33376 World Bank Pension Reform Primer Administrative charges Options and arguments for controlling fees for funded pensions T he adequacy of retirement incomes is a cen- The most familiar measure to investors and policy- tral goal of all types of pension system. In makers alike is the `reduction in yield'. This adds defined contribution pension plans, the benefit together all the charges over the lifetime of an ex- depends on the amount of money paid in, the in- ample pension policy and expresses them all as a vestment returns earned and the amount fund percentage of assets. An alternative approach is to managers charge for administering accounts and measure charges as a proportion of contributions. investing the assets. Government policy affects all This is the same as calculating the charges over the three factors directly and indirectly. lifetime of the fund as a proportion of the balance accumulated at retirement. This second measure is This briefing focuses on the third: administrative known as the `reduction in premium' or the charge charges. It looks at the policies on charges and ratio. compares the fees levied in practice in fourteen, very diverse countries. Different approaches to charges Figure 1 summarizes different countries' policies Measuring charges on charges. At the top are the most liberal re- Measuring the price of financial services is more gimes. Countries lower down impose direct difficult than comparing the cost of other goods or regulations on the structure or level of charges or services. Providers can levy many different kinds regulate industry structure with important indirect of fees. Among the fourteen countries surveyed, effects on charges paid. we find examples of one-off and ongoing charges. Some fees are proportional and some fixed rate. Australia Some are levied on contributions, some on the Australia introduced its superannuation guarantee value of assets in the fund, some on investment system in 1992. From 2002, employers will have returns. to contribute 9 per cent of their employees' pay into a defined contribution account. Only low- These different kinds of charge accumulate and income workers, earning less than A$5,400 a year, interact in complicated ways over the lifetime of are excluded. membership of a pension plan. This leads to the second problem: how to summarize these charges The superannuation mandate allows for a variety in a single number to compare charge levels both of different funds, but workers are members of: between different providers in a single country and ?? industry funds, which are collective plans across countries. covering a number of different companies; or This briefing is part of the World Bank's Pension Reform Primer: a comprehensive, up-to-date resource for people designing and implementing pension reforms around the world. For more information, please contact Social Protection, Human Development Network, World Bank, 1818 H Street NW, Washington, D.C. 20433; telephone +1 202 458 5267; fax +1 202 614 0471; e-mail socialprotection@worldbank.org. All Pension Reform Primer material is available on the internet at www.worldbank.org/pensions Administrative charges 2 ?? master trusts, which are individual accounts membership, have no need for marketing or a sales offered mainly by traditional financial services network. And information, services and invest- firms. ment choice tend to be more limited in the Managers are required to disclose their charges in a industry funds than they are in the retail sector. `key features' statement before purchase and in annual benefits statements to their members. United Kingdom The option of leaving the public pension scheme Industry funds typically levy a flat-rate administra- and taking out a personal pension instead has been tive fee of around A$45 a year plus a fund available since 1988. Around a quarter of employ- management charge of around 0.4-0.5 per cent of ees have a personal pension. Employer-based assets. The retail funds are more expensive. Flat- schemes, which are predominantly defined benefit, rate fees average A$70 a year, while fund cover another 45 per cent. management can cost as much as 1.9 per cent of assets. There is also a charge of around 4.5 per Personal pension providers use six different types cent of contributions. of fees. Average charges for diversified funds are: ?? £12 a year flat-rate Adding these different fees together, charges take ?? 6 per cent of contributions up around 9 per cent of contributions in industry ?? 