It's a matter of personal choice
When it comes to pensions, in many European countries workers are hardly accustomed to taking personal decisions. The main reason for this lies in the disproportionate share of public schemes, characterised by a very limited area of discretionary choices in the provision of retirement income.
Participation in social security is compulsory; the payroll tax rate is fixed by law and does not change, normally, according to age or needs; exit requirements allow limited possibilities of choice by the worker, retirement age being either established by law (legal retirement age) or strongly influenced by formulae which heavily penalise job prosecution after the minimum requisites have been met (early retirement rules).
Nor is the fruition of benefits much left to individual’s preferences: little choice is granted to workers with respect to, for example, the composition of benefits (as for survivors’ benefits and supplementary insurance) or to the time profile of the annuity and to its indexation mechanism (to prices or to wages). Finally, the PAYG feature of public systems does not allow, by definition, any investment decision on the part of the individual, the systems’ reserves (if any) being motivated by solvency requirements and not attributable to single individuals.
The pension reforms of the last 10-15 years have significantly modified this picture, by increasing workers’ responsibility in planning for their retirement. By reshaping social security in a way that has generally reduced its redistributive features and strengthened the correlation between contributions and benefits, reforms have increased the scope for individual decisions. In particular, this is the case of the notional defined contribution (NDC) system first adopted by Sweden and Italy and recently introduced by many other European countries, which - being based on actuarial principles - can easily accommodate many dimensions of personal choice, such as a flexible retirement age or different profiles of the annuity for a given ‘notional capital’.
By pursuing a better risk diversification, reforms have gone further, in the direction of either introducing or giving a new impulse to private funded schemes, both of the occupational and of the individual type. Within the former, the traditional defined benefit (DB) plans, characterised by more constraints, are giving way to the more flexible defined contribution plans, which allow for a greater activism on the part of workers as to whether or not to participate, how much to contribute, how to invest the accumulated funds, which part of the accrued wealth at retirement to convert into an annuity and which part to draw as a lump sum. As for individual accounts, they are obviously characterised by a wider scope for personal choice not only in the area of savings formation but also in the area of asset allocation; however, administrative and management costs are much higher than in collective schemes.
If widening the area of individual choice and responsibility is generally a good thing, the bad news is that workers seem to make little use of their increased discretion. In Italy, for example, legislation has tried to encourage workers to participate in newly created pension funds by granting fiscal advantages to the diversion of flows of severance pay (a form of deferred compensation, which the worker is entitled to cash as a lump sum whenever the leave their job, and which provides a small but guaranteed return, and no obligation to buy an annuity).
Although the objective was to facilitate the financing of private pensions with resources already provided for, the Italian law has not been very effective; only a small fraction of workers have opted for participation and, among those who have, there is little evidence of active choices been made in terms of both contributions and asset allocation.
Since this passivity may be a legacy of the inertia embedded in past rules, the law is now about to change the default option, by establishing automatic diversion of severance pay flows unless the worker explicitly opts out (ie, declares that they want to continue with the present regime of severance pay).
This situation is not an Italian peculiarity, having been observed in other countries, where workers have some degree of freedom in their retirement savings, such as in Sweden and in the US. (The UK seems to portray a situation of greater activism, but also of mistakes made possible by weaknesses in the regulatory framework.)
Inertia and procrastination seem to characterise individual behaviour giving rise to scepticism as to the individual’s decision-making ability. Empirical evidence shows that, even in countries generally highly favouring individual choices (such as the Anglo-Saxon countries), the majority of people simply do not choose, rather letting the default option apply.
In Sweden, for example, the government tried to promote a policy based on ‘libertarian paternalism’ (defined by two American scholars, Richard Thaler and Cass Sunstein, see suggested reading), with the purpose of creating the condition for ‘gently’ pushing short-sighted individuals towards responsible decisions, without limiting the freedom of far-sighted individuals. It turned out that more than 90% of the participants chose the default option, while only a small percentage opted for portfolio diversification.
These considerations lead to two (preliminary) conclusions, which are relevant for policy purposes. Firstly, that an important role in pension reform should be given to aspects of education, both with respect to savings formation (to overcome individual myopia and help individuals to accumulate an adequate amount of resources) and asset allocation (to encourage choices compatible with an appropriate diversification of risks).
Secondly, that since default options work as attractors, care should be given to their design to avoid entrapping workers in bad choices, such as too low contribution rates or too risky and insufficiently diversified portfolio compositions. In general, one should favour highly transparent solutions, with a reduced number of options, in order to limit costs. The problem, however, is complicated by the
fact that having a few defaults can cause distortions and deadweight losses when individuals are characterised by a high degree of heterogeneity.
Up to now pension reforms have privileged aspects of macroeconomic sustainability of pension expenditure. It is time to move in the direction of microeconomic choices, ie, towards encouraging individuals’ responsibility for retirement savings and financial education. Apart from being essential ingredients of a well-functioning market, these innovations are central to the construction of a good multi-pillar system, where the public and private components co-operate in order to provide workers with an adequate retirement income.
Elsa Fornero is professor of economics at University of Turin and director of Center for Research on Pensions and Welfare Policies (CeRP)