Private retirement provision must be introduced fast
Private retirement provision must be introduced fast
Professor Malmendier, Professor Werding, you want to see reform of Germany’s funded private pension system. In what way?
Werding: We propose a savings portfolio for retirement, based on international models and scientific evidence.
What does it look like?
Werding: Our portfolio combines automatic enrollment with a limited selection of low cost, high return investment funds, simple standard products following a life cycle approach and flexible payout options.
What do you expect from this portfolio?
Malmendier: Pensions are the starting point, but we want to solve several problems at once. The pension system is heading toward collapse. The Riester system is stuck. At the same time, wealth accumulation in Germany is very disappointing. Germany is where the United States or other countries were sixty years ago.
What disappoints you so much?
Malmendier: People save a lot, but they invest in low yield, fixed income products and miss out on roughly five percent returns over the long run. This is not only people with low education or low income. It often includes the upper middle class. Encouraging people to move toward capital market investments would strengthen wealth formation. Deeper capital markets would be good for the country.
The funded pension pillar will include a standard product. What does it look like?
Werding: Two elements matter: product standardisation to foster competition, and a state provided default option. The standardised product with a life cycle model can be offered by many providers. These will be Ucits funds with tradable securities and Eltifs with unlisted assets. Providers may differ slightly in design, but the type must remain comparable. In addition, there will be a default product for participants who do not actively choose. It is also a standard product and competes with private providers.
How does the planned early start pension for children aged six to eighteen fit in?
Malmendier: The portfolio should last a lifetime and remain capital market based from childhood through working life and into retirement. Money saved in the early start pension must flow seamlessly into the main portfolio.
Werding: This means regulatory requirements for the investment products must be largely identical.
What criteria should investment products meet?
Werding: Diversification is essential. Liquidity rules and Ucits criteria also matter. During childhood and the accumulation phase, portfolios can be one hundred percent equities. In the life cycle model, high risk classes must be reduced as retirement approaches. Class three can be excluded. Mixed funds are too conservative in the saving phase and too risky in the payout phase.
Does this also apply to the long retirement phase?
Werding: We follow the Swedish model. There, allocations shift between age fifty five and seventy five from one hundred percent equities to about one third. Equities should not go to zero. ZEW calculations suggest a model shifting gradually between fifty two and sixty seven, ending at fifty five percent equities.
Who should the funded private pension target?
Werding: It should cover all working people, with an opt out option. The early start pension should reach all children and adolescents aged six to eighteen.
That sounds complex. How can they be identified?
Malmendier: The family benefits offices can reach all families through child benefits. With identification numbers they can check residency and school status.
What about adults?
Malmendier: Ideally people move from the early start pension into the portfolio automatically. At the beginning, insured persons in the statutory pension system could be included. They represent eighty seven percent of employees.
How much time is left for this?
Werding: None. We have discussed reforms of the pay as you go system for years. We need a funded pillar quickly. This especially concerns people in their thirties and forties.
How should the state deal with people who remain in the system but struggle to choose?
Malmendier: We want a state organised solution similar to Sweden or the United Kingdom. The default product should help people who lack time, knowledge or confidence.
This is not a collective model like Generation Capital?
Werding: No. Individuals must have ownership and an individual account. Their capital must be protected from government access.
What must the default option offer?
Malmendier: There are strong international models. Fees must be low and equity exposure broad. There should not be guarantees that reduce returns. Competition remains important. People must be free to switch to private products at any time.
Who should run the default fund?
Malmendier: It could be Kenfo, the Bundesbank or the development bank KfW. The best concept should win.
Should the Bundesbank remain neutral?
Werding: It already manages long term funds for long term care and civil servant pensions.
Why limit the number of funds?
Malmendier: Sweden learned this the hard way. Too many options confuse people. We want a manageable number of highly diversified, low fee funds. This is sensible from a behavioural economics perspective.
Would that exclude a large part of the market?
Malmendier: Flooding people with thousands of funds under the banner of choice is misleading. Most people cannot handle it.
Who decides on the restricted fund list?
Malmendier: We propose an independent fund selection authority, as in Sweden. It must ensure diversification, liquidity, low fees and investor protection.
You are calling for more bureaucracy?
Malmendier: It does not need to be large. In Sweden it has about thirty staff. It must be independent and focused on the public interest.
And what do you say to your critics?
Werding: We made many mistakes with Riester. Sweden also started imperfectly, but we can learn from them. We must begin now.
You want low costs. Does this include price regulation?
Werding: Costs can be kept down through simple design and efficient distribution. Competition helps. A low cost default product sets a benchmark..
Malmendier: International examples show that funded pensions can be very cheap without price controls. Transparency is essential.
Should the financial industry earn less?
Malmendier: Providers know they will gain many new customers. Sweden and Denmark show how well this works.
What about switching costs?
Malmendier: Upfront fees should be spread over time. Switching must be simple. Since the products are liquid funds, high switching fees are unnecessary.
What should the law regulate?
Malmendier: The default fund with extremely low fees should set a standard. For other products, low cost providers should win. A reasonable cap is helpful.
Does this cap concern running costs or upfront fees?
Malmendier: Mainly running costs. Ideally there should be no extra fees for entering or exiting funds.
What happens to spread out entry fees if someone switches?
Malmendier: They should only pay for the period they used the product.
May providers adjust portfolio composition during the term?
Werding: Rules apply for a fixed term, as in Sweden where contracts run for six years. After that they can adjust, but they must remain within the retirement system.
Should longevity risk be insured?
Malmendier: Mandatory annuitisation lowered returns in Riester. That is not necessary.
How will payouts work?
Werding: Individuals own their savings. They can use it freely or pass it on. It must be an individual account.
The state does not want to fund luxury spending.
Malmendier: There is no evidence that retirees squander lump sums and fall into basic security.
What about current Riester contracts?
Werding: A penalty free transfer should be possible. It would help the new system gain traction.
Will tax rules remain the same?
Werding: Yes. Deferred taxation and allowances should continue.
What does this cost the state?
Werding: More people saving means higher costs. Riester costs four billion euros per year. With automatic enrollment this could rise to five billion. Allowances must be adjusted for wages and inflation.
Should the early start pension cover only six year olds or all up to eighteen?
Malmendier: Starting with six year olds ensures a long investment horizon. They gain real market experience.
Werding: If payouts occur only at retirement, all age groups up to eighteen could start.
If some children do not enroll, is a collective fallback needed?
Malmendier: To develop a broad investor culture, everyone must join. A default option is crucial but must protect individual ownership.
A draft law is expected by year end. Is that realistic?
Werding: The private pension pillar must come quickly. Germany needs better savings products and fewer gaps. Our proposal for a savings portfolio can improve both.
