OPINION
2020 Sep/01
Default Funds from the Perspective of Behavioral Economics
Sep. 01, 2020
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- Summary
- Default funds have been widely regarded in other countries as an effective tool that helps DC plan members overcome their behavioral biases. Although Korea has long discussed about the need for default funds, the issues related to DC plan holders’ behavioral biases have yet to come to the fore. Against the backdrop, it’s worth shedding another light to the need for default funds from the behavioral economics perspective.
Korea’s retirement pension plans have been long invested in principal-protected products. One of the primary reasons could be plan members’ behavioral biases arising from the complex management process and their lack of long-term investment strategies, not to mention other reasons such as the pension regulation and high interest rates when Korea first shifted to the retirement pension scheme. Default funds could properly tackle those behavioral biases.
Amid today’s low interest rate trend, many plan members are more likely to consider or actually choose investment products. However, a significant number of them could be affected by behavioral biases in managing their investment in the long run. Those biases could be effectively dealt with by default funds as well.
A default fund refers to a system where a set of pre-specified investment assets is automatically selected when a plan member does not select specific investment assets. Widely known to be based on behavioral economics, it is also regarded as an effective system helping DC plan members overcome their behavioral biases. However, the problems related to DC plan members’ behavioral biases have yet to come to the fore although South Korea has long discussed about the need to introduce default funds. This article tries to shed new light on the need to introduce default funds in retirement pensions in Korea from the behavioral economics perspective.
Management of Korea’s retirement pension plans
As of 2019, a high percentage (80.5%) of DC plan assets in Korea was invested in principal-protected products. Investment products took up only 9.1%, with the rest being held as cash sitting idle in DC accounts. Even in investment products, bond-type and hybrid products accounted for about 70.7%, showing conservatism in investment management. However, such asset allocation focusing on principal protection can hardly be construed as a suitable strategy for accumulating plan assets for a longer investment horizon such as two to three decades with the aim to secure post-retirement income. This also makes a stark contrast to the National Pension Fund’s portfolio which invests 38.1%, 48.9% and 12.4% in stocks, bonds, and alternative investments, respectively. DC plans in the US and other developed economies tend to invest a high percentage of assets—about 20% to 60%–in equity, and to allocate their assets in bonds and alternative investments for diversification. Asset allocation is critically important because it’s the strategy that could make large differences in long-term returns. Indeed, the 5-year annual average investment return in retirement pension plans stood at 1.92% as of 2019, while that of the NPF reached 4.11% as of 2018. As a domestic DC pension plan shares a common long-term investment goal with the NPF and DC plan in developed countries, it’s worth looking at why its asset allocation strategy is diverging from the others such as now.
Investment management regulation and high interest rates
Since established in the 1961 reform on the Labor Standards Act, Korea’s severance pay system exposed many problems such as employers’ payment delay and employees’ early withdrawal. In response, the Korean government implemented the retirement pension system in December 2005, seeking to replenish the severance pay system and to devise a multi-pillar pension scheme that has been widely adopted in developed economies. Any employer (also called a plan sponsor) adopting the retirement pension provides a defined benefit (DB) plan that pays out benefits accumulated throughout the service period at the time of retirement, and a defined contribution (DC) plan that pays out benefits every year during the service period. DC plan members are required to come up with their own plans and investment strategies as they are the ones responsible for investing and managing annual benefits until retirement. However, Korea’s current retirement pension system has originated from the severance pay system that prioritizes safety over long-term investment strategies and performance. This is evidenced by the early-stage pension regulation that once banned DC plan members from holding equity or hybrid funds. At that nascent stage, DC plan members had no option but to invest more heavily in principal-protected products.
Another factor behind the preference over principal protection is the competitiveness of the products themselves amid the high market interest rates when the retirement pension scheme was first introduced. The interest rates were as high as 5%–6% in 2007–2008, and hovered around the mid-3% range until the early 2010s. Thanks to the high interest rates, principal-protected products could provide plan members high returns and safety at the same time. It was only natural for DC plan members to favor those products to others, which triggered all financial sectors to vie for launching even more products with principal protection. Bank’s high market share in this segment also helped fuel the preference over principal-protected products, an area in which banks are traditionally competitive. However, the retirement pension market has changed in many ways since then: The market has seen asset management regulation be relaxed, market interest rates fall significantly, and a new competition rule put a hold on the practice of a distributor selling its own products. Nevertheless, there has still been the tendency of DC plan holders to mostly invest in principal-protected products. What explains such a phenomenon better could be found in behavioral economics presented as follow.
