the future. Present bias can lead to self-control problems such as procrastination.

Reference dependence and loss aversion

When evaluating a product or future prospects, people do not think of the choice or product in isolation. Instead they assess it with respect to changes relative to a reference point, thinking in terms of gains and losses from that reference point. Preferences may therefore change when the reference point changes. In addition, psychologically, losses are felt roughly twice as much as gains of the same magnitude. Loss aversion may lead to the endowment effect (valuing a good more just because the individual owns it), a preference for the status quo and distortions in attitudes to risk.

Regret and other emotions People avoid choice or are willing to pay for products just to avoid making a decision that they may come to regret. They may also shy away from ambiguity, uncertainty or stress even if making a choice is likely to result in a positive outcome for them. Their choices can also be distorted by temporary strong emotions (e.g. fear).

Beliefs

Overconfidence People can show overconfidence about the likelihood of good events occurring or their own ability and success at different tasks, including the accuracy of their judgements.

Over-extrapolation People often make predictions on the basis of only a few observations, when these observations are not representative. As a result, people also underestimate uncertainty.

Projection bias People expect their current tastes and preferences to continue in the future and underestimate the possibility of change.

Decision making

Mental accounting and narrow bracketing

Mental accounting describes how people treat money or assets differently according to the specific purpose that they have assigned to them, instead of treating all money as the same.

Narrow bracketing describes how people often consider the decisions they take in isolation, without integrating these decisions with other decisions that affect their overall wealth and level of risk they take on.

Framing, salience and limited attention

People may react differently to essentially the same choice situation because the problem is framed differently. Frames usually work by triggering a particular bias (e.g. loss aversion, reference dependence, regret, a rule of thumb), as certain information is made more salient and limited attention is paid to other factors.

Decision-making rules of thumb

Consumers simplify complex decision problems by adopting specific rules of thumb (heuristics). When choosing from a wide range of options, people may choose the most familiar, avoid the most ambiguous or uncertain, choose what draws attention most (e.g. the first option on a list), or avoid choice, including sticking to the status quo. When estimating unknown quantities, people may anchor estimates to some relevant or irrelevant figure and adjust from there.

Persuasion and social influence

Emotions and norms in social interactions are important: consumers may allow themselves to be persuaded to buy a product just because the sales person is 'likeable' and therefore trustworthy. Emphasising good personality traits or overemphasising bad personality traits may substitute for a reasoned judgement. Consumers may also be influenced by usage patterns without adequately considering whether those apply to their own circumstances.

Source: Erta et al. (2013).

13. Some of the behavioural biases described in Table 1 particularly affect

individuals' retirement planning. Present bias, framing, rules of thumb, persuasion,

overconfidence, over-extrapolation, loss aversion, and regret and other emotions are

specifically important when making decisions for retirement. First, present bias can be

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strong as saving for retirement is for the long term and may compete with other short-

term needs. Therefore, the combination of delayed benefits until retirement and small

short-term costs (e.g. transaction costs, paperwork) can be a real barrier to action,

including participation in retirement savings plans. Second, financial products, and in

particular retirement products, are complex. Individuals usually consider that making

financial decisions is hard, unpleasant and time-consuming. They often lack motivation to

invest time and effort to make informed decisions and, because of the complexity, cannot

easily evaluate some products at all. They are therefore more likely to rely on simple

rules of thumb and be sensitive to framing and persuasion. Third, effective retirement

decisions require sophisticated risk assessments (e.g. longevity and investment risks).

Most people lack the skills, practice or intuition to assess risk and uncertainty when

making important decisions. Overconfidence and over-extrapolation may therefore lead

individuals to underestimate uncertainty and risk. Fourth, many financial decisions are

emotional. Emotions, whether positive (like optimism or excitement) or negative (like

stress, anxiety, fear and regret), can drive decisions rather than logical cost/benefit

analyses. Finally, it can be difficult to improve one's ability to deal with retirement

products over time. Decisions related to retirement planning are made infrequently. The

consequences of these decisions are often only revealed long after the decision has been

made, with little opportunity to learn and correct past decisions. Because of loss aversion

and fear of regretting one's decisions later on, people may therefore fail to act.

14. The following sections focus on each of the key decisions that people need to

make for their retirement at different stages of their lives: whether to participate in the

plan, how much to contribute, how to choose the pension provider, how to invest and how

to allocate the accumulated savings when retiring. Poor financial literacy and behavioural

biases potentially affect those decisions in a different way. OECD and non-OECD

jurisdictions have implemented different policies to address the implications of poor

financial literacy and behavioural biases, improving as a result the design of DC pension

plans. These policies either simplify the decision-making process or harness the power of

behavioural biases to nudge people into acting in their own long-term interest.

3. Participation decision

Issues posed by poor financial literacy and behavioural biases

15. Present bias is the main behavioural bias affecting participation in private pension

arrangements. The complexity of retirement savings products also makes it difficult for

people to plan for retirement and properly assess how well prepared they may be for

retirement.

16. Because of present bias, individuals are bad at committing to save for retirement.

Procrastination, myopia and inertia lead many individuals to postpone or avoid making

the commitment to save for retirement even when they know that this is ultimately in

their best interest. In addition, retirement planning competes with other short-term needs,

especially at younger ages (e.g. buying a house, pay tuition fees, raising a family).

17. Saving for retirement is a complex financial decision. One potential consequence

of this complexity is that individuals put off confronting these decisions. For example,

Iyengar, Jiang and Huberman (2004) find that participation rates in 401(k) pension plans

in the United States decline as the number of fund option increases. Other things equal,

every ten options added was associated with 1.5% to 2% drop in participation rates.

Therefore, the complexity of the retirement savings decision, combined with low levels of

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financial literacy to appropriately assess the different options, discourages employees

from timely enrolment in private pension plans, even when they prefer participation to

non-participation.

18. It is also of concern that many people have a misperception of their retirement

preparedness, as they would fail to take action in case their future retirement income falls

short of their expectations. Munnell, Hou and Sanzenbacher (2017) show that 57% of

households in the United States have realistic expectations about their retirement

preparedness, with 33% recognising that they are at risk of being unable to maintain their

standard of living in retirement. Other households have a misperception of their

retirement readiness, with 24% of households reporting that they are inadequately

prepared while the index calculated by the authors says they are not at risk and 19% of

households being less worried than they should be about their retirement preparedness.

The key drivers of being in the "not worried enough" group are having a DC plan and

having high income. Households with a DC plan may indeed suffer from "wealth

illusion", not realising how much income can be derived from their DC balances. In

addition, high-income households may not properly assess how much wealth

accumulation is required to maintain their standard of living.

Assessment of policies

19. Policies aiming at increasing participation in DC pension plans fall into three

broad categories: policies related to the enrolment process, policies providing financial

incentives and policies increasing people's access to knowledge. Policies related to the

enrolment process include making participation compulsory, enrolling workers

automatically in pension plans, simplifying the choice for individuals and prompting an

active decision about participating in a private pension arrangement. Financial incentives

can help re-aligning people's wish to save for retirement with the action to join a private

pension plan. Historically, tax incentives have been the main type of financial incentives

to promote private pensions. Matching contributions and flat-rate subsidies are more

recent types of financial incentives. Finally, increasing people's knowledge about the

pension system and pension reforms, through better communication and financial

education, can help people realise about the importance of saving for retirement and

encourage them to take action.

Policies related to the enrolment process

20. Making enrolment into private pensions compulsory is ultimately the most

effective policy in reaching high and uniformly distributed coverage rates. As shown in

Figure 1, coverage rates are higher in countries having mandatory or quasi-mandatory

pension plans, usually at or above 70% of the working-age population. OECD (2012) also

shows that coverage is more evenly distributed across different socio-economic

characteristics in such systems, as compared to voluntary systems. Compulsory enrolment

addresses the behavioural biases identified above (procrastination, myopia and inertia),

ensuring that individuals save for retirement and start saving early in their career.

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Figure 1. Coverage of private pension systems

As a percentage of the woking-age population

Note: Coverage rates are provided with respect to the total working-age population (i.e. individual aged 15 to

64 years old) for all countries except Germany, Ireland, Sweden and the United Kingdom for which coverage

rates are provided with respect to total employment.

Source: OECD (2015a) and The Pensions Regulator (2016) for the United Kingdom.

21. One of the limits of compulsory enrolment is that it may not be necessary for all

individuals depending on the design of the overall pension system. Forcing low income

workers to contribute may lead them to become more indebted or divert funds from other

necessary expenses, such as children education or housing. When these workers can

already expect high replacement rates from the public pension system, making private

pension contributions compulsory for them may not be justified. Recognising this

problem, in Australia, only workers 18 years old or over and earning at least AUD 450 a

month are entitled to mandatory employer contributions to the superannuation system.

22. Another limit to compulsory enrolment is when the informal sector is large.

Workers outside the formal economy are not paying social security contributions, let

alone pension contributions. In Mexico for example, nearly 60% of all workers are

informal. In that country, informal workers are not only common among self-employed

workers and unpaid workers, but also among salaried workers (according to the National

Survey of Occupation and Employment, 45.5% of salaried workers were informal in the

third quarter of 2014). This explains why the mandatory private pension system only

covers around 60% of the working-age population (Figure 1).

23. As an alternative to compulsory enrolment, automatic enrolment has gained

popularity in the last decade. In some countries, compulsory enrolment would be difficult

to implement politically, because mandatory contributions to private pensions would be

perceived as another tax. Automatic enrolment involves signing up people automatically

to private pensions but giving them the option to opt out within specified timeframes and

conditions. The policy exploits individual behavioural traits such as inertia and

procrastination to make people engage in retirement and pension saving, while preserving

individual choice and responsibility for the decision about whether to participate in a

private pension arrangement. It is used in the context of occupational pension plans and

0.010.020.030.040.050.060.070.080.090.0

100.0

Mandatory/Quasi-mandatory Auto-enrolment Voluntary

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changes the default enrolment from "not participating" to "participating" in the employer-

sponsored pension plan. It is also associated with default options for the contribution rate

and the investment strategy to simplify the choice of individuals. The policy has been

introduced at the national level in Italy (2007), New Zealand (2007), Turkey (2017) and

the United Kingdom (2012), it is developed at the state level in the United States (2012)

and it is encouraged by regulation in Canada (2012) and the United States (2006). Table 2

provides a description of the different schemes.

Table 2. Description of automatic enrolment schemes

Country Description

Canada A Pooled Registered Pension Plan (PRPP) is a kind of multi-employer DC pension plan in which unrelated employers and self-employed

persons are eligible to participate. Where an employer elects to offer a PRPP, enrolment of employees would be automatic unless an

employee chooses to opt out. The PRPP framework, introduced in 2012 at the federal level, will be fully in place across Canada pending

provincial enabling legislation. So far, six provinces have introduced PRPP legislation. Italy Automatic enrolment was introduced in January 2007. For all private sector employees, it involved the payment into pension funds of the

future flow of the severance pay contributions (Trattamento di fine rapporto, TFR), set at 6.91% of salary. Individual workers were given

a period of six months in order to decide whether to opt out of this arrangement, keeping their rights regarding the TFR as in the past.

