Large funds equals lower costs
The two major components determining the costs of pension provisioning are the quality of the pension scheme and the net rate of return on investments. However, administrative and investment costs can also increase the cost of retirement security substantially.
Under certain conditions, operating costs (administrative costs and investment costs) erode retirement benefits. An increase in annual operating costs of 1% of pension fund assets imply a cumulated reduction of 27% of eventual pension benefits or, equivalently, an increase of more than 37% in pension costs.
In the Netherlands, annual administrative costs typically lie between 0.1% and 1.2% of pension fund assets.
The relatively high cost level of pension plans was one of the main reasons for the closure of around 300 smaller Dutch pension funds, around 25% of the funds, between 1992 and 2004. Nonetheless, many relatively inefficient pension funds have continued to operate.
During the recent pension crisis, pension funds have generally focused on other measures, such as lower inflation or wage indexation and a move from final to average salary schemes, to reduce the overall costs of retirement security.
Given the significant cost differences across pension funds and the huge cumulative impact of additional costs, cost reduction should receive more attention.
Economies of can be expected in pension fund administration and investment activities, as many costs are fixed or likely to increase less than proportionally with size. Examples are the costs of policy development (especially asset and liability management), data management systems and reporting, and the expert personnel required, such as actuaries, accountants, legal staff and investment managers.
Pension funds can also outsource fund administration and investment to specialised companies, thus gaining access to the necessary expertise at relatively low costs.
We use a detailed data set on all Dutch pension funds for the 1992-2004 period, provided by De Nederlandsche Bank. The number of pension funds in our dataset declined gradually from 1,131 in 1992 to 742 in 2004.
Summary statistics of 655 pension funds that reported administrative costs in 2004 shows the average administrative costs of pension funds for various size categories in terms of the number of participants. The data shows that the (weighted) average of administrative costs per participant decrease sharply across the number of participants classes, although the average increases somewhat for participants in the highest size category.
These costs vary, on average, from €927 for the smallest pension funds to around €30 for the largest two classes. Actual differences in costs across size classes are likely to be even larger, due to under-reporting of costs by the smallest company funds.
The average administrative costs as percentage of total assets decrease substantially across the number of participants classes, from 0.59% for the smallest funds to 0.07% for the largest class.
About half of the pension funds in the smallest size category are legal vehicles for director-large shareholders and director funds for board members and members of the supervisory board, which explains why average total assets per participant for this size class is much higher than in the other categories.
Analysis of the weighted average administrative costs for different size categories in terms of total assets shows that administrative costs as a percentage of total assets are, again, negatively related to the size of the pension fund. Where the smallest pension funds run up administrative costs of, on average, 1.23% of total assets, the largest funds have costs of only 0.10% of total assets. This differences implies a potential reduction of benefits of more than 30%, or an increase of pension costs of more than 40%.
The data shows that the provision of pension plans is characterised by large economies of scale, either expressed in number of participants or in total assets under administration.
The administrative costs for different pension fund categories vary widely. At around €221, company funds' average annual administrative costs per participant are high compared to the mere €33 spent by industry funds. Again, actual differences are likely to be even larger, due to under-reporting of costs by company funds.
Industry funds provide relatively straightforward pension plans. Further, they have fewer costs from the transfer of pension rights, whereas scale effects may play a role too. Company funds have generally more total assets per participant than industry funds, often reflecting their more generous pension plans.
Company funds often choose customised pensions, tailored to the wishes of company and participants. Among the industry funds, compulsory funds face average administrative costs of only around e31 per participant per year, whereas non-compulsory funds are twice as expensive. The compulsory industry funds category has the largest number of participants.
Professional group funds are much more expensive than industry funds, but less pricey than company funds. Scale effects seem to be the largest single cause of these cost differences across categories of pension funds.
Average costs for DB schemes are significantly higher, at e49 per participant, compared with e25 per participant for DC schemes. In contrast, the costs as a percentage of total assets are much higher for DC schemes. This is due to the much higher average total assets per participant for DB schemes compared to DC schemes, probably because many of the DC schemes are quite new.
On balance, pension funds that outsource seem to incur lower administrative costs per participant, although, remarkably, somewhat higher costs in terms of total assets. The costs of pension funds that do not outsource are most probably underestimated due to the underreporting of costs by the smallest company funds. Such underreporting is impossible in the case of outsourcing. This exploratory survey of possible drivers of administrative costs reveals that scale effects dominate governance characteristics, pension plan features and managerial choices with respect to outsourcing. However, a simultaneous approach is needed to determine the marginal contribution of each of these drivers more precisely.
