Administrative Costs and the Organization of Individual Retirement Account Systems: A Comparative Perspective
77 Pages Posted: 20 Apr 2016
Date Written: February 2001
Organizing individual retirement accounts through the institutional market and with constrained choice could substantially lower administrative costs. The tradeoff: rebidding problems, weaker performance incentives, inflexibility in the face of unforeseen contingencies, and an increased probability of corruption, collusion, and regulatory capture.
What is the most cost-effective way to organize individual accounts that are part of a mandatory social security system? Defined-contribution individual-account components of social security systems are criticized for being too expensive. James, Smalhout, and Vittas investigate the cost-effectiveness of two methods for constructing mandatory individual accounts:
Investing through the retail market with relatively open choice among investment companies (the method first used by Chile and adopted by most Latin American countries).
Investing through the institutional market with constrained choice.
For the retail market, they use data from mandatory pension funds in Chile and other Latin American countries and from voluntary mutual funds in the United States. For the institutional market, they use data from systems in Bolivia and Sweden and from larger pension plans and the federal Thrift Saving Plan in the United States.
The institutional approaches aggregate numerous small accounts into large blocks of money and negotiate fees on a centralized basis, often through competitive bidding. They retain workers' choice on some funds. Fees and costs are kept low by reducing incentives for marketing, avoiding excess capacity at system start-up, and constraining choice to investment portfolios that are inexpensive to manage.
In developed financial markets, the biggest potential cost saving stems from constrained portfolio choice, especially from a concentration on passive investment. The biggest cost saving for a given portfolio and for countries with weak financial markets comes from reduced marketing activities.
In the retail market, where annualized fees and costs range from 0.8 percent to 1.5 percent of assets, use of the institutional market in individual retirement account systems has reduced those fees and costs to less than 0.2 percent to 0.6 percent of assets. This reduction can increase pensions by 10-20 percent relative to the retail market. Countries that can surmount rebidding problems, weaker performance incentives, inflexibility in the face of unforeseen contingencies, and an increased probability of corruption, collusion, and regulatory capture should seriously consider the institutional approach, especially at the start-up of a new multipillar system or for systems with small asset bases.
This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to study pension systems. The authors may be contacted at email@example.com or firstname.lastname@example.org.
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