Domestic DC members’ behavioral biases
It’s possible to apply some widely applied behavioral economics concepts to the preference over principal-protected products among Korea’s retirement pension plan holders.
First, principal-protected products could have been recognized as a standard because many DC plan holders opted for those products at the early stage of Korea’s retirement pension system. When most of their peers choose principal-protected products, it’s possible for plan holders to view those products as a safer, more suitable option (“peer effect”).
Second, pension plan members have no clear preference for investment because they lack long-term investment experience and financial literacy (“unstable and undefined preferences”). Thus, their investment choice could be largely swayed by a recommendation from a plan sales professional. From the position of the sales professional, it’s less onerous to recommend a safer, easy-to-understand financial product than a risky investment product, taking into account the investment goal of securing long-term, post-retirement income. Another possibility is for a DC plan holder to choose those products over investment products due to the onerous and hassle process of asset management (“choice overload”).
Third, once settling with principal-protected products, DC plan holders tend to stay with them (“procrastination and inertia”). It’s well known that many members of DC plans haven’t adjusted their portfolio since they chose principal-protected products at the beginning. This also largely contributes to the higher share of principal-protected products.
Need to introduce default funds
It’s safe to conclude that DC plan members chose principal-protected products due to behavioral biases on top of the hassle investment management and the lack of long-term investment strategies. A default fund could be a proper choice given the behavioral biases mentioned above. More concretely, it’s reported that DC plan members tend to be hardly recommended risky products, or to follow other people’s choice. A default fund could effectively replace principal-protected products to the extent that it is regarded as a certificated investment recommendation.
A heavy focus on principal-protected products in Korea’s management of retirement pension plans is improper for long-term retirement asset management. To make matters worse, investment returns on those products are hardly likely to beat inflation amid today’s low interest rate trend. Accordingly, it becomes more likely for many pension plan members to consider or actually choose investment products. However, a significant number of them may hesitate to or be unable to make complex decisions associated with long-term investment management. Such behavioral issues could be effectively dealt with by a default fund.
Major economies including the US, Sweden, and the UK have successfully incorporated the behavioral dimension into default funds that actually take up a high portion of retirement asset management. Korea’s government and financial authorities are seeking to move its focus from keeping pension assets safe to achieving reasonable returns on DC plan assets. Towards that end, default funds are expected to become an effective tool. It is hoped that the upcoming session of the National Assembly could witness meaningful discussions for introducing default funds.
Management of Korea’s retirement pension plans
As of 2019, a high percentage (80.5%) of DC plan assets in Korea was invested in principal-protected products. Investment products took up only 9.1%, with the rest being held as cash sitting idle in DC accounts. Even in investment products, bond-type and hybrid products accounted for about 70.7%, showing conservatism in investment management. However, such asset allocation focusing on principal protection can hardly be construed as a suitable strategy for accumulating plan assets for a longer investment horizon such as two to three decades with the aim to secure post-retirement income. This also makes a stark contrast to the National Pension Fund’s portfolio which invests 38.1%, 48.9% and 12.4% in stocks, bonds, and alternative investments, respectively. DC plans in the US and other developed economies tend to invest a high percentage of assets—about 20% to 60%–in equity, and to allocate their assets in bonds and alternative investments for diversification. Asset allocation is critically important because it’s the strategy that could make large differences in long-term returns. Indeed, the 5-year annual average investment return in retirement pension plans stood at 1.92% as of 2019, while that of the NPF reached 4.11% as of 2018. As a domestic DC pension plan shares a common long-term investment goal with the NPF and DC plan in developed countries, it’s worth looking at why its asset allocation strategy is diverging from the others such as now.