Pension funds' size, governance, plan design and outsourcing choices each have their impact on administrative costs. To examine the marginal contributions of these determinants, we use a multiple regression model of administrative costs.
The impact of governance is investigated using four ‘dummy variables' [numerical variables used in regression analysis to represent sub-groups of a sample] that indicate the type of pension provider: non-compulsory industry funds, compulsory industry funds, company funds and professional group funds.
Since industry funds have generally more straightforward pension schemes and less transfers of accrued pension rights, they might incur lower costs compared to company funds. Professional group funds operate in a more decentralised environment and have to deal with the many ‘professionals', rather than with one or a few companies, for instance, in collecting premiums. Therefore, their administration is expected to be more costly than that of industry funds.
Pension plan design consists of a dummy variable ‘defined contribution', which identifies DC pension funds. DC plans may be easier to manage than DB plans as long as participants have no or limited choice with respect to pension fund and investment portfolio, as is commonly the case in the Netherlands. However, DC plans are likely to entail additional education and marketing costs.
Outsourcing choices include a variable ‘outsourcing of administration', which indicates the percentage of the activities, which have been outsourced. This coefficient will be negative if outsourcing improves efficiency, that is, if it leads to a net reduction of costs. We also include two dummy variables for, respectively, fully and partly reinsured pension funds, reflecting full or partial coverage of liabilities and investment risks and outsourcing of investment management.
A dummy variable for ‘investment costs reported' indicates whether or not the pension fund reports investment costs. If pension funds do not report investment costs, part of these costs may be reported under administrative costs. Hence, we expect reporting pension funds to have lower administrative costs.
Empirical results for administrative costs suggest that very strong and significant unused economies of scale exist in the administration of most Dutch pension funds. An increase of the pension fund size by 1% would raise administrative costs by only 0.59%. The observed 41% potential scale economies per additional unit of production are far greater for pension funds than those found for , for example, Dutch banks (10%) or insurance firms (21%).
The governance dummy variables indicate that administrative costs differ across types of pension provider. Professional group funds are the most expensive, probably because they operate in a more decentralised environment and have to deal directly with individual professionals - instead of companies - which makes their administration more costly. Industry funds have lowest costs, which may be due to the relatively straightforward pension schemes under the corresponding collective labour agreement (CLA) and to the fact that they need to transfer pension rights less often.
Among the industry funds, compulsory funds are most efficient, possibly because they do not need to compete for clients or suffer from adverse selection.
The administration of DC plans appears to be less costly than that of DB plans, as becomes especially clear from the estimation for 2004 , when more pension funds had DC plans, and from the compulsory and industry fund estimates. Apparently, DC plans are easier to manage and - due to their limited range of options and, in the Netherlands, their collective nature - do not incur high marketing costs and costs of education in risk awareness.
Remarkably, outsourcing of the administration seems to raise costs significantly. This outcome is most probably due to underreporting of costs where pension funds keep their own administration.
Full reinsurance, that is, outsourcing of liability and investment risks as well as - often - the administration appears to reduce administrative costs significantly, as expected.
Administrative costs are higher for pension funds with relatively higher investments, since part of the administrative costs may be related to investment. Costs are also significantly higher for pension funds with relatively many pensioners and lower for funds with relatively many inactive participants.
Finally, pension funds that report investment costs appear to have lower total operating costs than others.
All in all, we find plausible and highly significant coefficients for most explanatory variables. Also, we observe similar outcomes across the various samples used, so that the results appear to be fairly robust.
We have re-estimated the model for each single year in our sample. In all 13 years, we observe strong unused economies of scale, but the potential to reduce costs by increasing scale appears to decrease over time. This is in line with the fact that the average number of participants per pension fund gradually increases.
Investment costs include wages of portfolio managers and analysts, brokerage fees and the cost of electronic trading facilities. There are at least two possible causes for economies of scale in the investment of pension funds' assets. First, a larger fund can spread fixed costs over a larger asset base. Second, it is likely that large pension funds have more bargaining power.