The same mechanism applies since then to all first-time private sector employees. New

Zealand

KiwiSaver was introduced on 1 July 2007. Employers must enrol new employees (i.e. those starting a new job) into the scheme and

individuals have 8 weeks to opt out. The minimum contribution is 3%, which is deducted from employee earnings, and an employer

contribution of 3% of salary is added. The government also contributes 50 cents for every dollar of member contribution annually up to

NZD 521.43. Existing employees not subject to the automatic enrolment rule can also join (opt in) the KiwiSaver plan on a voluntary

basis. The kick start payment of NZD 1 000 has been removed for contracts opened after 21 May 2015.

Turkey Since 1 January 2017, employers have to choose a private DC pension plan and automatically enrol employees younger than 45 into it.

Employees may choose to opt out of the system within the first two months following their automatic enrolment. Employers are not

required to contribute, while employees must contribute at least 3% of their gross income. The government matches 25% of an

employee's contributions and makes an additional one-time contribution of TRY 1,000 for those who do not opt out within the first two

months. The duty on employers is being staged in between January 2017 and January 2019, starting with the largest employers and the

public sector. United

Kingdom

Automatic enrolment has been introduced in 2012 for all those workers who are not already covered by a private pension arrangement.

Employers are required to automatically enrol their eligible jobholders (worker aged at least 22 but under State Pension Age, who earn

more than GBP 10,000 a year) into a qualifying workplace pension. Workers can opt out within one month, and if so, will be

automatically re-enrolled by their employer on a three-year cycle. Employer and employee contributions are being phased in from

October 2012 to a minimum total contribution of 8% of qualifying earnings by October 2018. The duty on employers is being staged in

between October 2012 and February 2018, starting with the largest employers. United

States

- Pension Protection Act:

Automatic enrolment in 401(k) pension plans was introduced in 1998 for newly hired employees. Since 2000, the automatic enrolment

was extended to current workers who were not enrolled in a pension scheme. In 2006, the adoption of the Pension Protection Act greatly

encouraged automatic enrolment by giving employers incentives to automatically enrol their employees into a retirement savings plan.

- Automatic IRA:

Since 2012, several states have created state-facilitated retirement savings plans following the "Automatic IRAs" model, which has been

proposed by the Obama Administration in 2009 but has never been enacted.

24. As detailed in OECD (2014), available evidence in the United States, New

Zealand and Italy shows that automatic enrolment has a positive impact on participation

in retirement savings plans. However, its impact on participation may be reduced when

other incentives compete and interact negatively with its introduction. Several studies in

the United States demonstrate that automatic enrolment is associated with significant

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increases in 401(k) plan participation.1 In terms of participation, the KiwiSaver scheme in

New Zealand is a real success with nearly 2.7 million people enrolled as at December

2016, of which 41% have been enrolled automatically. In addition, KiwiSaver members'

distribution by income is similar to the one of the eligible population, meaning that low-

income individuals are not disproportionately left out of the scheme (Inland Revenue,

2015). Finally, while the increase in pension fund coverage in Italy following the TFR

reform was significant, with 1.4 million additional workers enrolled in a pension fund

between 2006 and 2007, only around 5% of new members in that period were

automatically enrolled. As shown in Figure 1, private pensions covered less than 20% of

the working-age population at the end of 2013, six years after the TFR reform. Rinaldi

(2011) identifies structural and implementation factors to explain the relative failure of

the reform. Fornero and Monticone (2011) show that the lack of knowledge of basic

financial concepts among Italians may also have reduced the impact of automatic

enrolment. They find that financial literacy increases the probability of participating in a

pension fund, as well as the probability of transferring the TFR contributions to a pension

fund.

25. Despite the success of automatic enrolment at the company level in the United

States, membership in 401(k) plans has remained broadly constant at the national level

after the adoption of the Pension Protection Act in 2006, leading several states to take

further actions. According to data from the US Department of Labor, 401(k) coverage

increased from 27.5% of the working-age population in 2005 to 29.1% in 2006 and

stagnated at 29-30% thereafter. To further increase coverage, the US Administration

proposed in 2009 the "Automatic IRAs" programme, aiming at mandating employers not

offering an occupational pension plan to automatically enrol their employees in an

Individual Retirement Arrangement (IRA), with contributions deducted from the salary

and an opt-out option for the employee. Despite this, no legislation has been enacted at

the federal level yet. Several states have stepped in and created state-facilitated retirement

savings plans following the "Automatic IRAs" model (John & Antonelli, 2017; Munnell,

Belbase, & Sanzenbacher, 2016). According to the Georgetown Center for Retirement

Initiatives, since 2012, 40 states have considered to establish state-facilitated retirement

savings programmes. Seven states have already passed legislation (California,

Connecticut, Illinois, Maryland, New Jersey, Oregon and Washington). These plans use

private sector providers to manage investments and provide other services. By combining

state facilitation with private providers, they aim at allowing small employers to offer

simple, low-cost retirement savings plans to their employees.2

26. Automatic enrolment also has a positive impact on participation in the United

Kingdom and in Turkey. Cribb and Emmerson (2016) show that automatic enrolment in

the United Kingdom led to an increase of 37 percentage points in the probability of

participating in a workplace pension scheme for eligible private sector employees.

According to The Pensions Regulator (2016), as at March 2016, 66% of all employees

were active members of a pension scheme (Figure 1), compared with just 47% in 2012.

Only 4.5 months after the introduction of the new system in Turkey (as at 19 May 2017),

1 See Madrian and Shea (2001), Choi et al. (2001), Choi et al. (2004), Beshears et al. (2009) and Butrica and

Karamcheva (2015).

2 It is not clear what will happen to these plans already stablished in seven states after the Senate, in May 2017,

voted to reverse the policy. States may still be able to set up plans as long as they comply with ERISA

rules (therefore excluding the use of IRAs).

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nearly 2.9 million employees had already been automatically enrolled. As a comparison,

the individual voluntary system was introduced in 2003 and covered 5.6 million

individuals at the end of 2015.

27. Other forms of enrolments have been tested voluntarily by employers in the

United States. As an alternative to traditional opt-in programmes (employees are not

enrolled in the 401(k) plan unless they make an affirmative election) and to automatic

enrolment (employees are automatically enrolled and can opt out), Choi, Laibson and

Madrian (2009) and Beshears et al. (2013) studied the effects of Quick Enrollment™.

This programme gives workers the option of enrolling in the 401(k) plan provided by

their employer by opting into a pre-set default contribution rate and asset allocation. The

goal of this policy is to reduce complexity. Instead of evaluating all possible contribution

rate and asset allocation options, employees just face a binary choice between

participating based on the default options provided by the programme and non-

participating. The authors find that Quick Enrollment resulted in substantial 401(k)

participation increases, although typically smaller than automatic enrolment: it increased

the participation among new hires by 16 percentage points after three months of tenure

(relative to a standard enrolment mechanism in which employees must actively select

both a contribution rate and an asset allocation); and it prompted 10% to 20% of

previously hired employees who were not participating in their 401(k) plan to enrol in the

plan. They also find that the participation increases produced by Quick Enrollment are

durable and that employees who join the pension plan in this way often remain at the

default contribution rate and asset allocation for years.

28. Automatic enrolment and Quick Enrollment involve default options, but defaults

may not be suitable when they apply to a large number of people with heterogeneous

needs and preferences. Studies show that most participants enrolled under those

arrangements stick to both the default contribution rate and the default asset allocation for

long periods. For example, KiwiSaver members tend to retain the default contribution

rate they have been assigned to when joining the system. Inland Revenue statistics show

that as of 30 June 2011, 80% of people who joined KiwiSaver after April 2009

contributed 2% (the default between April 2009 and April 2013), while 62% of those who

joined before that date were still contributing 4% (the default before April 2009).

However, even well-chosen defaults may not be optimal when they apply to individuals

with highly heterogeneous situations. For example, in a company whose workforce

includes both financially constraint young parents and older employees who need to save

for their retirement, a single contribution rate to the occupational pension plan may not be

appropriate. Default contribution rates and investment strategies could vary according to

some observable demographic characteristics such as age, but unobserved employee

heterogeneity may limit the usefulness of such employee-specific defaults and the

practical implementation may be difficult (in particular from a legal perspective as not all

employees would be treated equally).

29. An alternative to default mechanisms is to force people to take active decisions

about their participation in a pension plan. Carroll et al. (2009) compare two kinds of

401(k) enrolment: standard enrolment (i.e. the default is not to participate) and active

decisions (i.e. there is no default but rather a compulsory choice between participating or

not). On the one hand, the active decision mechanism encourages individuals to think

about an important decision and avoid procrastinating. On the other hand, an active

decision mechanism requires individuals to deal with a potentially time-consuming and

complex issue and then explicitly express their decision at a time which may be

inconvenient. The authors describe a natural experiment at one firm and find that

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compelling new hires to make active decisions about 401(k) participation raises

participation by 28 percentage points relative to a standard opt-in enrolment procedure

after three months of tenure. In addition, contribution rates in the active decision cohort

reach levels that would take 30 months to achieve under standard enrolment, i.e.

employees immediately choose a contribution rate that is similar on average to what they

would take up to 30 months to attain under standard enrolment.

Providing financial incentives

30. Historically, tax incentives (tax exemptions, tax deductions, tax credits or rate

reliefs) have been the main type of financial incentives provided by governments to

promote private pensions. DAF/AS/PEN/WD(2017)2 shows that tax incentives,

especially tax deductions, encourage participation in private pension plans. The impact of

tax deductions on participation increases with income, as high-income individuals usually

face higher marginal tax rates. Individuals also respond to changes in tax incentives (e.g.

tax reforms, changes in contribution limits) by adjusting their participation in private

pension arrangements.

31. The evidence on the impact of rate reliefs on private pension participation is less

conclusive. For example, Feng (2014) fails to demonstrate a positive impact of a reduced

flat tax rate on contributions on participation in salary sacrifice arrangements in Australia.

A salary sacrifice arrangement is where employees agree contractually and voluntarily to

give up part of the remuneration that they would otherwise receive as salary or wages, in

return for their employer providing contributions to a superannuation fund of the same

amount. Salary sacrifice contributions attract a favourable tax treatment, being taxed at a

fixed rate of 15% (same as for mandatory employer contributions), rather than at the

marginal income tax rate. Using data from wave 10 of the Household Income and Labour

Dynamic in Australia survey, the author determines the effect of higher tax incentives on

the participation in salary sacrifice arrangements at two marginal tax rate jump points of

the personal income tax system, from 15% to 30% and from 30% to 38%.3 The results

indicate that tax incentives lead to a small but insignificant increase in participation in

salary sacrifice arrangements. The author explains that this result is likely due to the

complexity of the incentive schemes and competing demands for long-term savings. In

addition, the name of the arrangement, "salary sacrifice", is framed as a loss which may

discourage participation.

32. Tax incentives can be complemented by other types of financial incentives to

encourage participation in private pension, such as matching contributions (from the state

or from the employer) and state flat-rate subsidies. These incentives are provided to

eligible individuals who actually participate or make voluntary contributions to the

private pension system. Both matching contributions and state subsidies are paid in the

pension account, thus increasing the assets accumulated to finance retirement.

