On the Asset Allocation of a Default Pension Fund
With the shift towards Defined Contribution pension plans, the responsibility rests more and more on individuals to decide on an optimal contribution rate as well as an optimal investment strategy. Due to a wide-spread inertia in the pension context, setting default options that best serve the participants is an important task. As more people are covered by DC plans, heterogeneity also increases among the population participating in the plan. The authors examine data from a Swedish pension plan in order to determine whether a one-size-fits-all approach is reasonable as the fund’s default option. The authors also create an optimal asset allocation rule with the help of a life-cycle consumptions savings model. How does inequality in pensions change with this rule, compared to age-based rules?
The authors find that a one-size-fits-all approach is unreasonable. Participants who remain in the default fund are 37% less likely to participate in the stock market (outside the pension fund) than participants who are active – that is, those who have made at least one change to the fund allocation. They are also less educated, and do have less labor income and wealth. They therefore rely more heavily on their pension savings. Among the defaulters, participants who do participate in the stock market do have more labor income and are wealthier than defaulters who do not participate in the stock market outside of the pension fund. Consequently, heterogeneity between the participants leads to pension inequality in a fund with only one default option.
The optimal asset allocation rule for the Swedish fund is threefold: “Reduce the DC equity share by half a percentage point every year. In addition, reduce the DC equity share by 6.3 percentage points for every SEK 100,000 invested in the account. Finally, reduce the life-cycle path by 19.5 percentage points if the individual is a stock market participant” (p. 34).
The authors test their rule’s consequences on inequality in pensions compared to other rules (for example, the “100-minus-age” rule). They find that their rule decreases pension inequality as it takes into account more heterogeneous factors than age. Under their rule, poorer individuals invest more in equities and thus have a higher pension than under the simple age rule. For wealthier individuals, the reverse is true. On average, the authors’ rule leads to an increase in pensions of 3% as well as a narrower distribution of pensions.
The paper shows how a simple three-fold rule can improve pension wealth as well as decrease inequality in pensions. Designers of default options for DC pension plans can thus improve the asset allocation of most participants by using information on age, the pension account balance as well as stock market participation outside the pension fund. As DC pension plans spread, participants in these plans do differ in several more characteristics. It is therefore important to consider legal and practical ways to use data to help participants achieve an optimal pension level.