Customised default funds or blanket solutions, choice or guided decisions. The issue of creating the right default funds for defined contribution systems was the subject of discussion among Nobel Laureates, academics and investment specialists at Pioneer Investments' second European Colloquia in Vienna.
When developing retirement products, asset managers should first identify "how people are different from each other" to form sets of prototypes and create choice within each set, suggested Joseph Stiglitz, the US economist who shared the Nobel Prize in economics in 2001 with two other scientists for their work on information asymmetries between participants in the financial markets.
He noted that the capital asset pricing model (CAPM) of relationship risk and expected return now used to create defaults was "inappropriately describing markets" as it failed to take non-financial assets such as human capital, housing and family structure into account.
David Laibson, professor of economics at Harvard University, wanted default funds to be tailored to each company's needs, with the government providing minimum standards for the solutions.
"Governments need to build parameters which exclude nasty defaults," he explained. "But within these parameters companies should be able to choose." He noted it was "difficult to know what is good but very easy to know what is wrong", such as a money market fund with 2% contribution rate. Laibson warned many default funds are constructed "wrongly", for example, with an asset allocation that is too conservative, leading to a much lower savings rate.
Stephen Zeldes, professor of finance and economics at Columbia University, argued against portfolio customisation as too little is known about the individuals concerned and such a step could only rely on surveys or questionnaires.
"Customisation would be based mostly on noise, leading customised portfolios to be worse than one-size-fits-all models. Furthermore, the complexity of customisation might scare away pension plan members," said Zeldes. He argued for a review of the common 100 minus age rule-of-thumb approach to calculate equity exposure in a portfolio.
Zeldes noted there were arguments for reducing equity exposure towards retirement and while life-cycle models or target date funds, which re-balance the bond/equity ratio to a specific date, "are not better in tailoring to individuals' needs" they were "much better relative to the actual behaviour of people".
However, not all agreed on the principle of reducing equity risk right before or during the decumulation phase. "The idea is to create a safer portfolio by decreasing equity exposure towards retirement," Stiglitz explained. "However, as human capital matters less at that stage, hence the human capital risk is getting lower, some people might want to compensate by taking higher financial risk."
In a previous interview with IPE, Christian Böhm, managing director of the Austrian multi-employer pension fund APK, suggested that decreasing equity investments in a portfolio along with the age of a member of a pension fund - the so-called life-cycle model - fully exposes members to the risks of the market.
"Why should a pensioner suffer because he retires in a market with low bond yields?" he asked. "There is no correlation between the age of a pension fund member and how the market behaves."
Nevertheless, assets in these funds, also known as target date funds in the US, are growing rapidly. Zeldes quoted a figure of $160bn (€109.1bn) of US target date funds with annual net inflows of $40bn since the government decided to allow these funds as defaults for 401(k) pension plans.
In total, at year-end 2006, more than 40% of the $23.2trn in worldwide total pension assets were in defined contribution schemes, according to statistics compiled by Watson Wyatt.
Because of higher contribution flows the average growth of defined contribution schemes was 9.8% a year since 1997 compared with 5.5% for defined benefit plans.
The importance of good default funds is underlined by figures released by the Organisation for Economic Co-operation and Development (OECD) showing that the majority of defined contribution scheme members did not make a choice but stayed in the default fund. Membership numbers for default funds were higher in countries where individuals were offered more choice.
About 90% of people in Sweden - where individuals are offered a choice of more than 600 funds in the mandatory first pillar defined contribution system - are leaving their money in the default option managed by AP7, Waldo Tapia and Juan Yermo, pointed out a recent OECD report.
Laibson noted his studies confirmed these findings and suggested limiting choice to about 10 funds at the most. He also suggested the Swedish government introduce an auction-like system that would see a different selection of funds for a certain period, which would be chosen according to their performance and fee structure.
For the UK, consultancy Watson Wyatt identified a similar trend. According to new findings, more than two thirds of contract-based defined contribution schemes had more than 80% of their members in the default fund. Already these pension plans were starting to reduce the fund choices to about 20.
"This demonstrates a perverse situation where greater choice of investment funds leads to a greater reliance on the default option," Crispin Lace, senior investment consultant at Watson Wyatt, said. "When it comes to the number of investment options, increasing choice does not necessarily mean improving choice."
Stiglitz agreed that people had problems making choices but stressed it was important to "give individuals the right to choose as, firstly, they value choice and, secondly, they know more about themselves than anyone else".
All delegates at Pioneer's colloquia agreed people need help planning for retirement as the subject was too difficult to understand for most. Even experts in the field seldom followed through on plans to adapt their portfolio regularly to changes in their lives, research found.
"Left on their own, individuals do not rebalance their portfolio," he pointed out, as his studies showed 65% of active participants to a defined contribution scheme made no or only one change to their portfolio over 10 years.
Zeldes noted that the amount of equities in people's portfolios depended very much on the situation on the stock markets in the year they joined the scheme, as well as the behaviour of other members in the cohort.
"Even if they understand the problem and the subject their follow- through is abysmal and only slightly better than that of the next person," said Laibson, noting findings from
Therefore, "financial education is a very expensive and weak lever for making changes," he added, albeit stressing he was not against educating people. His explanation is that people value future benefits only half as much as benefits they can get now.
"Individuals have problems judging probabilities and future retirement needs," Stiglitz agreed. "People often fall prey to advice, some of which is exploitive, as asset managers and distributors often seem to have an incentive to increase their profits by exploiting people's ignorance and living - mildly - off reputation," the 2001 Nobel winner pointed out.
He urged regulators to "identify deceptive and unacceptable practices" by asset managers. As one example, he suggested firms hiding bad assets in complicated instruments should be reviewed. "Better regulation will help restore confidence in the market," Stiglitz said.
All academics called on their fellow researchers to look more into the saving behaviour of defined contribution scheme members in order to facilitate portfolio construction in default funds. (See also US report p10.)