David Hume, the famous Scottish philosopher, once said: “A social contract holds together like a masonry arch. Each stone supports and is supported by its neighbours, without any need for cement or glue“. In other words, many of our rules of social behaviour are no more solidly founded than the convention we use to select equilibrium.
How do we build sustainable pension systems?
Designing a pension system is a complex business in which difficult trade-offs must be made. On the one hand, we may want everyone to receive a retirement income that is linked to their own contributions; on the other, we want to protect people from poverty. How do we weight these two goals? The choice will depend on societal preferences and cultural values.
And what risks are to be insured? There are limits to what even a robust pension system can provide. Risks such as macro-longevity are very expensive to insure against, since they cannot be diversified away by pooling. And what would happen if a medical breakthrough suddenly increased life expectancy
by 10 years? There are no simple solutions to problems like these. Good pension design also depends crucially on local context and cultural values.
These are just some of the dilemmas facing pension system designers as they try to build systems that are:
Adaptable enough to provide choices to a diverse population, but also to protect them from making bad decisions
Stable enough to withstand the unavoidable risks embedded in today’s uncertain world, while at the same time providing certainty about retirement income
Fair to all participants, regardless of gender, income level, or generation, while leaving room for solidarity and risk sharing.
Three Groups of Principles
Behavioural principles underlie people’s needs, preferences, and shortcomings; they ensure that any system is realistic in the sense of taking into account what people actually do when confronted with pension matters.
Stability principles ensure that a system can cope with uncertainty in today’s world and remain stable.
Risk-sharing principles ensure that the right risks are shared appropriately, in ways that are accepted and defensible, and with outcomes that will be considered sustainable and effective, now and in the future.
Three Behavioural Principles
Ideally, in our diverse and increasingly heterogeneous society, people have some freedom of choice in pension matters. However people also find complex choices difficult to understand. This difficulty often results in inertia, leaving people in danger of being sold inappropriate products, either inadvertently or deliberately. Given these behavioural tendencies, pension design should acknowledge that people need the option to tailor their pension to their own specific circumstances, but should also reduce the risk of poor decision making due to behavioural pitfalls.
This implies that one of the key building blocks in a strong pension system should be an “architecture of choices” that nudges people in a sensible direction without taking away their freedom of choice. Pension information systems should enable people to see the consequences of possible choices for their future retirement income prospects.
Three behavioural principles:
Keep it simple. Don’t make the pension solution any more complex than necessary. Complexity and lack of transparency make decision making more difficult, increasing the risk that people will make decisions they will later regret. Simplicity helps manage people’s expectations and increases their trust, both vital qualities for a successful pension system.
Provide sensible choices. Employees should be given a standard package, on top of which a limited set of well-considered alternatives are offered, to protect them from making mistakes while allowing them individual freedom. Creating a set of choices for a pension system is like drawing up a good restaurant menu: it offers people tools (the menu) for tailoring the solution (the meal) to their needs, but without expecting them to be financial experts (the chef).
Under-promise, over-deliver. Research has shown that people experience twice as much pain from a loss as pleasure from a gain of equal size. Therefore, it is wise to avoid delivering outcomes below people’s expectations, which implies that a pension system should offer people a minimum level of pension income that, in practice, will likely be exceeded. Research shows that people value some kind of certainty very highly and are willing to pay substantial sums of money for it, but too much certainty will make the pension design unaffordable.
Three Stability Principles
We live in a complex world in which we must accept fundamental “unknowns”, and future retirement income is no exception. Some unknowns result from the complexity of the environment in which we operate, while others result from the ways in which pension systems are designed. The implication is that we need to design pension systems that can deal with uncertainty and minimize the chances that the system will break down under stress.
Systems should be designed to adapt to socio-economic developments that affect the value of pension assets and liabilities. This requires assigning clear, explicit ownership rights and reducing ambiguities in how pension assets and liabilities are valued. Beneficiaries should not feel that they are treated worse in a collective system than when they invest individually in the same way.
The following three principles should provide a pension system with sufficient stability:
Ensure adaptability. Constantly changing external conditions require an adaptable pension system. Explicit individual ownership rights ensure flexibility, so that the system can adjust itself over time, and also make pensions more mobile to move to other systems.
Keep it objective. The health of a pension system should be measured based on objective market valuations. An objective diagnosis ensures that beneficiaries feel comfortable with how the pension fund deals with their property rights. If the valuations are calculated differently from market practice, participants may feel they are better off outside the system.
Prepare for extreme weather. The world is uncertain and unpredictable things happen; a pension system should be robust under extreme circumstances, built not on predictions but on consequences of possible outcomes. To assess the system’s robustness, draw up a set of “extreme weather” scenarios for risks outside and inside the pension system. The design of the pension system should target the ability to endure these extreme scenarios.
Sharing risks is a cornerstone of many pension systems. But widespread support and trust requires a delicate balance between insurance solidarity, based on the risk-reducing benefits of diversification, economic efficiency and fairness. Sharing risks that cannot be diversified or traded at an objective market price should be avoided. For example risk sharing between generations can result in discontinuity risk leading to conflicts between generations. “You lose, I win” situations undermine the social acceptance and sustainability of collective pension solutions, as Hume taught us.
These considerations lead to the last three principles on which any well-developed pension system should be based:
Avoid winner/loser outcomes. To avoid losing support and distrust, pension system design should prevent any one group of participants benefitting at the cost of another group.
Only diversifiable risks should be shared. A system founded on solidarity in bearing diversifiable risk creates value for all by reducing individual risk. For example, we have no idea how long we will live after we retire, but we can estimate the current average life expectancy of a homogenous group reasonably well, so it makes sense for individuals to pool their individual longevity risk with a large group.
Individuals must bear some risks. Risks that cannot be diversified or hedged in the market should be borne by the individual. Pooling non-diversifiable risks leads inevitably to transfers between groups in the collective pool and will eventually erode trust in the system. In reaching for higher long-term returns, younger people can absorb more market risk than older people; this calls not for risk sharing but for age differentiation in exposure to financial markets.
This post is a short version of the article published by my employer Cardano (2014, Rotman International Journal of Pension Management, Thomas van Galen, Theo Kocken and Stephan Lundbergh): Demystifying pension design: clearer principles foster better practices. http://utpjournals.metapress.com/content/212554jp1784p152/fulltext.pdf