0.9 per cent of assets funds and nearly 30 per cent in master trusts. But these averages disguise a huge range of differ- These are equivalent to 0.5 and 1.9 per cent of ent approaches. Two in five providers levy no funds assets respectively. fixed management fee, while one in ten asks for more than £30 a year. Half of funds charge 5 per The most intriguing question is why the charges cent of contributions, but some levy 12 per cent are three times higher for retail funds. Australian while others have no charge on contributions. experts have proposed: `a difference in govern- Charges on assets range from under 0.5 per cent to ance, historical ethos, institutional practices and 1.5 per cent. industry structure.' Industry funds, with a captive Strategies on pension charges 1 No restrictions Australia Hong Kong United Kingdom (personal pensions) United States (401k) Cross-subsidies to low-paid workers Mexico Limits on charge structure Argentina Chile more Hungary restrictive Partial ceiling on charges Poland Variable ceiling on charges Sweden Competitive bidding, multiple portfolios United States (thrift savings plan) Fixed ceiling on charges El Salvador Kazakhstan United Kingdom (stakeholder pensions) Competitive bidding, single portfolio Bolivia 3 Administrative charges Adding these different levies together, the average The new pension system builds on existing mutual charge is 1.2 per cent of assets or, equivalently, 23 funds. Fees are set by the public pension agency, per cent of contributions. using a complex formula based on the price charged for voluntary savings in the mutual fund, The government will introduce stakeholder pen- the value of pension assets attracted and the total sions next year. These plans share many of the assets under management. The result is that total features of personal pensions, but an important charges for a large fund must not exceed around aim is to control costs and charges relative to per- 0.75 per cent, about half the charges levied in the sonal pensions. Employers will have to pick a mutual fund market. stakeholder plan for their workforce and facilitate access to it. The aim is to reduce marketing ex- The ceilings were set low to avoid excessive mar- penses and, with collective provision, of supplying keting spending and to ensure that mutual funds information and advice. Secondly, some tax and could recover their marginal costs of managing regulatory rules will be simplified to reduce com- pension assets but not subsidize their fixed costs. pliance costs. Thirdly, regulations on charge The government did not, however, want to rule structure will only allow levies on assets. Finally, out portfolios that are more expensive to manage, charges will be limited to 1 per cent of assets, such as emerging markets or smaller companies. equivalent to a charge ratio of just under 20 per These funds have a higher charge limit (based on cent. their fees in the voluntary sector) without giving leeway to cheaper funds (investing, say, in large- At first sight, this is only marginally below the capitalization domestic stocks) to charge excessive charges for personal pensions. But stakeholder prices. plans must offer greater flexibility for people to stop and start contributions and change the The scheme has drawbacks. It is very complicated, amount they pay in. The charges on personal pen- with 12 different parameters determining the sions could be a much larger burden than the charge ceiling. It also redistributes the gains from figures quoted above because of their lack of the charge ceilings to investors in cheaper pension flexibility. funds. Poland Kazakhstan Pension funds can levy proportional charges on The Kazakh reform shifted all new pension rights both contributions and assets, but the asset-based to individual retirement savings accounts. Fees charge will be limited to 0.6 per cent a year. Al- cannot exceed 1 per cent of contributions plus 10 most all funds levy the maximum. Charges on per cent of the fund's investment return. These contributions are uncapped, but funds cannot ad- levies are very low: equivalent to an 11½ per cent just the charge with fund size or the value of charge ratio or just 0.55 per cent of assets. The contributions. They can, however, offer loyalty result is that most funds are loss making. Manag- discounts. The typical fee is between 7 and 9 per ers have indicated that they need 100,000 or more cent of contributions initially, declining to 5 per members to break even, and only one has reached cent after two years' membership. This is designed that target. This implies that substantial consoli- to prevent the excessive churning of members, and dation will be necessary or that some managers will the associated marketing ands administrative costs, have to withdraw from the market. that are characteristic of many of the Latin Bolivia American systems. The Bolivian government auctioned the rights to Sweden manage its pension funds internationally. The At just 2½ per cent of pay, Sweden has the lowest government picked two managers from a short list contribution rate to mandatory funded pensions. of nine, based mainly on the size of their proposed The government took great care to avoid charges fee. The successful bidders have a five-year guar- eating up this modest contribution. antee of their duopoly. The government will Administrative charges 4 initially assign people to one of the funds. People Different providers' charges will only be able to switch between them three Most studies of administrative fees for pensions years after the new scheme began. look only at the average. But the average disguises a huge range of different charge levels between This process has kept charges low, equivalent to different providers. less than 0.5 per cent of assets or a charge ratio of under 10 per cent. But Bolivia's experience is in large part unique. The two pension funds also Different providers' charges 3 manage $1.7 billion of privatization proceeds, 10 number Argentina equivalent to 15 or so years of mandatory pension 8 of funds contributions. There is a substantial cross-subsidy from the fees for managing these assets to the 6 charges on pension accounts. 