33. After tax incentives, matching contributions are the most common type of

financial incentive used by OECD and EU countries to promote private pensions (OECD,

2015b). Usually, the matching contribution is conditional on the individual contributing

and corresponds to a certain proportion of the individual's own contribution, up to a

maximum amount. The generosity of the match rate varies greatly across countries, from

3 The higher the marginal tax rate, the higher the drop in the tax rate on contributions and therefore the higher the

incentive to contribute.

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3% in Austria (paid by the state) to 325% in Mexico (paid by the state for civil servants).

A match rate of 50% can be found in Australia (paid by the state), Iceland (paid by the

employer) and New Zealand (paid by the state). Matching contributions usually apply to

all workers, but can also be targeted to specific groups, such as young workers (as in

Chile) or low-income individuals (as in Australia).

34. Empirical evidence from a large body of the literature in the United States

suggests that matching contributions increase participation in private pension plans. Choi

(2015) and Madrian (2013) review the rich literature in the United States regarding the

effect of matching contributions on participation and conclude that matching

contributions increase participation. Madrian (2013) however qualifies the quantitative

impact as small. This statement relies on a study by Engelhardt and Kumar (2007).

Indeed, using a nationally representative random sample of individuals aged 51 to 61 and

their spouses from the Health and Retirement Survey, they find that increasing the match

rate by 25 percentage points (for example, from 25 cents per dollar of employee

contribution to 50 cents) raises 401(k) participation by 5 percentage points. Choi (2015)

reports that an increase of 10 percentage points in the match rate increases the

participation rate in a range from 2.5 percentage points to 6.3 percentage points,

depending on the study.

35. Flat-rate subsidies paid by the state into pension accounts can be found in Chile,

Germany, Lithuania and Mexico. They are designed to attract low-income individuals, as

the fixed subsidy represents a higher share of their income. In Germany, financial

institutions can offer so-called Riester pension plans since 2002. The state encourages

people to contribute to a Riester plan via two types of incentives: tax exemptions and flat-

rate subsidies. Flat-rate subsidies are particularly valuable for low-income individuals,

while tax deductions attract more high-income individuals. There are three types of flat-

rate subsidies: a basic subsidy of EUR 154 per year and per person, a child subsidy of

EUR 300 per year and per child and a young worker subsidy of EUR 200 granted once at

the age of 25. In order to receive the maximum subsidy, the sum of the member's

contributions and the subsidy must be at least equal to 4% of his/her previous year's

annual income. Only very low-income households can get the full subsidy without

investing 4% of their income if they contribute at least EUR 60 annually. In 2012, 44% of

eligible households were covered by the Riester scheme (Börsch-Supan et al., 2016).

36. Evidence related to the introduction of the Riester pension scheme in Germany

shows that subsidies are effective in attracting families with children and low-income

earners. Indeed, Pfarr and Schneider (2013) find that child subsidies have an impact on

the take up of Riester plans. In addition, Börsch-Supan, Coppola and Reil-Held (2012)

and OECD (2012) show that despite the fact that coverage rates of Riester pensions

increase with income, Riester pensions are more equally distributed by income than

occupational pensions and unsubsidised private pension plans. For example, in 2009, only

around 19% of households in the lowest income bracket had taken up Riester pension

plans, while almost a half of those in the two upper income brackets participated in the

scheme. However, the distribution of participation is even more skewed towards high-

income individuals for occupational pension plans and other private pension plans, which

cover only around 5% of households in the lowest income bracket. Therefore, among

low-income households, Riester pensions are much more common than any other form of

private pension provision. As a result, Riester pensions are more equally distributed by

income than occupational pensions or unsubsidised private pension schemes.

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Increasing access to information, knowledge and skills

37. Policy makers increasingly recognise the role of financial education in supporting

individuals to plan for their retirement. OECD (2016a) summarises the different financial

education tools used in different jurisdictions to address various financial education needs

in relation to retirement planning. These can be split into three broad categories:

Providing information on retirement options and increasing awareness of

retirement issues: this includes general information through websites, awareness

campaigns covering retirement issues, comparison tools presenting plan features

in a standardised way, personalised pension statements, access to personal

information online, as well as calculators and simulators;

Instruction: this takes the form of seminars and workshops about retirement

planning, helping participants acquire financial knowledge and skills relevant for

retirement, explaining the risks that individuals may be exposed to and suggesting

how to manage them, and helping individuals estimate their retirement income

needs, with the ultimate goal to help them taking decisions about their pensions;

Advice: this ranges from factual information to fully personalised advice.

38. Evidence on the effectiveness of financial education for retirement is currently

limited but suggests that workplace financial education can be effective in increasing

enrolment in occupational pension plans (Atkinson, Messy, Rabinovich, & Yoong, 2015).

Workplace financial education initiatives that are efficient in increasing participation in

private pension arrangements include seminars and workshops and online courses. For

instance, Duflo and Saez (2003) studied a university that encouraged a random sample of

its employees to attend to an annual event providing information on benefits, including an

occupational pension plan. They found that 5 to 11 months after the event, plan

participation was higher in treated departments (i.e. those where a random sample of

employees received an invitation letter promising a reward for attending the event) than

in control departments. Collins and Urban (2016) show that online financial education

courses offered to employees increases self-reported IRA participation by six percentage

points.

39. In addition, providing more information on the employer's pension plan and how

to join it can also increase participation. Clark, Maki and Morrill (2014) find that young

employees (18 to 24 years old) who received a flyer containing information about their

employer's 401(k) plan and the value of contributions compounding over a career, were

more likely to begin contributing to the plan compared to workers of a similar age that

did not receive the flyer. Lusardi, Keller and Keller (2009) study the impact of helping

employees form and implement a savings plan through the provision of a planning aid

that (a) encourages individuals to set aside a specific time for enrolling in their savings

plan, (b) outlines the steps involved in enrolling in the plan (e.g., choosing a contribution

rate and an asset allocation), (c) gives an approximation of the time each step will take,

and (d) provides tips on what to do if individuals get stuck. This planning aid increased

enrolment in the studied occupational pension plan by 12 to 21 percentage points for

newly hired employees.

40. The take up of financial advice may be increased by facilitating the payment for

advice. For example, the United Kingdom has introduced a pension advice allowance to

enable people to withdraw money from their DC pension plan to access pension and

retirement advice. Since April 2017, pension providers are able to offer the allowance to

their members. Individual members and beneficiaries can, at any age, withdraw GBP 500

tax free, no more than once in a tax year, and up to a maximum of three times in total.

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Payment of the allowance must be made directly from the pension scheme to the financial

adviser and is only available for regulated financial advice, including "robo advice" as

well as traditional face-to-face advice.

41. Finally, not all type of information may contribute to increasing participation in

retirement savings plans. For example, Beshears et al. (2015) show that information about

peers' saving behaviour may discourage participation by generating "oppositional

reaction". The authors conducted a field experiment to assess the impact on retirement

savings choices of disseminating information about what a target population's peer

usually do. The expectation was that individuals may realise that participating in their

employer's 401(k) plan is more common than they had previously believed among their

co-workers, and thereby that social influence would motivate them to enrol in the plan.

On the contrary, the results show that the presence of peer information decreased the

likelihood of subsequently enrolling in the plan by approximately one-third from 9.9% to

6.3%. The authors find that the oppositional reaction is concentrated among employees

with relatively lower income. This result suggests that information about peers' savings

choices may discourage low-income employees by making their relative economic status

more salient, reducing their motivation to increase their retirement savings.

4. How much to contribute

Issues posed by poor financial literacy and behavioural biases

42. People need to decide how much money they may need for retirement and how

much they need to put aside to cover those needs. Determining the appropriate

contribution rate is difficult in both mandatory and voluntary private pension systems.

High enough contribution rates paid for long periods are necessary to improve people's

chances to achieve an adequate retirement income (OECD, 2012). In mandatory systems,

the contribution rate is determined by regulation but people need to assess whether they

need to complement it with voluntary contributions. In voluntary systems, people can

usually choose how much they want to contribute, although some minimum may be

prescribed by law. In any case, people need the numeracy and financial skills to assess

whether their contributions will translate into an income that will cover their needs in

retirement. That assessment should be done given the level of retirement income that may

be expected from the public pension system, which requires a good level of

understanding of the rules used to compute public pension benefits.

43. The main behavioural biases affecting how much people contribute in DC pension

arrangements are self-control, use of simple heuristics, projection bias and loss aversion.

44. Saving for retirement requires self-control. When surveyed about their low

savings rates, many households report that they would like to save more but lack the

willpower. For example, Choi et al. (2001) report that 67.7% of their sample of 401(k)

participants think that their contribution rate is “too low.” However, procrastination

makes them postpone action to increase their contribution rate. Among self-reported

under-savers, 35% expressed an intention to increase their contribution rate in the next

few months, but only 14% of this subgroup actually increased their contribution rate in

the four months following the survey. People tend not to follow through on their good

intentions. For the same reason, people automatically enrolled tend to stick to the default

contribution rate for long periods, even when this default is not the optimal rate for them.

45. There are no satisfactory heuristics that could help people approximate a good

contribution rate. The most common heuristics in place appear to be to save the maximum

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allowed by law to get tax incentives or to save the minimum necessary to receive the full

matching contribution offered by the employer or the state. Neither of these amounts

however was most likely computed to be the most appropriate contribution rate for

everyone.

46. Projection bias may also interfere with the contribution rate level chosen by

individuals. People may indeed underestimate how much income they will need during

retirement if they base their assessment on their current needs and preferences or if they

underestimate their life expectancy. They may underestimate the fact that their

preferences and circumstances may change when they get older and therefore fail to save

enough for retirement.

47. Finally, loss aversion affects savings. Many studies show that people have the

tendency to weigh losses significantly more heavily than gains. Estimates of loss aversion

are typically close to 2. Losses hurt roughly twice as much as gains yield pleasure. Once

people get used to a particular level of disposable income, they tend to view reductions in

that level as a loss. Thus people may be reluctant to increase their contributions to their

private pension plan because they do not want to experience a cut in take-home pay.

Assessment of policies

48. This section assesses policies that automatically increase contribution rates over

time or that aims at increasing savings rates through the provision of information about

retirement and expected benefits. It also looks at how automatic enrolment and matching

contributions interact with contribution levels.

Automatic escalation of contributions

49. To help individuals eventually save enough to reach their target retirement

income, several policies establish plans with automatic increases in contribution rates.

Individuals at early stages of their working life have generally less income and greater

consumption needs (e.g. housing, tuition) than later in their careers, making it harder to

save for retirement. In this context, it may be appropriate to have contribution rates

increasing as people age (Blake, Wright, & Zhang, 2014). However, one needs to be

careful about the potential time inconsistency of contribution rates as contribution rates

may need to reach extremely high levels at the end of one's career in order to attain the

same target retirement income (OECD, 2012). Two initiatives have been tested in the

United States to help people save more over time: Save More Tomorrow™ (SMarT

programme) and Easy Escalation™.

