CHAPTER 20 Policy Considerations for Hedging Risks in Mandatory Defined Contribution Pensions through Better Default Options* Gregorio Impavido CONTENTS 20.1 I ntroduction 20.2 Investment Choice and Default Options 20.2.1 Regulation and Design 20.2.2 Performance of Age-Dependent Default Options 20.3 Current Rules and Design: Rationale and Problems 20.3.1 Minor Design Limitations 20.3.2 The Need to Actively Manage Portfolios 20.3.3 Evidence of Gaps in Asset Manager Behavior in Chile 20.3.4 Inadequate Consideration of Key Background Risks 20.3.4.1 Human Capital Risk 20.3.4.2 A nnuitization Risk 511 511 511 518 523 524 525 527 530 530 532 * Prepared by Gregorio Impavido (gimpavido@imf.org) for “G.N Gregoriou, G Masala, and M Micocci (eds.) Pension Fund Risk Management Boca Raton, FL, Chapman & Hall.” 509 © 2010 by Taylor and Francis Group, LLC 510 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling 20.4 Reconnecting the Accumulation and Decumulation Phases 20.4.1 Target Annuitization Funds 20.4.2 Identifying the Long-Term Investment Target 20.4.3 Construction of Liability-Driven Investment Strategies 20.4.4 Funded Position of the Individual Participant and Endogenous Contributions 20.5 C onclusions Appendix References T 533 534 534 36 540 541 43 44 he r ecen t fi na ncia l t ur moil s h ighlighted t he i mportance o f default investment options in mandatory DC pens ions, especially for individuals cl ose t o r etirement P articipants i n ma ndatory DC pens ions fully bear the investment risk, which they are likely to be badly equipped to assess, monitor, and mitigate At the same time, the disconnection between the accumulation phase and the decumulation phase appears to leave excessive deg rees o f f reedom t o a sset ma nagers i n i mplementing t he st rategic asset allocation through tactical decisions, which may not be consistent with participants’ preferences This issue is particularly relevant to several countries in Latin America and Eastern Europe that have recently adopted the “multi-fund” design for investment choices and default options and many more that are currently considering the adoption of similar products in the coming y ears Ma ny o f t hese co untries a re c urrently co nsidering po licy options that aim at shielding individuals from excessive market risk These include the possible introduction of lifetime government guarantees like in Hungary, outright reversion to earning-related pensions like in Argentina, or a refinement of default investment options as discussed in this note This chapter su ggests t hat t he recent progressive l iberalization of t he regulatory framework for investments and the adoption of life cycle funds are expected to create long-term welfare gains for participants However, current arrangements are still subject to a series of weaknesses including secondary issues related to design a nd adequacy of default options provided in most countries, the need to actively manage portfolios, the lack of explicit considerations of key background risks, and the lack of an explicit long-term t arget f or a sset ma nagers co mpatible w ith t he p references o f participants S ubstantial add itional welfare gains for pa rticipants could be achieved by reconnecting the accumulation phase with the decumulation phase through the use of target retirement date annuitization funds without introducing liabilities for private providers © 2010 by Taylor and Francis Group, LLC Policy Considerations for Hedging Risks ◾ 511 20.1 INTRODUCTION The financial turmoil of 2008 highlighted the importance of default investment o ptions i n ma ndatory defined c ontribution p ensions Thei r design can improve the scope for intertemporal risk diversification for individuals and increase the likelihood of achieving adequate replacement rates during retirement.* This topic is relevant to several countries in Latin America and Eastern Europe that have recently adopted the “multi-fund” design for investment choices and default options and the many more that are currently considering the adoption of similar products in the coming years Many of these countries a re co nsidering po licy o ptions t hat a im a t sh ielding i ndividuals from excessive market risk including the introduction of lifetime government guarantees like in Hungary or the outright reversion like in Argentina This cha pter a ssesses t he de sign a nd t he r egulation o f defa ult i nvestment choices in mandatory defined contribution pensions as they have been recently adopted in countries like Chile, Peru, Mexico, and Hungary It also suggests policies aimed at improving their risk-diversification properties The rest of this chapter is structured as follows: Section 20.2 provides an overview of t he regulation a nd t he design of t he multi-fund product in representative countries like Chile, Peru, and Mexico; Section 20.3 discusses the rationale supporting these products and their limitations, and it suggests policies for improving the scope for intertemporal risk diversification within the current rule-based framework; Section 20.4 discusses policies f or i mproving t he sco pe f or i ntertemporal r isk d iversification within a risk-based framework; and conclusions follow in Section 20.5 20.2 INVESTMENT CHOICE AND DEFAULT OPTIONS 20.2.1 Regulation and Design The regulation of investment choice and the design of default options vary considerably across countries and a clear trend exists toward providing more choice to investors This, despite the large evidence that individuals are inert and that they are unable to make “rational” investment decisions.