4 2 International comparisons Figure 2 summarizes data on charges for thirteen 0 countries with mandatory funded pension systems. 5 Mexico Even very similar pension systems with similar ap- 4 proaches to charges deliver very different levels of fees in practice. Among Latin American countries 3 with individual accounts systems, the average 2 charge ratio varies from under 15 per cent in 1 Colombia to nearly 25 per cent in Argentina. 0 International comparisons 2 25 United Kingdom Australia - individual 20 UK - personal 15 Argentina Mexico 10 UK - stakeholder 5 Peru El Salvador 0 Poland 14 16 18 20 22 24 26 28 30 32 34 36 38 Chile charge ratio Sweden Uruguay Figure 3 shows the distribution of charges in three Colombia countries. The United Kingdom has the broadest Kazakhstan Australia - collective range, with the cheapest funds levying 15 per cent Bolivia of contributions and the most expensive, well over 0 5 10 15 20 25 30 35 30 per cent. The range in Mexico is 17 to 37 per charge ratio cent. Even in Argentina, with the narrowest range, charges vary between 23 and 36 per cent, meaning that the most expensive fund costs over 50 per Looking at all the systems, charges range from un- cent more than the cheapest. der 10 per cent in Bolivia to 35 per cent in Australia's retail superannuation funds. As noted These large ranges raise a difficult question: why above, the three cheapest systems offer very do consumers choose expensive funds? Improved limited choice of provider and/or investments. levels of service, for example, are unlikely to ex- plain such a large differential. There is evidence in 5 Administrative charges the United Kingdom that funds with higher Keeping charges low charges perform better, but the out-performance is Measuring the impact of charges on pension fund insufficient to offset the higher charge burden on returns is very complicated. The minimum gov- typical pension policies. Perhaps some consumers ernment policy should therefore be a requirement fail to take proper account of the burden of for funds to disclose charges in a standard format. charges. Whatever the reason, it is surprising that This will help consumers make informed compari- this distribution has attracted little research sons between different funds. Regulators can attention. make the task easier by producing `league tables' of charges. The supervisory authorities in Latin Charges over time America regularly provide comparative informa- An important assumption of the calculations tion on different pension fund managers, and the above is that charges remain constant until pen- new Financial Services Authority in the United sions are withdrawn. But pension providers' Kingdom will soon issue data on the charges for a revenues, especially from charges on fund assets, wide range of financial products. are back-loaded while expenses are front-loaded because of set-up costs. Also `learning by doing' A second step to bring charges to consumers' at- and the consolidation of the pension fund industry tention is to levy charges on top of (rather than in most reforming countries might put downward out of) mandatory contributions. This encourages pressure on costs over time. shopping around because charges reduce current net income rather than future pension benefits. Charges over time 4 Four Latin American countries have adopted this approach. 30 United The next stage is to make comparisons simpler 25 Kingdom still, by ensuring all providers stick to a common 20 structure. We have seen how complex liberal charge 15 ratio Chile charging regimes can be. A regulated fee structure, in contrast, can mean there is a single `price' that 10 consumers can compare across providers. And a 5 single proportional charge, on assets or contribu- 0 tions, means that the relative cost of choosing a 1988 1990 1992 1994 1996 1998 different provider does not vary with earnings or contributions. Most mandatory funded pension systems were in- troduced within the last five years or so. But Contribution or asset-based fees? reforms in Chile and the United Kingdom have The important policy option for governments been in place for longer. Average charges have taking this route is the type of charge to be per- declined in both countries (Figure 4): by almost mitted. There are four features of the two charges one half in Chile (from 30 to 15½ per cent) and a important in making this choice. sixth in the United Kingdom (from 27½ to 23½ per cent). The first is the time profile of charge revenues. Fees on contributions generate more up-front If other countries follow