PROspective Vol II No VII August 2011

Taking a world tour... of DC plans.

The US is not the only country with Defined Contribution plans. In some places, DC plans replace social security. Juan Yermo studies DC plans worldwide in his role as Head of the Private Pensions Unit in the Financial Affairs Division of the Organization for Economic Co-operation and Development (OECD.)

Juan gives us an overview of DC plans outside the US, how they compare, and how they address common problems.

Chuck Miller: What other countries have DC plans and how are they similar, and dissimilar, to US plans?

Juan Yermo: Defined contribution plans are becoming increasingly common throughout the world. In many countries, they are actually even more prevalent than in the US, as the plans have become mandatory and have in some cases replaced part of the social security system. Within the 34 OECD countries, nearly half have some type of mandatory private pension arrangement, mainly of the defined contribution type.

By and large, mandatory DC plans provide a relatively small, complementary income to the main social security or company DB/hybrid plan. The main exceptions are Australia, Chile and Mexico where DC plans provide more than one half of the total replacement rate from statutory pension system (see figure below from Pensions at a Glance, showing replacement rates for new workers from the mandatory pension system).

Source: Pensions at a Glance 2011: Retirement-Income Systems in OECD and G20 Countries; OECD, 2011

CM: Are there any problems that are common among these plans?

JY: DC plans face common problems in most countries. Probably the most important one, and the cause of other related challenges, such as fees, is insufficient member understanding and involvement. DC plans in most countries put a big burden on individuals to make difficult choices. Outside the US, members are generally even less willing to decide how to invest their retirement assets, especially if they are faced with a complex array of options.

CM: How are other countries addressing these problems?

JY: Policymakers in some countries, especially where the plans are mandatory have decided to direct their efforts towards simplifying choices and selecting appropriate default options. Hence, for instance, in Chile and Mexico, members face only five investment options, while they face only three in Peru and some Eastern European countries like Latvia and Estonia. The default option for those who do not make an active investment choice is a kind of life-cycle strategy, where the member is moved from a riskier to a less risky portfolio allocation according to age.

CM: Fees are a hot topic among US plan sponsors... how do they compare with other countries?

JY: Fees are a policy issue in many other countries. The OECD collected figures some years ago showing a wide variation across countries, with differences as high as 1 ½ - 2 percentage points. The US has levels that are in the middle of the ranking. The models that achieve the lowest costs are those that involve a high degree of economies of scale and centralization in administration, such as the Swedish PPM system, or Australia's industry-wide funds.

As shown in the chart below, the Swedish PPM system [(Prempensionsmyndigheten) – or Premium Pension Authority in English], has achieved one of the lowest levels of total fees of any mandatory DC system (under 0.5% of assets under management). In Sweden, the Pensions Agency acts as the single account administrator and reporting interface with the plan members. The Pension Agency also negotiates rebates with the asset managers chosen by the plan members. There is also a state-managed default fund that can also be actively chosen by plan members. A similar system will operate in the United Kingdom beginning in 2012 with the introduction of the National Employment Savings Trust (NEST.)

Fees in mandatory DC pension systems, 2008

As a % of assets under management

Source: Waldo Tapia, and Juan Yermo; Fees in Individual Account Pension Systems: A Cross-Country Comparison, OECD Working Papers on Insurance and Private Pensions, No. 27; OECD, 2008

CM: Plans in other countries offer multiple investment choices... is there any correlation between participation and the number of choices as we've seen in US plans?

JY: The truth is that there has been little research on these issues outside the US. Partly because of that experience, many countries have started their DC plans with a simplified structure, offering few choices, as I explained earlier. Evidence from other jurisdictions, such as Hong Kong (China) or Australia, however, confirm the US experience.

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