50. Thaler and Benartzi (2004) describe the SMarT programme and argue that it

successfully increased the contribution rate of participants. The goal of the programme is

to help employees who would like to save more but lack the willpower to act on this

desire. The programme therefore gives workers the option of committing themselves now

to increasing their contribution rate later. The increase in the contribution level happens

each time the individual gets a salary increase. This feature mitigates the perceived loss

aversion of a cut in take-home pay. The contribution rate continues to increase on each

scheduled salary increase until the contribution rate reaches a pre-set maximum. In this

way, inertia and status quo bias work towards keeping people in the plan. The employee

can opt out of the plan at any time. Knowledge of this feature also makes employees more

comfortable about joining. The initial experience with the SMarT plan took place in 1998

in a midsize manufacturing company. Most of the individuals who were previously

participating in their employer pension plan and were offered the plan elected to use it

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(78%) and a majority of those who joined the SMarT plan remained with it through four

salary increases (80%). Results show that SMarT participants almost quadrupled their

contribution rates: the average contribution rates for SMarT participants increased from

3.5% to 13.6% over the course of 40 months.

51. Easy Escalation allows employees already participating in a pension plan to

increase their contribution rate to a pre-selected level. Beshears et al. (2013) evaluate the

implementation of the Easy Escalation plan in one company. In January 2004 and

February 2005, that company sent Easy Escalation forms to employees already

participating in the company pension plan whose contribution rate was below 6%. These

forms allowed employees to tick a box to increase their total contribution rate to the 6%

threshold. The authors find that about 15% of low contributors who received an Easy

Escalation form raised their contribution rate to the pre-selected threshold. In comparison,

only about 1% of low contributors on average increased their contribution rate to 6%

outside the months during which Easy Escalation forms were sent.

52. Some countries set the default or mandatory contribution rate to the private

pension system below the level desired initially and raise it afterwards. For mandatory

pension schemes, this may be a way to make it easier for people to accept the policy and

adjust to it. For automatic enrolment schemes, the main goal is to minimise opt-out rates,

as too high contribution rates may reverse the effectiveness of automatic enrolment by

increasing the feeling of a loss on take-home pay. Ideally, this increase in the contribution

rate could be done in an automatic manner according to a set calendar. For example, in

Australia, the mandatory contribution rate was set at 3% initially and is being raised

gradually to 12% by 2025. In the United Kingdom, minimum contribution levels for

automatic enrolment schemes are being phased in to help both employers and individuals

adjust gradually to the additional costs of the reform. Between October 2012 and October

2018, the minimum total contribution rate will rise from 2% to 8% on a band of

qualifying earnings, while the minimum employer contribution rate will rise from 1% to

3%.

Provision of information

53. Salient information about retirement and expected benefits can also increase

contributions to private pension arrangements. Dolls et al. (2016) use a reform in

Germany that increased the information about future pension payments and made the

issue of retirement more salient to individuals to assess the impact of information letters

on retirement savings. Since 2004, the German pension authority sends out annual letters

which provide detailed and clear information about the pension system in general and

individual expected pension payments. The letters also highlight the importance of

additional voluntary retirement savings. Using tax return data from administrative

records, the authors find that receiving the letter increases contributions to a Riester

pension plan (excluding subsidies).

54. Personalised information, as opposed to general information, can better encourage

people to increase contributions. Fuentes et al. (2017) shows the results of randomly

giving low- to middle-income workers in Chile either personalised or generalised

information regarding their pension savings. Individuals in the treatment group received a

personalised estimate of their expected pension under different scenarios: status quo,

increasing the contribution density, increasing voluntary savings, and delaying retirement

by one year. Individuals in the control group received comparable general information

and recommendations on how to improve their future pensions (including by increasing

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their contribution density, by increasing voluntary savings and by postponing retirement

age) but without any reference to their individual situation. The authors find that

voluntary savings increased by about 10-15% for the treatment group compared to the

control group.

55. Finally, calculators and simulators can facilitate the estimation of the contribution

rate needed to cover people's needs in retirement and reduce the difficulties related to lack

of numeracy. By providing forward-looking information under different scenarios, they

make the long-term benefit of saving more salient and improve awareness of the link

between contributions and retirement income (OECD, 2016a). In addition, they usually

allow users to assess how their retirement income would change if they change their

expectation regarding the retirement age or the contribution rate for example, of if

external parameters (e.g. rate of return, inflation) change. Moreover, by combining

information about the different sources of retirement income (e.g., public and private),

simulators and calculators help people realise whether their overall target replacement

rate can realistically be achieved given their current saving behaviour. Such calculators

are available for instance in Chile, Latvia, the Netherlands and the United Kingdom.

Impact of automatic enrolment and matching contributions on contribution levels

56. While automatic enrolment increase participation in private pension

arrangements, evidence on its impact on contribution rates is mixed. In the United States,

Butrica and Karamcheva (2015) show that the total (employee plus employer)

contribution rate is 1.6 percentage points lower for automatically enrolled workers

compared to workers who opted in voluntarily, mostly due to lower employee

contributions. Soto and Butrica (2009) also show that employers adjust their 401(k)

match rate downwards in response to automatic enrolment. Evidence in the United

Kingdom however leads to opposite results, with automatic enrolment resulting in higher

total contribution rates (Cribb & Emmerson, 2016). The authors argue that this is partly

due to some employers contributing above the long-run minimum contribution rate

mandated by the government. For example, automatic enrolment is associated with a

4.1% percentage point increase in the proportion of employees receiving an employer

contribution above 5% (the minimum employer contribution rate will be 3% as of

October 2018).

57. The impact of matching contribution on total contributions is also unclear. Choi

(2015) and Madrian (2013) both show that the empirical evidence in the United States on

the impact of matching on total contributions is mixed: some studies find a positive

relationship between matching and contributions, others find no relationship and yet other

studies find a negative relationship. Choi et al. (2001) show however that the rate of

employee contribution up to which the employer offers the match (i.e. the match

threshold) has an impact on employee contributions. They study a company with a 50%

match rate that increased its match threshold from 5% to 7% of income for union workers

and from 6% to 8% of income for management employees. They observe an immediate

change in the distribution of employee contribution rates towards an increase in the

proportion of participants contributing between 7% and 8%. Finally, OECD (2012) also

shows that matching contributions targeted at low-income individuals may encourage

higher contribution rates for that sub-group. Indeed, in Australia, low-income individuals

are encouraged to make voluntary contributions to the pension system through a dollar-

for-dollar government matching contribution (up to a ceiling). Data show that among

individuals making voluntary contributions, low-income individuals have a higher

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contribution rate than other income groups, as taking advantage of the maximum

matching requires a larger contribution effort.

5. Choice of the pension provider

Issues posed by poor financial literacy and behavioural biases

58. Participants in private pensions are expected to choose among pension providers

the one that best fits their needs. This choice should be driven, among others, by

comparing the services offered, the long-term performance, and the fees charged.

Unfortunately, comparing pension providers takes time and effort. In addition, low

financial literacy and behavioural biases affect how people choose, which could lead to

lower competition between pension providers and ultimately increase costs and fees.

59. People may lack the skills to compare pension providers and choose the best one

for them, in particular when many providers are available (choice overload) and pricing

practices are complex. For example, when pension providers use different fee structures,

it becomes difficult for individuals to compare pension plans. This is the case in Latvia,

where voluntary private pension funds can use a mix of asset-based and contribution-

based fees.

60. Behavioural biases may create or strengthen market power in what would

otherwise be a competitive market (Erta et al., 2013). Because of procrastination and

inertia, pension plan members tend to stick with their existing plans, do not shop around,

do not compare plans based on their most critical characteristics, and do not switch to

better plans. For example, in Mexico weak member engagement and understanding

reduced the effectiveness of two traditional competition policies, increasing the number

of providers and allowing people to switch between providers. These policies have

actually led to higher costs and less competition. The annuity market in the United

Kingdom illustrates the potential consequences of inertia on competition. Before the

pension freedoms reform in 2015, individuals were basically required to buy an annuity

in the United Kingdom. The Financial Conduct Authority reports that, in 2012, 60% of

individuals purchased an annuity with their existing provider, even though an estimated

80% of these individuals could have gotten a better deal elsewhere (Financial Conduct

Authority, 2014).

61. Finally, framing, persuasion and simplistic rules of thumb may guide individuals'

choice of the pension provider rather than thorough analyses of plan characteristics.

Individuals may not choose the appropriate pension plan if they focus on the salient

information provided by pension providers and underweight or ignore the non-salient, but

potentially important, pieces of information. In addition, individuals may choose a

specific plan because they know the brand name of the management company, because

the sales person was nice to them, or because that plan was first in the list of options.

Assessment of policies

62. Most policies implemented in OECD and non-OECD jurisdictions, to help people

with the choice of their pension provider, focus on the demand side. Because of poor

financial literacy and behavioural biases, competition between pension providers may not

be effective. One solution could be to default people into low-cost providers.

Alternatively, policy makers may want to implement measures to strengthen competitive

pressures through disclosure-based initiatives that ensure that members receive timely

information on the fees they pay and can compare them across providers. These

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initiatives need to be complemented by measures improving efficiency in the pension

industry, so that individuals can expect good value for money independently of the choice

of the provider. These include transparency measures, pricing regulations and structural

solutions. DAF/AS/PEN/WD(2017)5 provides some more details on these measures.

Default providers

63. Low-cost providers with high quality standards can be introduced as a default. In

the case of New Zealand, default KiwiSaver providers are intended to be temporary,

managing assets following a conservative approach while members consider the best

provider for them. Default providers have a special contract with the government that

requires them to meet additional reporting requirements. Their activities and default

investment funds are closely monitored. Nine default KiwiSaver providers have been

appointed by the government for a seven year term starting 1 July 2014. If a member does

not choose a scheme, and his/her employer does not have a chosen scheme, then Inland

Revenue allocates that person to one of the default providers. By June 2016, 21% of

KiwiSaver members were with a default provider, 8% were with the provider chosen by

their employer and a vast majority (71%) were with a provider they had actively chosen.

The Chilean auction process (described later on) that assigns new entrants to the labour

market to the provider offering the lower fees could also be considered as an approach to

appoint default providers.

Disclosure-based initiatives

64. Enhanced disclosure primarily aims at encouraging plan participants to react to

differences in cost and fee levels. The Danish government-backed site

www.pensionsinfo.dk provides individuals with comprehensive information on their own

pension accounts including direct and indirect administration and investment costs, and

past returns. The 2015 Communications Act in the Netherlands requires schemes to

provide standardised information to their members. Individual pension statements in

Mexico include information on fees paid by the worker and compare net-of-fees returns

across pension funds. In the United States, participant disclosure regulation 404(a)

requires plan sponsors to ensure that participants and beneficiaries receive sufficient

information on fees, expenses and performance to make informed investment decisions.

As argued in OECD (2014), pension statements should ideally combine all sources of

retirement income and include accurate and standardised information, in as simple

language as possible.

65. The main limitation of disclosure-based initiatives is that pension statements and

information websites do not always succeed in prompting members' action regarding their

retirement savings. This is particularly the case for people with low financial knowledge.

Indeed, as people do not always have a good understanding of the effect of compounding,

they may not realise that small differences in fees (a few basis points) may translate into

large differences in assets at the end of the accumulation period. In addition, while greater

transparency and more straightforward comparisons should make it easier for plan

participants to switch providers, switches may not always occur in the intended direction.