this pattern of declining revenues than fees on assets (Figure 5). This al- charges over time, then the charge ratio measures lows providers to cover their start-up costs more above, which assume constant charges, are over- quickly. This might boost competition by encour- stated. aging more entrants to the pension market when the system is established. Administrative charges 6 Time profile of different charges 5 incentives and the continuing revenue stream from members suspending contributions. annual charges asset-based Ceilings on charges charge Quantitative restrictions on charges are rare. Only El Salvador, Kazakhstan, Poland, Sweden and the United Kingdom, in the new stakeholder plans, have such limits. contribution-based charge The problem with this approach is the risk that 0 10 20 30 40 governments set the `wrong' ceiling. Too high a years since joined plan limit would be ineffectual. Too low a ceiling might mean that fund managers could not cover their A second issue is the incidence of the levies across costs. This will restrict competition and choice. It different types of consumer. If there are fixed could even lead to the failure of weaker providers, costs per member--and the evidence suggests that undermining public confidence in the system. these are sizeable--then levies on assets redistrib- Ceilings all too often become a de facto minimum ute from people with large funds to people with charge as well as the legal maximum. Price com- fewer assets in their plan. Older workers, with petition, beyond meeting the regulatory larger funds on average, would cross-subsidize requirement, would be curtailed. younger workers, for example. Contribution- based charges redistribute from people with high The availability of data to help setting an appropri- levels of contributions (typically higher earners) to ate ceiling will vary. If capital markets are well people with low levels of contributions. developed, governments can see the costs and charges for similar financial services and make an Indeed, there would be no revenues from people informed choice of limit. But in emerging econo- who do not contribute. This might be because mies, there might not be an appropriate domestic they have lost their job, withdrawn from the labor yardstick, although international experience can be force or moved into the informal sector of the a guide. economy. But pension providers would still have to bear the cost of administering these people's Treatment of low earners funds. Asset-based fees ensure a continuing flow A common reason for any regulation of charges is of revenues from non-contributors, but this means to protect low-income workers. This is particu- that the fees bear more heavily on people who larly important in mandatory funded pension withdraw from work early. schemes. It would be manifestly unfair if low earners saw most or even all of their contributions Finally, a charge on fund value encourages provid- eaten up in charges. ers to maximize assets, both by attracting funds from other providers and, more importantly, by Regulating charge structures can provide a signifi- maximizing investment returns. cant degree of protection. Limiting fees to proportional charges (either on assets or contribu- The choice between the asset-based and contribu- tions) means that there are no fixed charges, which tion-based approach is finely balanced. bear disproportionately on the low-paid. Unsurprisingly, different countries have taken dif- Nevertheless, most countries provide a minimum ferent options. Levies on contributions are the pension guarantee, a universal flat-rate pension or norm in Latin America, while the United Kingdom social assistance incomes in retirement. People has opted for asset-based fees. The government's with persistently low earnings are unlikely to build main arguments were fund managers' performance up a funded pension above the minimum level. 7 Administrative charges A sensible solution is to exempt low paid workers cost of active management. Bolivia offered no from the requirement to contribute to a funded choice of fund initially and only a choice between pension or to allow them to opt out. The United two funds after a few years. Kingdom, for example, will aim the new stakeholder schemes at people earning more than This restriction of choice has a cost. Pension 55 per cent of average earnings. Australia excludes members are unable to choose investments that workers on less than 15 per cent of average pay, suit their preferences. For example, older mem- and has plans to allow people earning between 15 bers might want to invest more conservatively and 30 per cent of the average to opt out. than younger people, but both can be constrained by a `one-size-fits-all' fund. An alternative approach is to cross-subsidize low- paid workers' accounts directly. The Mexican The counterpart to restricted choice is limits to government ensures a contribution of at least competition, which might result in poorer service 5½ per cent of the minimum wage. Coupled with and performance than a deregulated, decentralized a