Pension funds must report investment costs separately. In order to obtain net investment returns, these costs are deducted from gross returns. Average investment costs per participant decrease sharply across the number of participants classes, from e 270 for the smallest pension funds to e13 and e 31 for the largest two fund classes. Investment costs as a percentage of total assets decrease from around 0.14% for the three smallest fund classes to 0.08% for the largest funds.
To construct an empirical model for investment costs we assume that the size, governance, plan design and outsourcing choices of pension funds determine not only their administrative costs but also their investment costs. To examine the marginal contribution of each determinant, we estimate a multiple regression model of investment costs:
Our model confirms that strong economies of scale exist with regard to investment costs as well. An increase of total assets by 1% would raise investment cost by only 0.86%. These unused economies of scale per additional unit of production (14%) are substantially less than those for administrative costs. The model shows the economies of scale with respect to the management of investment are also not constant, but change over the pension fund sizes, indicating that an optimal fund size exists.
The governance dummy variables indicate that investment costs differ across types of pension institutions. Compulsory industry funds have, on average, lowest investment costs, while non-compulsory industry funds are second best in this respect. Apparently, these types of pension funds are able to manage their investment more efficiently than the other categories: industry funds have lower costs. These governance dummies reflect similar cost level differences as in the administrative cost model. Pension funds with DC plans appear to have higher investment costs than those of DB plans in the quadratic full-data set sample. For the other samples we do not observe any significant effect.
Full or partly outsourcing of liability and investment risks does not affect investment costs significantly. As reinsurance premiums are booked separately, we would have expected lower costs. Underreporting of investment costs for do-it-yourself company funds may have distorted the comparison.
In general, a higher share of investments in stocks is accompanied by higher costs as stocks need more investment management. Apparently, industry funds are able to manage their stock investments relatively efficiently.
Overall, our study finds a strong dispersal in administrative and investment costs across Dutch pension funds that is explained mainly by their size.
Other pension fund characteristics play a minor role. Industry funds are significantly more efficient than company funds and other types of pension funds. The industry funds' DC plans are somewhat cheaper to manage than their DB plans. Higher shares of pensioners make pension funds more costly. Pension funds that outsource their administration appear to have higher costs than others, which we ascribe to under reporting of administrative cost of smaller funds.
Finally, reinsurance, that is, the outsourcing of liabilities and investment, reduces costs, as expected. A company's own pension fund can provide specific benefits, both to its participants and the sponsor company. These benefits may include tax gains, more discretion to adjust contributions and the option to claim part of pension fund surpluses.
However, such benefits come at high costs when the pension fund is small, as such pension funds are unable to fully exploit the large economies of scale that exist in pension plan administration and asset management. The market for pension provisioning may be seen as imperfect because collective pension arrangements are generally much cheaper than individual ones, due to scale and the absence of marketing and education costs, adverse selection and profits. This suggests scope for beneficial market intervention aimed at providing good pensions at low costs.
For these reasons, many countries have introduced mandatory pension schemes. An example of a legal instrument that reduces costs further is, in the Netherlands, the possibility for sectors to ask the government for a mandatory status within the sector of a collective labour agreement, so that industry fund pensions become ‘compulsory' for all companies in that industry.
This appears to be quite efficient, as we find that operating costs are lowest for large compulsory industry-wide funds. In fact, this structure has contributed to low average operating costs of pension funds in the Netherlands.
Given this finding, the question may arise whether the continuing presence of small pension funds with relatively high costs points to market imperfections, which prevent stakeholders from fully exploiting the unused economies of scale. Many companies, however, have the choice to operate independently, to co-operate with other pension funds or to outsource all activities.
Thus, since companies have different options, company funds indirectly face competition from other financial service providers. On the other hand, pension regulation limits the possibility for participants and firms to discipline pension funds, for example by switching pension funds, thereby eliminating competitive pressures that could potentially force (small) pension funds to lower their costs.
Our results support policy actions aimed at further improvement of pension fund efficiency, particularly for small funds. Public policy could be used to promote the transparency of pension plan operating costs and increase the incentives for small to medium-sized pension funds to merge. This would also reduce the costs of supervision. As industry funds are most efficient, it would also be desirable to promote further industry-wide consolidation of pension providers.
Jacob Bikker and Jan de Dreu work at De Nederlandsche Bank (DNB) Supervisory Policy Division. The views expressed in this article are personal and do not necessarily reflect those of DNB. This is an edited version of DNB Working Paper No. 109