Calderón-Colín, Domínguez and Schwartz (2008) indeed show that in Mexico, instead of

strengthening competition through lower fees and higher returns for the workers,

switching resulted in lower pensions for more than half of workers. Between 2001 and

2014, the majority of the workers who switched did so to a pension fund providing a

lower net return (negative switch). In addition, pension funds actually increase their

market share through larger marketing costs and a greater number of sales agents that try

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to convince workers to switch (OECD, 2016c). The regulator is therefore considering

extending the period during which workers cannot switch from one to three years, with

the possibility to switch after one year only if the pension fund receiving the account

offers better returns and better services.

Transparency measures

66. In some countries, transparency is seen as a key element to encourage competition

and aims at changing the behaviour of pension plan providers. This includes measures to

improve reporting, communication and benchmarking of investment costs and plan fees.

In the Netherlands and Denmark for example, pension plans are required to provide

granular information on administration and investment costs. This has led to greater cost

awareness, resulting in better outcomes for members. Table 3 indicates that pension

providers in the Netherlands had an incomplete picture of their costs before reporting

requirements were introduced in 2011: ABP and PMT for example significantly

understated their 2010 costs. The data also show that pension funds were able to take

action on the basis of the new information, as PME and PMT both reduced their costs

over the period 2011-2013. Other funds took similar action but made other changes that

mean that overall costs did not decline.

Table 3. Asset management costs in selected Dutch pension funds, 2010-2013

In basis points of assets under management

Pension fund 2010 2011 2012 2013

ABP* 39 64 73 76 PFZW 48 55 57 61 PMT 17 62 54 40 BPF Bouw 52 46 50 58 PME 70 53 37 29

Note: ABP restated the 2010 figure to 70 basis points.

Source: Pension Federation (2016), "Recommendations on Administrative Costs", revised version.

Pricing regulations

67. Changing the charge structure can facilitate comparisons between pension

providers. Some countries replaced their mixed fee structures (usually with fees on both

assets and contributions) with a single, asset-based fee. This is the case for example in

Mexico (2008) and Costa Rica (2011). Avoiding mixed fee structures can contribute to

disclosure efforts by making it easier for participants to understand what services they are

paying for and exactly how much they are paying. In Latvia, investment management

companies can only charge fees on assets, but voluntary private pension funds can still

use a mix of asset-based and contribution-based fees, making it difficult for participants

to compare across pension funds.

68. As a complement to a single charge structure, some countries have introduced

more direct controls over pricing, such as caps on fees. This measure is useful when

competition is not sufficient by itself to bring down prices. The United Kingdom

introduced a cap on fees of 0.75% of assets under management that applies to workplace

default funds since April 2015. The cap includes all direct and indirect administration and

investment costs, but does not include transaction costs. In Turkey, fees in the new

automatic enrolment system have been capped at 0.85% of assets under management a

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year (compared with 1.7% a year in the individual voluntary system). Poland has

successfully used price caps to lower fees. In 2004, the regulator capped the management

fee at 7% of contributions. In 2010, a new legal limit of 3.5% was introduced. Under the

2014 pension reform law, the maximum fee fell again to 1.75%. In Costa Rica, the fee

was initially capped at 1.1% of assets and will be reduced to 0.35% by 2020, so that

members share in the benefits from economies of scale. Finally, Hong Kong (China)

introduced a new Default Investment Strategy in April 2017 for mandatory pension funds,

with a cap on management fees of 0.75% of the net asset value of the funds per year, and

a cap on recurrent out-of-pocket expenses of 0.2%.

69. Caps set a clear and simple standard for member fees but can have unintended

consequences. First, if the cap is set too high, fees tend to rise to the level of the cap. For

example, when stakeholder pensions were introduced in the United Kingdom in 2001

with a maximum fee of 1%, this limit became the market price for all similar retirement

savings products. In a similar manner, the German government estimated that Riester

products could run with a total fee of 10% of assets and this has become the de facto

standard fee. The cap is probably also too high in Latvia, as all investment management

companies charge the maximum fee allowed by regulation (1% fixed fee and 0.5% to 1%

performance-based fee depending on the investment plan). Second, if the cap is set too

low, plan providers may try to cut costs by offering lower-quality plans or by reducing

the number of transactions they undertake, even when the trades would be in the best

interests of members. Third, if the cap does not include all costs, providers may have an

incentive to exaggerate uncapped costs in order to compensate for any lost profits in areas

that do fall within the scope of the cap. This is a concern in the United Kingdom, as the

new 0.75% cap does not cover transaction costs.

Structural solutions

70. Structural solutions entail an intervention in the structure of the market. These can

include measures to strengthen competition. Where enhanced market mechanisms are not

sufficient to control fees charged to members, policy makers may consider measures to

influence the operational set-up of pension providers or the organisational set-up of the

market in which they operate.

71. In order to strengthen competition, Chile introduced an auction process in 2008.

The auction applies to the fees charged for the management of the individual accounts for

new members. New members are automatically enrolled in the pension fund which

charges the lowest fees and they are required to remain in this pension fund for at least 24

months. The fees cover administration costs and internal investment costs. There have

been three auctions since the reform was enacted. The first auction took place in 2010 and

it allowed a new pension fund to enter the market starting from August of that year,

offering the minimum fee of the system equal to 1.14% of salary. The same pension fund

won the second auction in January 2012, decreasing the fee offered to 0.77% of salary.

As a result, another pension fund decided to lower its fees from June 2012, the first

reduction by any of the incumbents since 2009. During the third auction, carried out in

January 2014, the pension fund previously with the highest fee won the auction by

lowering it to 0.47% of salary.

72. Policy makers in several jurisdictions are encouraging the development of bigger

and more efficient plans through mergers or other organisational changes in order to

benefit from economies of scale. Fund mergers can be mandatory, as in Sweden, or a

voluntary response to other regulatory pressures such as increased scrutiny of costs, as in

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the Netherlands and Switzerland. The Pooled Registered Pension Plan (PRPP) framework

in Canada is designed to pool individual accounts in order to benefit from economies of

scale. Total costs charged to PRPP members cannot be higher than those incurred by the

members of DC plans that provide investment options to groups of 500 or more members.

Since 2013, Australian superannuation funds are required to determine each year whether

their MySuper product has access to sufficient scale, with respect to both assets and

number of members. This requirement seeks to ensure that members of a particular

MySuper product are not disadvantaged in comparison to members of other MySuper

products.

73. Another structural solution may involve the establishment of a new, centralised

institution. Centralised institutions can help to control member fees in a number of ways:

Provide additional competition to plan providers: e.g. NEST in the United

Kingdom competes with other providers for automatic enrolment business.

Offer low-cost solutions directly to underserved populations: e.g. NEST has an

obligation to take on smaller accounts.

Ensure that economies of scale are available to all participants: e.g. the PPM

clearinghouse in Sweden offers a platform to negotiate better terms (lower fees)

on behalf of plan members.

74. This policy solution can be very effective in achieving low fees as it ensures

economies of scale and can avoid the marketing expenses of the retail model. However, it

could be argued that centralised institutions have an unfair marketing advantage and can

price in economies of scale before they are realised thanks to government support. A

centralised institution can also raise governance challenges that call for effective and

strong independent oversight.

75. Finally, reduced costs can be implemented via the use of passive investment

strategies or the introduction of simple, low-cost pension products, for example MySuper

in Australia and MyRA in the United States. MySuper was introduced in 2012 in

Australia. It offers lower fees (with restrictions on the type of fees that can be charged)

and simple features (e.g. MySuper products offer a single diversified investment option or

a lifecycle investment option). All superannuation funds can apply to offer a MySuper

product. Since 1 January 2014, only funds offering a MySuper product are eligible to be

the default fund for new employees. From 1 July 2017, all member accounts in default

investment options will be required to be transferred to MySuper products. Since

November 2015, Americans having an annual earned income below USD 132 000 (or

USD 194 000 if married filing jointly) can start saving for their retirement in a MyRA

account. myRA is a public-managed Roth IRA that invests in United States Treasury

savings bond and guarantees the capital. myRA accounts cost nothing to open, have no

fees, and do not require a minimum amount of savings. Once the account reaches 30

years or a maximum balance of USD 15 000 (whichever comes first), the balance in the

account must be transferred into a privately-managed Roth IRA. In that sense, it is a

product to help people who do not have access to occupational pension plans to start

saving for retirement in an easy, safe and costless way.

6. Choice of the investment strategy

Issues posed by poor financial literacy and behavioural biases

76. In DC pension arrangements, participants usually bear the risks and consequences

of their investment decisions. If participants behave as predicted by economic theory,

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such responsibility would be welfare-enhancing as members would invest and hold a

portfolio of financial assets with a risk-return combination consistent with their

investment horizon, degree of risk aversion and the portfolio of other assets they hold.

This assumes that members have the knowledge to exercise choice and that their choice is

not distorted by behavioural biases.

77. However, individuals lack good financial knowledge and are prone to various

behavioural biases that can have an impact on investment choice (Tapia & Yermo, 2007),

including:

Choice and information overload:

Contrary to popular belief, more choice is not always better. Individuals can be prone to

choice overload and therefore fail to act. For example, Iyengar, Jiang and Huberman

(2004) find that participation rates in 401(k) pension plans decline as the number of fund

option increases.

Time-inconsistent preferences:

Risk aversion and preferences vary over time, complicating optimal investment plan

design. In addition, inertia (keeping things as they are) and procrastination (put the

decision off until tomorrow) affect individuals' decisions, leading to sub-optimal choices.

For example, Benartzi and Thaler (2002) show that plan participants rarely rebalance

their investment portfolios after joining plans and have relatively week preferences for

the portfolio they elect.

Heuristic decision making:

When making investment decisions, people are confronted with a complex sequence of

choices. To start with, they have to decide whether to invest in the default option. If not,

they then have to decide in how many funds to invest, in which funds to invest and finally

what percentage to invest in each fund.

Faced with complex decisions, people rely on simple rules of thumb or heuristics, that

serve to reduce the complexity of the options to be assessed. Benartzi and Thaler (2001)

show evidence that participants make decisions that seem to be based on naive notions of

diversification, such as the "1/n heuristic". The rule simply divides contributions evenly

among the n options offered in the retirement savings plan. There is nothing wrong a

priori with this allocation per se, but the authors show that the complete reliance on the

l/n heuristic could be costly. For example, individuals who are using this rule and are

enrolled in plans with predominantly stock funds will find themselves owning mostly

stocks, while those in plans that have mostly fixed income funds will own mostly bonds.

The empirical evidence in Benartzi and Thaler (2001) confirms that the array of funds

being offered affects the resulting asset allocation: the proportion invested in stocks

depends strongly on the proportion of stock funds in the plan.

Framing effects:

Another bias in decision-making is a result of the fact that many participants are

influenced by the way in which saving and investment issues are presented or "framed".

In addition, if a number of different investment options are presented, issues such as

numbering and the order in which they appear will affect choice, as people may not

bother going through the whole list.

