Public Policy

CALIBRATING THE SCALES

OF PENSION FUNDS

The OECD says new regulations are needed to help employees avoid major pension losses. But which regulations are the right ones?

The current economic crisis has upset the balance of risk and return that Defined Contribution (DC) pension plans have long maintained. Organisation for Economic Cooperation and Development (OECD) has called for new rules, claiming that “regulations can be designed so as to limit some of these risks and avoid situations where older workers and retirees are exposed to major losses on their retirement income.”

According to the study titled Investment Regulations and Defined Contribution Pensions and co-authored by Allianz Global Investors, there is a case for protecting DC pension income from large market shocks, at least in default options designed for those who do not make an active choice of investment. Quantitative regulations can have some advantages over the risk-based regulations analyzed in the study.

A simple limit on equities in the DC pension plan can be effective. Risk-based regulations, on the other hand, might lead to a pro-cyclical investment policy which increases the return during a boom as well as the loss during a downturn, the OECD warns.  

 Quantitative regulations must be checked against real events. “Policymakers must consider regulations could be efficient a priori but inefficient a posteriori depending on whether real events fail to validate the modeling,” argues Pablo Antolín, the OECD-affiliated author of the report. National laws must be considered too. “The weight of the DC portion in total retirement income should be a key factor in the design of default investment strategies,” the OECD paper states.

IN MEXICO AND CHILE, DC plans are a large part of pension income. The default fund for an employee 10 years from retirement has a maximum allocation to equities of 20% for Chile and 0% for Mexico. However, a low equity allocation for younger employees may result in lower retirement benefits. Is the best protection against losses a fund that takes some risks for young employees and less for older ones? The answer is an emphatic “yes,” the OECD says. “More analysis is needed on the design of suitable life-cycle investment strategies.” Reducing equity investment to zero over the last 10 years before retirement “may not be the optimal strategy for an individual contributing regularly to a DC plan.” The task for regulators is not easy. “There is not a single correct risk-retirement income trade-off to guide public policy decision,” the study warns.

Published by PROJECT M in November 2009