Smart investments? The costs of choice and excessive switching in pension funds

Pension funds are rightly viewed as an important source of long-term capital in many countries. Following the global financial crisis of 2008, the theme of long-term investment and the role of institutional investors as providers of domestic capital for economic development has been high on policy makers’ agendas. Despite generally positive findings linking pension system development and economic growth, there are also plenty of disappointments. In too many countries, pension fund investments remain highly concentrated in bank deposits and traditional government bonds. This lack of diversification can be explained by many factors, for instance, unsupportive macro conditions, shortage of investment instruments, poor governance, limited investment knowledge, and regulations with restrictive asset class limits and excessive reliance on short-term performance monitoring.

Fund managers are also expected to adjust their portfolios to accommodate volatile flows and manage redemptions. For pension funds, since saving for retirement is mandatory in many countries and early withdrawals are restricted in most cases, outflows are expected to be stable. For this reason, the potential effects from flows on pension investments have been largely overlooked. However, to promote competition and provide flexibility to clients, regulatory authorities typically allow workers to transfer their pension savings across different portfolios and switch management companies – often at will. In such settings, excessive switching might distort pension funds’ asset allocation and skew portfolios towards short-term instruments.

In a recent study (Fuentes, Pedraza, Searle, and Stewart, 2017), we obtain administrative data from national authorities in ten countries operating define contribution (DC) pension systems and examine the extent to which switching between pension providers and across different portfolios affect asset allocations. We find that while total benefit payouts are still small in most countries (less than 2% of total asset during a year), the amounts transferred across managers and between portfolios are large and highly volatile — yearly flows from members switching exceed 30% of total assets in many cases.

Switching appears to be driven by competition, market structure, and investment advice, and, unfortunately, frequently results in poor investment returns for members.  Furthermore, we show that in response to these large flows, pension fund managers increase their holdings in short-term and more liquid assets, affecting the value of the funds and future pension outcomes.

Whether the benefits of competition, marketing, and lenient switching policies outweigh the costs of a potentially weaker long-term performance is a question that needs to be answered by local authorities in jurisdictions operating DC pension systems.

1. Use administrative controls to prevent fraudulent switching between pension providers.
2. Provide clear performance/costs comparisons to inform members’ choice of provider/fund and encourage informed decision-making, beneficial to members and to the system.
3. Supervise and control advertising and marketing (including reporting of performance periods) carefully to avoid switches based on misleading advice.
4. Control financial incentives for sales agents so that switching advice in given in members’ interest and not for commercial gain.
5. Concentrate issuance in government securities to create more liquid instruments.
6. Conduct further research on the concept of a central liquidity pool to manage unexpected outflows.

References

Fuentes, O., Pedraza, A., Searle, P., and Stewart, F., 2017,“Pension funds and the impact of switching regulation on long-term investment”, Policy Research Working Paper 8143.