For instance, a recent study by Bateman et al. (2016) shows that individuals are more

influenced by asset allocation information than risk and return information when

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comparing different investment options. The authors conduct an experiment in Australia

to see how university students and staff participating in the university retirement plan

choose retirement savings investment options using a new short-form product disclosure

statement prescribed by the regulator. The prescribed information includes expected

return, risk, percentage allocations between risky and risk-free assets, minimum

suggested time frame for investment, and textual risk label. They find that asset allocation

information had the largest impact on choices. Participants preferred investment options

with more, and more evenly weighted, asset classes. Individuals appear to focus on asset

allocation information at the expense of risk and return information. When asset

allocation information is not shown to participants, they revert to a risk-return trade-off.

Overconfidence and over-extrapolation:

A large experimental literature finds that individuals are usually overconfident (Tapia &

Yermo, 2007). Overconfidence is the tendency for people to overestimate their

knowledge, abilities and the precision of their information. Over-extrapolation occurs

when people make projections on the basis of only a few observations, implicitly

believing that these observations suggest real patterns or trends (e.g. using the past year's

return to guess on the future performance of an investment strategy). These biases mean

that investment decisions may become based on conjectures rather than fundamental

value.

Loss aversion:

People often strongly prefer avoiding losses to acquiring gains. This may result in under-

diversified portfolios with an over-reliance on fixed income.

78. Overall, women, as well as older, low-income and less educated individuals are

more likely to make portfolio "mistakes". Hung and Yoong (2013) diagnose portfolio

mistakes based on commonly accepted principles of investment, mainly avoiding overly

conservative portfolios (no equity exposure or less than 40% in equities), overly

aggressive portfolios (more than 95% in equities) and under-diversified portfolios (100%

in a single asset class). Based on a sample of 401(k) plan participants from a nationally

representative household survey, they find that more than half (56%) of respondents'

portfolios have at least one mistake. Women tend to be more conservative in general,

being more prone to having too few equities: 42.2% have too conservative portfolios, as

opposed to 26.2% for men. As a result they also tend to be under-diversified overall.

Similarly, individuals older than 45, those earning less than USD 50 000 and individuals

without college degree are also more likely to be holding no stocks.

Assessment of policies

79. In order to account for the implications of low financial literacy and behavioural

biases on investment decisions, policy makers have focused on three key aspects of

pension plan design: the range of investment options, the design of the default investment

strategy and the opportunity to offer investment return guarantees.

Investment options

80. In DC pension arrangements, policy makers need to find the appropriate balance

between a wide range of individual choices on the one hand, allowing people to take into

consideration their individual risk profiles and preferences, and the simplicity of a

restricted menu of choices on the other.

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81. Some countries, such as Sweden and Australia, give priority to individual choice

and allow a large number of investment options. These are complemented with default

strategies for those unwilling or unable to choose. For example, in Sweden, individuals

can choose up to five funds from the 830 registered with the Swedish Pensions Agency at

the end of 2015. If an individual decides not to choose his/her own funds, the

contributions go to the publicly-managed fund AP7. According to the Swedish

Investment Fund Association (2013), 63% of Swedes like having fund choice within the

premium pension system. The share of individuals appreciating this choice is even greater

(71%) for the youngest age group (aged 18 to 42). By the end of 2016, just over 2.8

million workers had chosen their own funds, representing 50% of all active members

(The Swedish Pensions Agency, 2016).

82. At the other extreme, many countries in Latin America and Central and Eastern

Europe (CEE) allow participants to choose only from a restricted number of investment

options. In Mexico for example, each asset manager has to propose four pension funds,

which by default are targeted to people of different age groups (up to 36 years old, 37 to

45 years old, 46 to 59 years old, and from 60 years old). As members get older, their

pension assets are invested in a more conservative investment strategy, with a lower

exposure to equities and a greater proportion of fixed-income instruments. Nonetheless,

members can opt to invest their assets in a more conservative fund than the default

option. In Chile, the multi-fund system is composed of five different funds, named A, B,

C, D and E according to the level of risk (fund A being the most risky). Members can

freely choose any fund, except pensioners, men over 55 years old and women over 50

years old. Older members are not allowed to choose the most risky fund (A), while

pensioners are not allowed to choose the two most risky funds (A and B) (see Table 4).

The reason for these restrictions is to prevent pensioners or members approaching

retirement age from taking high risks on investments, since a shock in financial markets

for these members may produce irreversible damage to the amount of their pensions and

the level of solidarity pension paid by the state. In CEE countries, funds are usually

named by their risk level. For example, in Estonia, members can choose from four funds:

conservative, balanced, progressive and aggressive. In Latvia, members can only choose

from three funds: conservative, balanced and active. In both cases, the funds are

differentiated mainly by the proportion of each fund invested in equities.

Table 4. Chile multi-fund system

Type of fund Up to 35 years old Men: 36 to 55 years old

Women: 36 to 50 years old

Men: over 56 years old

Women: over 50 years old Pensioners

Fund A - Most risky

Fund B - Risky Default

Fund C - Intermediate Default

Fund D - Conservative Default Default

Fund E - Most conservative

Note: Green cells represent funds that members can choose from.

83. Reducing and simplifying investment options can improve members' outcomes.

Keim and Mitchell (2016) examine how employees in a large U.S. firm changed their

fund allocations when the employer streamlined its pension fund menu and deleted nearly

half of the offered funds. The authors examine plan participants' investment choices prior

to and after the streamlining event and evaluate what happened to participant fund

allocations, risk exposure, and costs as a result of the change. Participants holding the

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deleted funds could either i) reallocate their money to funds kept in the list in advance of

the deadline, or ii) be defaulted into the age-appropriate target date fund. Post-

streamlining, participants who held the deleted funds adjusted their portfolio, ending up

with fewer funds, significantly lower within-fund turnover rates, and lower expense

ratios. The authors estimate that these portfolio adjustments could lead to potential

accumulated savings for these participants over a 20-year period of more than USD 9,400

per participant.

84. Finally, financial advice should help members tailor their investment strategy to

their needs but may be ineffective when it is unsolicited. In a randomised experiment,

Hung and Yoong (2013) ask individuals to allocate a hypothetical portfolio between six

different mutual funds, with different fees and past performances. They identify four

portfolio "mistakes", which are having (i) no equity exposure, (ii) an overly conservative

strategy (less than 40% in equities), (iii) an overly aggressive strategy (more than 95% in

equities), and (iv) an undiversified strategy (100% in a single asset class). Individuals in

the control group do not receive any advice, those in the "default treatment group" all

receive the same financial advice and those in the "affirmative decision group" are given

the choice of whether or not to receive the advice. The results show that individuals who

receive unsolicited advice disregard it almost completely, they are not doing any better

than those not receiving advice. When individuals can choose whether or not to receive

financial advice, those with low financial literacy are more likely to take it. In spite of this

negative selection on financial literacy, individuals who actively solicit advice perform

better, making fewer portfolio mistakes.

Design of the default investment strategy

85. Default investment strategies are necessary because some people lack the

knowledge and the commitment to design and manage their own portfolio, while others

have the commitment to design and manage their own fund portfolio, but lack sufficient

knowledge to do so.

86. There may be several reasons why default options work. The first reason is that

many people do not want to choose and therefore inertia will lead them to remain in the

default. In addition, people may treat defaults as a form of advice. People may perceive

the default option as the one endorsed by the authority that determines the default.

Defaults may also act as a signal as to the choices made by others, leading people to be

drawn towards them through behavioural convergence. In other cases, defaults might

serve as a psychological reference point, against which other options are judged.

87. The default investment strategy may be designed according to a balanced

investment strategy that keeps the same asset allocation throughout the investment period

or following a life-cycle strategy. In Australia, providers of the new default product can

choose between a single diversified investment strategy and a lifecycle investment

strategy. According to the Australian Prudential Regulation Authority (Quarterly

MySuper Statistics), at the end of 2016, of the AUD 533 909 assets managed by MySuper

products, 34% were invested in a life-cycle strategy. Other countries usually choose one

of the two designs for their default investment strategy.

88. In some countries, such as Estonia and Latvia, all contributions are invested in the

most conservative strategy (no equity exposure) until the participant designates an

alternative pension fund. The reasoning for such regulations may be that those unable to

make choice may also be the most risk averse. It also gives members time to think about

the strategy that best fits their needs. Thus, pension funds invest contributions in a fixed

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income portfolio under the expectation that at some point in the future, participant will

make their own appropriate investment choice.

89. The drawback with such a strategy is that it could be inconsistent with two

financial principles if people stick to it until retirement. Indeed, conservative investment

strategies account neither for the existence of an equity risk premium, nor for the

principle that younger individuals are able to assume greater risk than older individuals

because the former have more time to recover from periods of low returns and have more

human capital. However, people are prone to inertia and procrastination. If members are

passive decision makers, the default option selected by policy makers or employers

becomes the de facto member's choice. For example, Choi et al. (2004) find that about

45% of workers automatically enrolled in their employer pension plan still save at the

default contribution rate and invest exclusively in the default conservative investment

strategy three years after enrolment. Some people may therefore remain with a

conservative investment strategy for the entire accumulation period. This fear may not be

valid in every country however. For example, most participants in the Latvian mandatory

funded pension scheme make an active investment choice getting out of the default

conservative plan.

90. The main trend in recent years is to establish a life-cycle strategy as the default

investment strategy to allow younger individuals to take more risk and reduce risk as

people age. As members get older, their pension assets are invested in a more

conservative investment strategy, reducing the risk of large losses in their account as the

retirement age approaches. Several Latin American countries follow a multi-fund system,

with members assigned to one of the funds by default according to their age (e.g. Chile

and Mexico). Members' assets are transferred from one fund to the next when they hit the

age thresholds.4 The age thresholds are determined considering the investment horizons

of members, that is, the time remaining until they reach the retirement age, and their

likelihood of recovering from periods of low returns.

91. In some countries, like Hong Kong (China) and Sweden, the default life-cycle

investment strategy uses a mix of funds, the proportions of which evolve as members

reach a certain age. Effective 1 April 2017, Hong Kong (China) introduced the Default

Investment Strategy (DIS) for members of the Mandatory Provident Fund (MPF) who do

not select an investment strategy for their account.5 The DIS uses two mixed assets funds,

the "Core Accumulation Fund" (CAF) and the "Age 65 Plus Fund" (A65F). The new

legislation requires 60% of the CAF to be invested in assets with higher risk, mainly

global equities, and 40% in assets with lower risk, mainly global bonds. The A65F holds

80% in lower risk assets and 20% in higher risk ones. When members are younger than

50, all of their MPF is invested in the CAF; once they turn 50, their portfolio is

automatically adjusted every year to reduce their investment in the CAF and increase that

in the A65F; when they turn 64, all of their MPF is invested in the A65F. In the case of

the Swedish default fund AP7, the cut-off age between the Equity Fund and the Fixed

4 The transition from one fund to the next can also be smoothed out over several years. For instance, in Chile, 20%

of the balance is transferred at the time of the age change, and then 20% per year over a four-year period

until all resources are transferred.

5 The DIS is a long-term retirement investment solution that has been designed with reference to advice from the

OECD Secretariat and input from other overseas experience.

