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The OECD Roadmap

for the Good Design of

Retirement Saving Plans

Pablo Antolin OECD DAF/FIN Pension Unit

Tallinn, December 2012

Background and motivation

Retirement saving plans in which benefits depend on assets accumulated are increasingly an integral part of most countries’ overall pension system.

All countries rely on these plans, different degree. Their importance keeps growing

In some countries is already the main source to finance retirement: Australia, Canada, Chile, Mexico, UK, US.

2

Background and motivation

The OECD has been working for a few years on improving the design of DC pension plans in order to strengthen retirement income from these plans.

We have compiled the lessons learnt into a set of policy messages.

Policy messages have been endorsed by the OECD WPPP: regulators and policy makers from OECD countries

3

Background and motivation

Saving for retirement is for the long haul.

Retirement income depends on several factors, some policy makers, regulators and individuals have certain control over (contributions, ret.age) and other uncertain (returns, life expectancy).

Financial and economic crisis highlighted the importance of risk factors.

4

Guiding principles

• The policy messages based on three

guiding principles:

–Coherence

–Adequacy

–Efficiency

5

Coherence

• Policy messages to strengthen retirement

income in DC plans need to assess these plans in the context of each country overall pension system, they are not in a vacuum.

6

Adequacy

• DC pension plans are complementary to

other sources to finance retirement (e.g. PAYG-financed pensions).

• DC plans need to be designed (e.g. contribution rates, contribution periods, payout phase, etc.) taking into account that they may provide a ret. income that complement other sources.

• What is an adequate ret. inc. is highly controversial. But assuming that for example, one can get by on 70% of pre-retirement income …

7

Efficiency

• Efficiency: reducing risks for retirement income or saving for retirement (de-risk).

• E.g. choosing investment strategies (many in the return-risk spectrum) that reduce the impact of extreme negative outcomes on retirement income

• Efficiency also required to properly structure the payout phase: allocate assets efficiently. Strike out a balance btw liquidity and flexibility, and protection from longevity risk

8

Main policy messages

9

Main policy messages

1. Ensure the design of DC pension plans is coherent (globally, internally, monitoring all risks)

2. Encourage people to enrol, contribute and contribute for long periods

3. Improve the design of incentives to save for retirement to increase contributions and coverage, in particular when voluntary.

10

Main policy messages

4. Promote low-cost retirement savings instruments

5. Establish appropriate default investment strategies, while also providing choice btw investment options with different risk profile and investment horizon

6. Consider establishing life-cycle investment strategies as defaults to protect against extreme negative outcomes

11

Main policy messages

7. Encourage annuitization as a protection against longevity risk

8. Promote supply of annuities & cost-efficient competition in the annuity mkt

9. Develop appropriate information and risk-hedging instruments to facilitate dealing with LR

10. Ensure effective communication and address financial literacy

12

Messages related to

cost, investment

strategies and defaults

13

M2. Encourage people to contribute

and contribute for long periods

• Best way reduce uncertainty about achieving a target retirement income is to contribute large enough amounts and for long periods.

• Long contribution periods allow for higher retirement income for given level of contributions (compound interest)

• Lengthening contribution period by postpo. retirement more efficient approach of increasing retirement income.

14

Encourage people to contribute

and contribute for long periods

• ∆ contributions or the contribution period ∆ the probability of reaching the target retirement income (RR).

15

Prob (RR≥30%) Prob (RR≥70%)

5% C – 40 years 61.6 13.9

10% C – 40 years 91.7 52.8

5% C – 20 years 2.8 0.1

10% C – 20 years 33.0 1.3

M3. Improve the design of

incentives to save for retirement to

increase contributions and coverage

• Contribution could be ∆ through mandates or with the help of “nudge” measures.

• “Nudge” measures include matching contributions (employer or state), and auto-escalation (e.g. SMTP).

• Also important to increase the number of people saving for retirement in DC plans

16

Improve the design of incentives to

save for retirement to increase

contributions and coverage • Compulsion

• Soft compulsion: auto-enrolment with an opt-out clause (Italy, New Zeeland, UK). Take advantage of behavioural financial literature stressing the role of inertia or passive decision.

• Strengthen the value of tax incentives for mid to low income people: tax credits or matching contributions instead of tax deductions.

• Better communication and improve fin-ed 17

M4. Promote low-cost retirement

savings instruments

• The amount of fees charged has a large impact on retirement income.

18

Fee as % assets Reduction of pension

0.05 % 2 %

0.15 % 5 %

0.25 % 8 %

0.50 % 15 %

0.75 % 22 %

1.00 % 28 %

1.50 % 39 %

Promote low-cost retirement

savings instruments

• Policy approaches to keep fees reasonable

1. Disclosure-based initiatives: ensure members receive timely info on fees they pay, including comparisons btw providers

2. Pricing regulations: single charge structure, and setting ceiling on fees

19

Promote low-cost retirement

savings instruments

3. Structural solutions include: in occupational pensions employers and trustees act as intermediaries, can negotiate fees. Another option could be the establishment of a centralised institution (Sweden, Nest)

20

M5. Establish default investment

strategies with appropriate risk exposure

• DC plans aimed at providing people choice

• Behavioural econ and financial literacy research show that some people are either unwilling or unable to choose among I strategies.