Investment management regulation and high interest rates
Since established in the 1961 reform on the Labor Standards Act, Korea’s severance pay system exposed many problems such as employers’ payment delay and employees’ early withdrawal. In response, the Korean government implemented the retirement pension system in December 2005, seeking to replenish the severance pay system and to devise a multi-pillar pension scheme that has been widely adopted in developed economies. Any employer (also called a plan sponsor) adopting the retirement pension provides a defined benefit (DB) plan that pays out benefits accumulated throughout the service period at the time of retirement, and a defined contribution (DC) plan that pays out benefits every year during the service period. DC plan members are required to come up with their own plans and investment strategies as they are the ones responsible for investing and managing annual benefits until retirement. However, Korea’s current retirement pension system has originated from the severance pay system that prioritizes safety over long-term investment strategies and performance. This is evidenced by the early-stage pension regulation that once banned DC plan members from holding equity or hybrid funds. At that nascent stage, DC plan members had no option but to invest more heavily in principal-protected products.
Another factor behind the preference over principal protection is the competitiveness of the products themselves amid the high market interest rates when the retirement pension scheme was first introduced. The interest rates were as high as 5%–6% in 2007–2008, and hovered around the mid-3% range until the early 2010s. Thanks to the high interest rates, principal-protected products could provide plan members high returns and safety at the same time. It was only natural for DC plan members to favor those products to others, which triggered all financial sectors to vie for launching even more products with principal protection. Bank’s high market share in this segment also helped fuel the preference over principal-protected products, an area in which banks are traditionally competitive. However, the retirement pension market has changed in many ways since then: The market has seen asset management regulation be relaxed, market interest rates fall significantly, and a new competition rule put a hold on the practice of a distributor selling its own products. Nevertheless, there has still been the tendency of DC plan holders to mostly invest in principal-protected products. What explains such a phenomenon better could be found in behavioral economics presented as follow.
Domestic DC members’ behavioral biases
It’s possible to apply some widely applied behavioral economics concepts to the preference over principal-protected products among Korea’s retirement pension plan holders.
First, principal-protected products could have been recognized as a standard because many DC plan holders opted for those products at the early stage of Korea’s retirement pension system. When most of their peers choose principal-protected products, it’s possible for plan holders to view those products as a safer, more suitable option (“peer effect”).
Second, pension plan members have no clear preference for investment because they lack long-term investment experience and financial literacy (“unstable and undefined preferences”). Thus, their investment choice could be largely swayed by a recommendation from a plan sales professional. From the position of the sales professional, it’s less onerous to recommend a safer, easy-to-understand financial product than a risky investment product, taking into account the investment goal of securing long-term, post-retirement income. Another possibility is for a DC plan holder to choose those products over investment products due to the onerous and hassle process of asset management (“choice overload”).
Third, once settling with principal-protected products, DC plan holders tend to stay with them (“procrastination and inertia”). It’s well known that many members of DC plans haven’t adjusted their portfolio since they chose principal-protected products at the beginning. This also largely contributes to the higher share of principal-protected products.
Need to introduce default funds
It’s safe to conclude that DC plan members chose principal-protected products due to behavioral biases on top of the hassle investment management and the lack of long-term investment strategies. A default fund could be a proper choice given the behavioral biases mentioned above. More concretely, it’s reported that DC plan members tend to be hardly recommended risky products, or to follow other people’s choice. A default fund could effectively replace principal-protected products to the extent that it is regarded as a certificated investment recommendation.
A heavy focus on principal-protected products in Korea’s management of retirement pension plans is improper for long-term retirement asset management. To make matters worse, investment returns on those products are hardly likely to beat inflation amid today’s low interest rate trend. Accordingly, it becomes more likely for many pension plan members to consider or actually choose investment products. However, a significant number of them may hesitate to or be unable to make complex decisions associated with long-term investment management. Such behavioral issues could be effectively dealt with by a default fund.
Major economies including the US, Sweden, and the UK have successfully incorporated the behavioral dimension into default funds that actually take up a high portion of retirement asset management. Korea’s government and financial authorities are seeking to move its focus from keeping pension assets safe to achieving reasonable returns on DC plan assets. Towards that end, default funds are expected to become an effective tool. It is hoped that the upcoming session of the National Assembly could witness meaningful discussions for introducing default funds.