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Income Fund is 55 and the adjustment is made up to age 75, at which time two thirds of

the capital is invested in the Fixed Income Fund and one third in the Equity Fund.

92. In the United States, the use of target date funds is also growing in 401(k) plans.6

According to Vanguard (2016), 90% of employers using Vanguard DC plans offered a

target date fund in 2015, up from 43% of employers in 2006. In 2015, nearly all

Vanguard participants were in plans offering target date funds (98%) and 69% of them

used target data funds (up from 10% in 2006).

Investment return guarantees

93. Investment return guarantees alleviate the impact of market risk on retirement

income by setting a floor on the value of accumulated assets at retirement, either in

nominal or real terms. They provide some predictability in the savings phase with respect

to future pension benefits. They may increase the attractiveness of saving for retirement

in DC pension plans as they overcome people's fear of losing the nominal value of their

contributions.

94. Investment return guarantees enter into two main categories. Absolute return

guarantees are set against a pre-specified return (e.g. 0% nominal annually for Riester

plans in Germany). Relative return guarantees are set in relation to a market benchmark

(e.g. government bonds in Slovenia), a synthetic investment portfolio or the average

performance of pension funds in the industry (e.g. Chile). Only absolute return guarantees

pre-determine the minimum value of the accumulated assets. The minimum value of

accumulated assets under a relative guarantee will vary with market performance.

95. Investment return guarantees have to be paid for, and this cost reduces the

expected value of benefits from DC plans relative to a situation where there are no

guarantees (OECD, 2012). The cost of the capital guarantee, that makes sure that people

will get back at least their contributions (in nominal terms), is affordable for long enough

contribution periods. Guarantees above the capital guarantee may be too costly however.

96. In addition, the assessment of whether to introduce investment return guarantees

needs to be done in the context of the overall pension system. Investment return

guarantees may not always be the best way to provide a floor or minimum income at

retirement to prevent people from having inadequate pensions. In many OECD countries,

public pensions' automatic stabilisers and old-age safety nets already provide such a floor.

These forms of public protection may be more valuable than investment return

guarantees, as they guarantee a minimum level of income throughout retirement rather

than a minimum value for the assets accumulated at retirement. In addition, if DC

pensions are just a voluntary complement to public pensions (and occupational DB plans)

that already provide sufficient guaranteed retirement income, investment return

guarantees in DC plans may lose some of their purpose.

97. Some countries are moving away from investment return guarantees, such as the

Czech Republic, Denmark and Germany for example. Since November 2012, transformed

pension funds in the Czech Republic are closed to new members and replaced by

participation funds. While transformed funds offered a capital guarantee on a yearly

6 Target date funds base portfolio allocations on an expected retirement date, with allocations growing more

conservative as the participant approaches the fund's target date. The glide path is usually smoother than

with multi-fund life-cycle funds.

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basis, participation funds offer no guarantees but provide different risk profiles and

investment strategies. To cope with the new environment of low interest rates and longer

life expectancies, pension companies in Denmark have developed pension products with

lower or even no guarantees. Products with guarantees require higher technical

provisions, meaning that the investment opportunities of the pension companies are

limited to investment products with lower risk and thereby lower expected returns. Lower

risk eases the pressure on solvency, but eventually, lower expected returns can make it

difficult for pension companies to generate returns that are sufficient to meet their

guarantees. Consequently, developments in recent years have resulted in even more non-

guaranteed pension products. Thus, the percentage of technical provisions for market

return products, which are generally non-guaranteed, relative to total technical provisions

has increased from around 4% in 2003 to around 37% in 2015. In Germany, a new law

introducing DC pension plans without guarantees is currently under discussion in the

parliament.

7. Choice of the pay-out product

Issues posed by poor financial literacy and behavioural biases

98. One of the key goals of pensions is to provide a stream of income for life after

retirement. In DC pension arrangements, life annuities are the easiest way to achieve that

goal. The biggest risk people face during retirement is to run out of money while they are

still alive. Unlike lump sums and programmed withdrawals, life annuities guarantee a

payment for the entire lifetime of the retiree and therefore protect retirees from longevity

risk. Low financial literacy and behavioural biases however affect how people perceive

annuities. They also affect the way in which people may draw down their savings when

choosing programmed withdrawals as an alternative to annuities to get an income stream

during retirement.

99. The effect of financial knowledge on annuity demand is unclear (Brown J. ,

2009). For example, Agnew et al. (2008) find that, conditional on education, individuals

with high levels of financial knowledge are significantly less likely to choose annuities.

This may be due to the fact that more financially knowledgeable individuals are over-

confident in their investment skills, perhaps leading them to believe that they can "do

better" than an annuity by investing on their own. Brown, Casey and Mitchell (2008) find

that more highly educated individuals are less likely to annuitise. However, conditional

on education, they find that more financially knowledgeable individuals are more likely

to choose an annuity. In both studies, financial knowledge is measured based on the

capacity to correctly answer three basic questions on interest compounding, inflation and

risk diversification. However, the decision to annuitise may be linked to other types of

financial knowledge, such as understanding the implications of longevity on retirement

outcomes.

100. Because of loss aversion, people tend to dislike annuities. Indeed, people do not

like to give away large amounts of money (annuity premiums are large one-off payments)

for a small amount (payments are relatively smaller). Moreover, people tend to view

annuity providers as institutions taking their money away. It is indeed important to

individuals to keep control over their assets and investment strategies, in part because of

fears of illiquidity. In addition, people feel that they lose money if they die early. Finally,

there is also the issue of insolvency risk. People wonder whether the institutions taking

their money now for promised pension payments in 20-30 years will still be around over

that time.

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101. Improving individuals' awareness of the risk of living to an old age does not

necessarily increase the preference for annuities. While the expectation of a longer life

has been shown to be related to the increased preference for annuities, individuals also

tend to underestimate their expected survival. Mosher (2015) assessed whether improving

individuals' awareness of the risk of living to an old age could improve these estimates

and lead to a higher preference for annuities. Results showed that while subjective life

expectancies may be influenced by this information, it does not affect the preference for

life annuities and may even reduce the take up of annuities. A potential explanation for

these results is that individuals having higher subjective life expectancies also have a

higher risk tolerance because they have a longer investment horizon. In addition,

increasing individuals' awareness of longevity risk may also increase their perceived need

for liquidity for future healthcare costs, reducing their preference for illiquid life

annuities.

102. Framing also influences demand for annuities. Brown et al. (2013) argue that life

annuities are more attractive when presented in a "consumption frame" than in an

"investment frame". The two alternative frames, which are just two representations of the

same financial choice, may lead to different perceptions of gains and losses. The

consumption frame presents financial products by highlighting consequences for

consumption over the lifecycle. The investment frame focuses instead on the risk and

return features of the financial products. In an experiment, the authors randomly assigned

people over the age of 50 to choose between different financial products using the

consumption or investment frame. The financial products include life annuities, savings

accounts, bonds and period annuities (i.e. annuities paying a fixed number of

instalments). The results show that life annuities are preferred when financial products are

presented in a consumption frame. On the contrary, when these same products are

presented in an investment frame, savings accounts and other financial products are

strongly preferred to annuities.

103. Programmed withdrawals are an alternative to annuities to get an income stream

during retirement. However, as they do not provide full longevity cover, choosing the

right withdrawal rate becomes crucial but is difficult. On the one hand, withdrawing too

much and too early causes individuals to face an increased risk of outliving their pension

assets. On the other hand, withdrawing too little may lead people to reduce the standard

of living that they can enjoy in retirement. In Australia for example, plan members can

choose to receive their pension assets as a lump sum or as programmed withdrawals.

With programmed withdrawals, a minimum amount is required to be paid each year, from

4% under age 65 to 5% between 65 and 74 years old and up to 14% of assets at age 95

and older. According to the Australian Government (2016), a majority of individuals

draw down account-based pensions at or close to the minimum rates. This reduces the

risk of outliving one's pension wealth, but it also reduces the standard of living that

individuals can enjoy in retirement. Individuals are self-insuring against longevity risk,

but in an expensive way measured in terms of forgone income.

104. There are three traditional rules of thumb to draw down pension assets in

programmed withdrawals, but according to Sun and Webb (2012), none of them are

optimal. People adopt rules of thumb for drawing down their assets because rules are

relatively simple to follow. Some retirees use the straightforward strategy of leaving the

principal in their retirement accounts untouched and spending only the investment

income. This strategy may be desirable for those who want to leave a bequest but it

reduces retirement consumption. A second draw-down strategy is to divide each year all

financial assets by the remaining life expectancy, as predicted by life tables. However,

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33

people living beyond their cohort's life expectancy will outlive their resources. A third

strategy is the so-called 4-percent rule advocated by some financial planners, under which

the retiree each year withdraws 4% of the initial amount of assets accumulated at

retirement.7 However, this strategy lacks flexibility, as the withdrawn amounts do not

adjust to the performance of the portfolio. Sun and Webb (2012) compare these three

strategies to an optimal draw-down pattern that maximizes the expected utility of

consumption. The three strategies underperform the optimal strategy, with the life

expectancy strategy being the closest and the 4-percent rule the farthest from the optimal.

Assessment of policies

105. Policy options to help individuals transforming the assets accumulated in their

pension account into a retirement income range from giving complete freedom on how to

allocate their assets in retirement, to promoting annuities without making them mandatory

and to mandating life annuities.

Freedom of choice

106. The design of the pay-out option needs to be determined in coherence with the

overall structure of the pension system. The need to annuitize DC pension pots depend on

how much is already received as an annuity from funded and PAYG DB plans. In

addition, the design of the accumulation and pay-out phases needs to be internally

coherent, for example, flexibility in the pay-out phase makes sense if the accumulation is

flexible (e.g. voluntary).

107. In some countries, pension funds only offer lump sum and programmed

withdrawal options to their members. In turn, the lump sum may be used to cover

expenses or reimburse debt. The money can also be invested or used to buy a life annuity

with a life insurance company. Therefore, individuals have complete freedom on how to

allocate their resources during retirement, but they also have the responsibility of dealing

with the risk of outliving these resources. This is the case for example in Hong Kong

(China) and Australia.

108. There is popular demand for flexibly accessing pension assets, as demonstrated by

the pension freedoms reform in the United Kingdom. Since April 2015, individuals aged

55 and over can access their DC pension savings as they wish, subject to their marginal

rate of income tax. Before this reform, people withdrawing the whole pot from a DC plan

were charged a 55% rate. According to HMRC’s latest statistics, GBP 6.45 billion was

withdrawn from pension funds in the financial year 2016-17, up from GBP 4.35 billion

the previous year. Payments were made to 393 000 individuals, up from 232 000 in 2015-

16. In addition, according to FCA statistics, based on a sample of firms covering

approximately 95% of DC contract-based pension schemes assets, between April 2015

and September 2016, 972 703 pension pots have been accessed for the first time and full

cash withdrawals were the most used product for consumers accessing their pension pots

(55% of the total) (Financial Conduct Authority, 2017). These numbers demonstrate that

there is popular demand for the increased flexibility brought about by the reform.

7 This rule originates from a study by Bengen (1994) who looked at the spending rate that would allow a pension

pot to survive exactly 30 years of retirement.