• Default I strategies concentrate on reducing the risk of extreme negative outcomes on retirement income.

21

Establish default investment strategies

with appropriate risk exposure

• Choosing the appropriate default options

Balancing trade-off higher potential ret. inc. and associate risk.

Risk measured as ret. inc. in extreme negative outcomes

Choose the probability threshold established to assess risk: I strategies reduce downside risk by e.g. 99%

22

M6. Establish life-cycle investment

strategies as defaults • Life cycle I strategies reduce the exposure to

risk assets (e.g. equities) as people ages. Easy to understand

• They provide protection for those close to retirement in case of a negative stock market shock just before retirement

• They provide protection when contribution periods are short

• The glide path important: ones with sharp decrease in equities in the last decade

23

Estimated probability that pension benefits

based on LC strategies will be higher than

those based on a fixed portfolio strategy for

two different contribution periods

24

Life-cycle investment strategies 20 years 40 years 20 years 40 years

Sharp decrease after age 55230.2 42.1 71.0 61.5

Entire random

sample (10,000 obs)

Negative stock

market shock1

Contribution period Contribution period

Establish life-cycle investment

strategies as defaults

• Life cycle I strategies not a panacea: provide protection from extreme negative shocks for those close to retirement, but do not eliminate volatility, do not address adequacy

• LC strategies can be organised around one single fund (e.g. target date, US) or around several funds (e.g. multi-funds, Chile, Mexico)

25

M10. Ensure effective communication

and address financial literacy

• Members should be provided with regular individualised benefit statement. Including accounting info and projections on future benefits with prudent assumptions.

• Members able to access freely and readily comparative info on costs and performance

• Disclosure materials written using accessible language

26

M10. Ensure effective communication

and address financial literacy

• Use web tool to communicate risk

• Goal: members be pro-active:

– target retirement income,

– likelihood,

– contribute more,

– contribute longer

27

Ensure effective communication

and address financial literacy

• NPCC can be useful to inform the population about reforms and “ nudge” them towards specific choices (e.g. retire later).

• Targeted campaigns: one issue, well defined policy goal (e.g. increase savings)

• Measurable objectives

• Evaluation standards. Constant evaluation against obejctives

• Dedicated and sustainable budget. 28

Ensure effective communication

and address financial literacy

• Training in financial education (inc. pensions) should start as early as possible (e.g. as part of school curricula) in order to encourage individuals to start saving as young as possible.

• Training of financial advisers is also important.

29

Thank you

very much

30

pablo.antolin@oecd.org

www.oecd.org/daf/pensions

Boxes:

Supporting evidence

31

Box 2:

The impact of market

conditions on

retirement income

32

Hypothetical RR in DC pension plans

33

Japan

France

United States

01

02

03

04

05

06

07

0

Retir

em

en

t in

com

e o

ver

fina

l sala

ry (

%)

194019451950195519601965197019751980198519901995200020052010Year retiring

Impact of market conditions at the time of

retirement is large large fluctuations in RR

0

10

20

30

40

50

60

70

80

193

9

194

1

194

3

194

5

194

7

194

9

195

1

195

3

195

5

195

7

195

9

196

1

196

3

196

5

196

7

196

9

197

1

197

3

197

5

197

7

197

9

198

1

198

3

198

5

198

7

198

9

199

1

199

3

199

5

199

7

199

9

20

01

20

03

20

05

20

07

Ret

ire

me

nt

inco

me

ove

r fi

nal

sal

ary

(%)

Year retiring

US Japan

Hypothetical replacement rate 40-yr contribution

Impact of market conditions at the time of

retirement is large large fluctuations in RR

0

10

20

30

40

50

60

70

80

90

100

110

120

130

193

9

194

1

194

3

194

5

194

7

194

9

195

1

195

3

195

5

195

7

195

9

196

1

196

3

196

5

196

7

196

9

197

1

197

3

197

5

197

7

197

9

198

1

198

3

198

5

198

7

198

9

199

1

199

3

199

5

199

7

199

9

20

01

20

03

20

05

20

07

Ret

ire

me

nt

inco

me

ove

r fi

nal

sal

ary

(%)

Year retiring

UK

Hypothetical replacement rate 40-yr contribution

Box 3:

Performance of different

LC investment strategies

using historical data

36

Hypothetical RR diff. LC (40 yrs)

37

fixed portfolio 50-50

life cycle steep at 55

life cycle ld

life cycle steep at 45

United States

10

20

30

40

50

retir

em

en

t in

co

me o

ver

final s

ala

ry (

%)

1940 1950 1960 1970 1980 1990 2000 2010Year retiring

Hypothetical RR diff. LC (40 yrs)

