How can we improve the one-size-fits-all default pension fund model? An article recently published in the Journal of Finance explored the optimal asset allocation for a default fund, and found an alternative that produces only winners and no losers.
Researchers Magnus Dahlquist, Stockholm School of Economics and Swedish House of Finance, Roine Vestman, Stockholm University and Swedish House of Finance, and Ofer Setty, Tel Aviv University designed a model that considers individuals’ pension account balance and stock market participation in addition to the investor’s age. Relative to a common age-based asset allocation the model’s optimal asset allocation produced substantial welfare gains.
The researchers used detailed Swedish data from 2000 to 2007 on fund holdings in the government-mandated premium pension plan, holdings outside the pension system and individuals’ socio-demographics. The data showed heterogeneity across passive and active pension investors. It also showed a vast amount of heterogeneity among passive investors. To address that heterogeneity, a life-cycle model that allows for investor heterogeneity and endogenous opt-out/default was set up.
– Remaining in the default fund, or not changing funds for a long time after an initial opt-out decision, is a strong indicator of having no equity exposure outside the pension system. The stock market participation of these passive investors outside the pension system is 16 percentage points lower than that of active investors, says Magnus Dahlquist.
Another important finding is the heterogeneity of passive investors. Those who participate in the stock market have financial wealth equal to 1.4 years of labor income, while those who are not exposed to the stock market only have financial wealth equal to five months of labor income. Similarly, participating passive investors have 4.3 times as much financial wealth as nonparticipating passive investors. These facts call into question the ability of a one-size-fits-all default fund to meet all passive investors’ needs.
The model presented in the article is the first one to generate these differences in a non-trivial way. It takes into account that passive investors are an endogenously selected group in that investors with low financial literacy or lack of interest are likely to be passive investors.
The individual customization of the default fund’s asset allocation yielded sizable welfare gains of 1.5 percent compared to and age-based allocation. The implementation of the model can be made using a simple rule of thumb.
– Designing a default pension fund based not only on age but also on other observable characteristics is an interesting option for default funds, such as the national Swedish AP7-alternative. It is also relevant to other pension agencies with default options as well as funds that are part of a fund menu and need to be actively selected. Given the developments in big data, fintech and robo-advising, the timing may now be the right one to develop such funds. Tailoring the asset allocation produces only winners and no losers. It is an option well worth considering, says Roine Vestman.