† * We acknowledge the large debate on c ompetition policy for m andatory defined contribution pensions and the importance of reducing administrative fees However, in this chapter, we treat these as exogenous and make considerations only gross performance or rates of return † Individuals not only act in an irrational way and make mistakes, but they also so in a very inconsistent a nd u npredictable way Individuals tend, i n practice, to a dopt si mple r ules of thumb to solve the relevant optimization problem and subsequently implement their choices, leading to systematic biases We refer here to the vast literature on behavioral economics The literature is vast: see Benartzi and Thaler (1999, 2001, 2002), Madrian and Shea (2001), and Choi et al (2002) for just a few examples related to the issues covered in this chapter © 2010 by Taylor and Francis Group, LLC 512 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling Countries l ike S weden a nd A ustralia ve be en g iving pa rticipants increasing degrees of freedom in selecting their portfolios and have paid little attention to the investment portfolio to which undecided participants are assigned by default In the Swedish Premium Pension System (PPM), 86 fund managers had be en licensed at the end of 2007, each a llowed to register up to 25 funds As a result, a total of 785 funds had been registered at t he end of t he same year, as shown in Table 20.1 Individual choice is restricted to up to five f unds w ith u nfettered s witches (PPM 007) a nd undecided i ndividuals a re a ssigned to a defa ult option t hat s a n 0% equity exposure, reflecting the fact that the PPM represents a small component of the whole pension system (Palme et al 2007) In Australia, participants in the superannuation system have potentially even more deg rees of f reedom At t he end of 2007, t here were some 575 pension firms (superannuation entities) w ith at least four members a nd 63% of them offered on average 38 a lternative funds (Table 20.2) Not all entities are required to offer a default investment option but when offered, this contains, on average, a la rge percentage of equities, a s d isplayed i n Table 20.3 TABLE 20.1 Managers Funds Investment Choices in the Swedish PPM 2003 2004 2005 2006 2007 85 664 84 697 83 725 83 779 86 785 Source: PPM, Ann ual Rep ort, https://secure.ppm.nu/Current Issues.html, 2007 TABLE 20.2 Investment Choices in the Australian Superannuation System Corporate Industry Share of entities offering investment choicea June 2007 55% 85% June 2006 48% 85% Public Sector Retail Total 65% 67% 66% 66% 63% 56% 97 88 38 34 Average number of investment choices per entityb June 2007 10 June 2006 10 Source: APRA, Ann ual S uperannuation B ulletin, http://www.apra.gov.au/ Statistics/Annual-Superannuation-Publication.cfm, 2006; APRA, An nual Superannuation Bulletin, http://www.apra.gov.au/Statistics/AnnualSuperannuation-Publication.cfm, 2007 a Number of entities with at least four members b Average calculated on the share of entities actually offering choice © 2010 by Taylor and Francis Group, LLC Policy Considerations for Hedging Risks ◾ 513 TABLE 20.3 Asset Allocation of Default Investment Options in the Australian Superannuation System Instrumentsa Australian shares International shares Listed property Unlisted property Australian fixed interest International fixed interest Cash Other Total Corporate Entities (%) Industry Entities (%) Public Sector Entities (%) Retail Entities (%) Total (%) 40 33 29 26 31 23 26 24 20 24 4 4 12 10 22 11 6 7 100 14 100 8 100 15 100 10 100 Source: APRA, Annual Superannuation Bulletin, http://www.apra.gov.au/Statistics/AnnualSuperannuation-Publication.cfm, 2007 a Not all su perannuation en tities a re r equired t o ve a defa ult in vestment stra tegy Where there is no default strategy, the strategy of the largest option is reported or the fund strategy as a whole Investment choice in Latin American and Eastern European countries is more limited and the default investment option for undecided individuals is often de signed around the concept of life cycle funds (more commonly known as “multi-funds”) according to the age of the participant Countries that have introduced multi-funds include Chile, Peru, Mexico, and Hungary while many other are considering their introduction in these times Chile was the first country that introduced multi-funds in 2002 Pension firms are required to offer four funds (Fund B to Fund E) and can offer an additional, more aggressive fund (Fund A), all with separate quantitative limits i n a sset cla sses, a s reported i n Table 0.4 Nowadays, a ll pens ion firms in Chile offer all five funds Participants who not choose a fund are automatically assigned to three funds according to their age as reported in Table 20.5 Individuals can always switch to more- or less-volatile funds, if they so wish, with the exception of participants close to retirement who cannot elect the most aggressive Fund A Finally, switching to other funds © 2010 by Taylor and Francis Group, LLC 514 ◾ Pension Fund Risk Management: Financial and Actuarial Modeling Key Maximum Investment Limits for Chilean Multi-Funds TABLE 20.4 Fund A Instruments a Fund B Fund C Fund D Fund E Limits per Instruments Government paper (a) Time deposits, bonds, other financial Institutions (b and c) Letters of credit (d) Bonds of public and private companies (e and f) Bonds convertible to shares (f) (sub-limit) Open plc shares and real estate plc shares (g and h) Investment and mutual fund shares + Committed payments (2) (i) Mutual funds shares (i) (sub-limit) Commercial paper (j) Foreign (k) (super limit across all funds) Other authorized by the C.B.CH (l) Risk hedging operations (m) Foreign currency without exchange coverage Financial loan (n) 40 40 50 70 80 40 40 50 70 80 40 30 40 30 50 40 60 50 70 60 No sub-limit No sub-limit 10 Not eligible 60 50 30 15 Not eligible 40 30 20 10 Not eligible 5 5 Not eligible 10 10 10 20 30 1–5 1–5 1–5 1–5 30 1–5 Investment of the fund in instruments being hedged 37 22 18 13 15 10 5 20 Not eligible Not eligible Limits per Group of Instruments (a) Equities Equities (g, h, i, committed contributions and k and l capital) Maximum 80 60 40 Minimum 40 25 15 © 2010 by Taylor and Francis Group, LLC Policy Considerations for Hedging Risks ◾ 515 TABLE 20.4 (continued) Key Maximum Investment Limits for Chilean Multi-Funds Instrumentsa Freely available equities (g and i) Low liquidity shares (g) Freely available foreign shares traded on the local stock exchange (k and l) (b) Fixed income BBB and N-3 (b, c, d, e, f, j, and k and l: debt) (c) Fixed income and equities Equities (g, h, i, committed contributions and k and l equities) + debt BBB and N-3 + Bonds that are exchangeable for shares (f) Issuers with a history of less than three years (e, f, g, j, y, l) Restricted (g: low liquidity; g and i: freely available; k and l: freely available and traded on local stock exchange; i: issuers with a history of