38

Fixed portfolio 50-50

Life cycle ld

life cycle steep at 55

life cycle steep at 45

JAPAN0

10

20

30

40

50

retire

men

t in

co

me o

ve

r fin

al sa

lary

(%

)

1940 1950 1960 1970 1980 1990 2000 2010Year retiring

Hypothetical RR diff. LC (20 yrs)

39

Fixed portfolio 50-50

Life cycle linear decrease

Life cycle steep at age 55

United States

510

15

20

retir

em

en

t in

com

e o

ver

fina

l sala

ry (

%)

1940 1950 1960 1970 1980 1990 2000 2010Year retiring

Hypothetical RR diff. LC (20 yrs)

40

fixed portfolio 50-50

life cycle steep at age 55

life cycle linear decrease

05

1015

2025

retir

em

ent i

nco

me

ove

r fin

al s

alar

y (%

)

1940 1950 1960 1970 1980 1990 2000 2010Year retiring

JAPAN

Box 4:

Tax incentives

41

Tax form – tax incentives

• Earned income

• Deductions, exemptions, reliefs (e.g. charity)

• Taxable income

• Applied tax rates by income brackets

• Tax due

• Tax credits (e.g. credits per child)

• Tax payments

42

Tax incentives

• Most common: deductions on income Tax deductions (incentives increase with income)

• Alternatively, tax credits (inversely related to income)

• Matching contributions

43

Tax incentives - Tax deductions

0

0.5

1

1.5

2

2.5

0.2 0.4 0.6 0.8 1 1.2 2 4 8 16

Re

du

cti

on

in

ta

xe

s r

ela

tiv

e t

o p

re

-ta

x i

nc

om

e

(pe

rc

en

tag

e p

oin

ts)

Income level (times median income)

Tax incentive – Tax credits

0

0.5

1

1.5

2

2.5

3

0.2 0.4 0.6 0.8 1 1.2 2 4 8 16

Re

du

cti

on

in

ta

xe

s r

ela

tiv

e t

o p

re

-ta

x i

nc

om

e

(pe

rc

en

tag

e p

oin

ts)

Income level (times median income)

Tax credit based on a fixed amount for all

Tax credit based on a percentage of contributions plus a cap

Incentive – Matching contributions

0

0.2

0.4

0.6

0.8

1

1.2

0.2 0.4 0.6 0.8 1 1.2 2 4 8 16

Re

du

cti

on

in

ta

xe

s r

ela

tiv

e t

o p

re

-ta

x i

nc

om

e

(pe

rc

en

tag

e p

oin

ts)

Income level (times median income)

Fixed contribution match (1 pp)

Fixed contribution match with a cap (1 pp,

plus cap of median income)

Tax deduction + matching contributions

0

0.5

1

1.5

2

2.5

3

3.5

0.2 0.4 0.6 0.8 1 1.2 2 4 8 16

Re

du

cti

on

in

ta

xe

s r

ela

tiv

e t

o p

re

-ta

x i

nc

om

e

(pe

rc

en

tag

e p

oin

ts)

Income level (times median income)

Tax deduction with a matching contribution of 1pp

Tax deduction with a matching contribution of 1 pp and a cap

at the median income matching

Work in preparation

• OECD developing project to examine tax rules on pensions systems

• Tax rules on contribution, returns & benefits

• Tax rules on the accumulation, on the payout phase and on different products (annuities, PW, lump-sums)

• Assess the impact of tax incentives (country specific)

• Assess the impact of alternative ways of introducing incentives (country specific)

48

Box 5:

What type of default

investment strategies?

49

IV. Default investment strategies

Stochastic modelling with different structures of the payout phase

Different investment strategies:

– Fixed portfolios

– Life cycle strategies (diff gliding paths):

• Linear decrease

• Step-wise linear approach

• Piece-wise linear approach

• Dynamic multi-shaped

• Average multi-shaped

– Dynamic risk budgeting

Default investment strategies:

Payout Phase • Life annuity

• Inflation-indexed life annuity

• Fixed programmed withdrawal

• Variable programmed withdrawal

• Combined arrangement mixing:

– Variable programmed withdrawal

– Deferred inflation-indexed life annuity that starts paying at age 80

Default investment strategies:

Results Life annuity: Median replacement rate vs. 5th percentile

Default investment strategies: Results

Payout Options Default Investment Strategies

Life annuities at retirement

Step or piece-wise life cycle strategies with medium exposure to equities (50-60%)

Programmed withdrawals

Average multi-shaped and dynamic risk budgeting with medium exposure to equities

Combined arrangements

A mixed of investment strategies from the other two payout options

The relative performance of investment strategies depends on the type of benefit during the payout phase.

Default investment strategies: Results

The introduction of dynamic management strategies can provide somewhat higher replacement rates for a given level of risk than the more deterministic strategies, at least in the case of pay-outs in the form of variable withdrawals

Default investment strategies: Results

Life cycle strategies that maintain a constant exposure to equities during most of the accumulation period, switching swiftly to bonds in the last decade before retirement seem to perform best.