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109. However, individuals may not fully understand the consequences of such

withdrawals in terms of taxes paid. The Treasury indeed increased its forecasts of tax

revenues from the pension reform. The measure was initially estimated to raise around

GBP 0.3 billion in 2015-16 and GBP 0.6 billion in 2016-17, but it has actually raised far

more than anticipated: GBP 1.5 billion in 2015-16, while the latest estimate for 2016-17

is GBP 1.1 billion. The Treasury now expects the measure to bring in GBP 1.6 billion in

2017-18. The difference between the initial estimates and the reality stems from the fact

that individuals spread their withdrawals over a shorter period than the anticipated four

years. In addition, some individuals are taking larger amounts than they would have been

able to purchase through an annuity, thereby creating a higher tax liability.

110. The United Kingdom is also introducing new rules to encourage shopping around

in the annuity market. While the number of members purchasing annuities has decreased

following the introduction of the pension freedoms, the market for annuities remains

significant in the United Kingdom, with around 80 000 plan members purchasing

annuities each year. In addition, FCA's data suggest that around 60% of annuity sales are

still being made to firms' existing members (Financial Conduct Authority, 2017). In order

to improve competition in this market, the FCA introduced new rules requiring providers

to give members information to encourage shopping around in the annuity market. From

1 March 2018, firms will be required to provide information about the amount used to

purchase the proposed annuity, whether the annuity is single or joint life, whether

payment is in advance or in arrears of the start date, whether the income paid by the

annuity is guaranteed for any period and whether the income will increase in line with

inflation or some other specified rate. The document will also give the provider's own

quote and explain how to shop around, encouraging use of the Money Advice service.

111. In order to help people compare different pay-out options, one could introduce a

system where plan members can see the bids from all insurance companies and pension

funds in one place. The Online Pension Consultation and Bidding System (Sistema de

Consultas y Ofertas de Montos de Pensión, or SCOMP) in Chile does this. Upon

retirement, people can choose from four different options: programmed withdrawal, life

annuity, programmed withdrawal with immediate life annuity and programmed

withdrawal with deferred life annuity. In order to make that choice, all members must

consult the SCOMP. Life insurance companies and pension funds respectively transmit

bids for life annuities and pension payments under the programmed withdrawal option. In

this way, members simultaneous receive and compare all available retirement bids.

Consultation with this system is mandatory for any member wishing to choose a life

annuity and receive a pension, as well as for all pensioners in the programmed withdrawal

option who wish to switch pension options. The mandatory consultation of the bids is

used here as an alternative to defaulting people into a specific pay-out option. However,

this consultation system is only informative. Indeed, there is no restriction in terms of the

bids that members may choose, or any obligation to accept any of them. Once they review

the bids, members have five options: accepting one of them, submitting a new

consultation, requesting external bids (i.e. bids from an insurance company outside of the

consultation system), requesting an auction on the system (i.e. ask at least three insurance

companies to present bids), desisting from retirement, or switching pension options.

Promote the demand for annuities

112. When mandating annuities is not an option, the role of annuities in the pension

system may still be strengthen to help people cope with longevity risk by making

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annuities an explicit option for retirement, providing tax incentives and fostering product

design innovation.

113. Policy makers may wish to make annuity products a more explicit option within

their pension system. For example, in Australia, superannuation funds currently only

offer lump sums or programmed withdrawals. However, from 1 July 2017, the

government will extend the tax exemption on earnings in the retirement phase to

innovative products, such as deferred lifetime annuities and group self- annuitization

products. The goal is to encourage the development of new retirement income products

and provide greater choice and flexibility for retirees to manage the risk of outliving their

retirement savings. In addition, the government is currently consulting on the

development of a framework for Comprehensive Income Products for Retirement

(CIPRs). The CIPRs framework would aim to facilitate the development and take-up of

products that better manage longevity risk through risk pooling. Upon retirement,

individuals would however still be free to accept the offered product, modify the product

to reflect their individual needs, or take their pension benefits in any other way.

114. Tax incentives can also be used to encourage individuals to purchase annuities.

Both the Czech Republic and Estonia incentivise people to annuitize their pension income

through a more favourable tax treatment for annuities as compared to programmed

withdrawals (OECD, 2015b). Annuities can also be indirectly incentivised by taxing less

favourably other pay-out options. For example, in Denmark, a tax reform in 1999 reduced

the deduction that high-income workers could take for contributions to "capital" pension

accounts, which are accounts that provide lump-sum payments at retirement. That reform

however left unchanged the treatment of contributions to accounts that provide annuity

payments. Chetty et al (2014) show that individuals in the top income tax bracket reduced

significantly their contributions to capital pensions following the reform, redirecting

nearly all that saving to annuity pension plans and other savings accounts.

115. Product design innovations try to overcome the low levels of demand for

traditional annuity products. OECD (2016d) provides an overview of the different types

of annuity products, describing the guarantees that they offer. It shows that there is a

trend towards more flexibility and risk-sharing in the design of annuity products. For

example, variable annuities provide flexibility in the sense that, although a minimum rate

at which the accumulated funds can be converted into an annuity is guaranteed at issue,

annuitization is not mandatory and the policy may be surrendered instead. Risk-sharing

features can be found in participating life annuities for instance. These annuity products

generally offer a minimum guaranteed level of income to the annuitant, but give

additional bonus payments depending on actual return or profit measure.

116. Another way to strike a balance between flexibility and protection from longevity

risk is to combine programmed withdrawals with a deferred life annuity bought at the

time of retirement that starts paying at old ages (e.g. 80-85).8 This combination could be

an appropriate default option as it achieves a balance between protection from longevity

risk (through the annuity), as well as flexibility, liquidity, possibility of bequest and

access to portfolio gains (through the programmed withdrawals). This option exists in

Chile. NEST in the United Kingdom also explores the possibility for its members to be

able to make small payments from an income drawdown fund to gradually buy a deferred

life annuity (NEST, 2015).

8 This combined arrangement is advocated in the OECD Roadmap for the Good Design of DC Pension Plans.

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Mandatory annuitization

117. While annuities are usually mandatory with occupational funded DB plans, this is

much less common with funded occupational DC plans and personal plans. The

institution responsible for paying annuity income can be the pension fund that managed

the assets during the accumulation phase (e.g. occupational pension plans in Iceland and

the Netherlands), a life insurance company (e.g. the mandatory funded pension scheme in

Latvia) or a centralised public institution (e.g. Sweden and Singapore).

118. A centralised public institution providing annuities ensures that economies of

scale are available to all participants. It can be more effective in achieving low costs than

with competing private providers. However, it can also raise governance issues, such that

costs need to be closely monitored.

119. In Sweden, two types of annuity products are provided by the Premium Pension

Authority or PPM. The PPM is the clearinghouse for fund transactions, keeps individual

accounts, collects and provides (daily) information on participating funds, provides

information services to participants and is the unique annuity provider for the mandatory

funded pension system (Premium Pension System or PPS). The possible annuity products

are specified in the law regulating the PPS. Accordingly, participants can choose between

single and joint life annuities, and between fixed or variable rate annuities. A fixed

annuity is purchased from the PPM and entails moving fund assets to the PPM. The PPM

is then responsible for investing the funds. Alternatively, the participant can leave his/her

money in investment funds and receive annuity payments that vary on an annual basis.

This is the variable rate annuity. The annuity is recalculated each year based on the

amount of money remaining on the individual account and life expectancy for the

individual's birth cohort at that year.

120. In Singapore, the mandatory annuity scheme offers some flexibility. In 2009,

Singapore introduced mandatory annuitization in the Central Provident Fund (CPF). All

CPF members must set aside a retirement sum in their retirement account to finance their

future retirement income. They must join the CPF Lifelong Income For the Elderly (CPF

LIFE) scheme, which is provided by the CPF Board, as long as their retirement account

balance is at least SGD 60 000 six months before reaching the eligibility age (currently

65). CPF LIFE monthly pension payments can be deferred up to age 70, thereby

increasing future pension payments. Under the CPF LIFE plans, all unused annuity

premium (without interest) and retirement account savings, if any, are paid to the

member's beneficiaries after his/her death. CPF members not automatically placed on

CPF LIFE can still apply to join the scheme voluntarily anytime between age 60 and 80,

or remain on the Retirement Sum Scheme, which a programmed withdrawal scheme

paying monthly payments for about 20 years.

8. Conclusion

121. Given the growing importance of DC pensions in people's future retirement

income in many countries, policy makers increasingly recognise the need to improve the

design of these arrangements. Several factors need to be taken into consideration when

implementing policies to improve the design of DC pension arrangements, such as the

structure of the overall pension system and political constraints, but also the level of

financial literacy of the population and the existence of behavioural biases when people

have to take decisions.

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37

122. This document has argued that low financial literacy levels and behavioural biases

can undermine people's ability to take action and make appropriate decisions in the

context of DC pension arrangements. It has then assessed experiments and policies

implemented in different OECD and non-OECD jurisdictions to improve the design of

DC pension plans through motivating or facilitating the appropriate behaviour by

individuals.

123. The policies can be divided into six broad categories: default options,

simplification of information and choice, salient information, financial incentives,

product features and cost-reducing policies.

124. Defaults are widely used to increase participation in and contributions to DC

pension arrangements (e.g. automatic enrolment and automatic escalation of

contributions). In this case, the policy harnesses the power of inertia to keep people in the

plan. Default options also help people who are unable or unwilling to choose a pension

provider (e.g. KiwiSaver default schemes in New Zealand), an investment strategy (e.g.

the Default Investment Strategy in Hong Kong, China) or a pay-out product (e.g.

mandatory annuitization in Sweden). The default option usually implies lower risks for

individuals. However, default options may not be suitable for everyone failing to make a

choice given different needs and preferences.

125. People can make better choices if the decision-making process is simplified. This

can be achieved through the provision of a reduced set of options (e.g. investment

strategies), better disclosure of comparable information (e.g. cost information) or

facilitated comparison of options (e.g. the SCOMP platform in Chile that allows people to

compare all pay-out offers from pension funds and insurance companies).

126. People tend to focus on salient information. Making sure that important

information related to retirement saving is emphasised can therefore improve decision

making. This information can be conveyed through pension statements, financial

education programmes and financial advice.

127. Matching contributions and flat-rate subsidies are increasingly used to promote

private pension arrangements, as a complement or as a substitute to tax incentives. These

financial incentives intend to realign people's intentions (they know that saving for

retirement in their best interest) with their actual behaviour (procrastination and status

quo biases are barriers to action).

128. Policy makers also introduce product features that may help alleviate some of the

fears that people have when locking in their money in private pension plans. For example,

investment return guarantees albeit they cost, alleviate the impact of market risk on

retirement income, while innovative annuity products provide access to the underlying

capital.

129. Finally, policies reducing costs are important to improve retirement income

outcomes. Pricing regulation and structural solutions help containing costs during the

accumulation and pay-out phases.

130. The next steps of this project are to share the paper with the OECD INFE and get

their comments. The OECD Secretariat will prepare an additional paper distilling

effective practices and policies on how to design DC pension plans given the level of

financial literacy and behavioural biases.

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38

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