tax-credit system that boosts the incomes of low- market. paid workers, this encourages Mexicans into the formal sector. Together, these policies promote How large are economies of scale? broader coverage of the pension system. A second The potential for economies of scale in managing advantage of direct subsidies is that they make the pension funds has important consequences for redistribution from higher-paid to lower-paid public policy on charges and industry structure. workers transparent. The evidence, unfortunately, is inconclusive. Alternative institutional structures Figure 3 showed the very broad distribution of The pension plans discussed above are mainly de- charges across providers in three countries with centralized: people choose between a range of mandatory funded pension systems. Despite this competing pension fund managers. An alternative variability, there is no relationship between fund approach is some sort of collective mechanism. size and charges. Australia's collectively provided industry funds, for Various studies have suggested anything from un- example, tend to be cheaper than retail master der 100,000 to 500,000 members as the minimum trusts. (Although there are many potential expla- to achieve efficient scale. In mutual fund markets, nations for this difference: see above). The new which share many of the features of pension mar- stakeholder plans in the United Kingdom will have kets, some studies have suggested that the fall in a similar structure. costs with size comes to a halt once funds reach $0.5 billion. Others suggest this could be as high A step further is to move to a single, publicly man- as $40 billion. aged fund. However, research in the pension reform primer series shows that public manage- Currently available evidence does not demonstrate ment has typically led to poor returns. Even with that highly centralized approaches to managing good management, the state as a large shareholder funded pensions will significantly reduce costs. raises corporate governance concerns that are very And the potential gains must be balanced against difficult to resolve. the cost of stifling competition, which in the me- dium term should act as a spur to innovation and Trade-offs in regulating charges cost control. The main cost of strict regulation of charges is the reduction in pension members' choice. Low-cost regimes, such as the thrift savings plan for federal employees in the United States, offer only a small range of funds, often indexed to avoid the extra Administrative charges 8 Conclusions and recommendations Further reading ??administrative charges are just one James, Estelle, Gary Ferrier, James Smalhout, and variable affecting retirement incomes in Dimitri Vittas (2000), `Mutual Funds and funded pension systems Institutional Investments: What is the Most ??governments must at the least ensure Efficient Way to Set Up Individual Accounts clear and transparent disclosure of in A Social Security System?' Administrative charges so people can compare different Costs and Social Security Privatization, ed. funds' fees John Shoven, University of Chicago Press, also ??there is a good case for regulating available as NBER Working Paper No.7049 charge structures to ease comparisons and World Bank Policy Research Working ??the choice between restricting charges to paper No. 2099, 1999. assets or contributions is finely balanced, Shoven, J.B. (2000), Administrative Costs and Social depending on the structure of the labor Security Privatization, National Bureau of market, the desire to encourage entry Economic Research, Cambridge, Mass. into the pensions market and views on (Earlier versions of chapters available as the importance of manager incentives NBER working papers nos. 7049 and 7050; ??imposing ceilings on charges has the risk Internet: www.nber.org.) that limits are set at the wrong level, Whitehouse, E.R. (2000), `Administrative charges discouraging entry and competition for funded pensions: an international comparison and assessment', Pension Reform ??the evidence on economies of scale is Primer series, Social Protection Discussion mixed Paper no. 0016, World Bank. ??even if centralized management of World Bank (2000), `Collection: transferring pension assets is cheaper because of contributions to individual pension accounts', economies of scale, the restriction of Pension Reform Primer briefing note. choice and competition imposes a difficult trade-off On public management of pension funds: Iglesias, A. and Palacios, R.J. (2000), `Managing public pension reserves, part I: evidence from the international experience', Pension Reform Primer series, Social Protection Discussion Paper no. 0003, World Bank. World Bank (2000), `Public management: how well do governments invest pension reserves', Pension Reform Primer briefing note. paymentor age periodic n.1. onretirement specified etc.)better re-for“m pe“nsion made above REFORM ofimperfections, PRIMER byremoval & v.t. PENSION i.1. faults orabandonment(institution, make equipprimer orerrors person n. 1. with elementary procedure information book to