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Mutual funds and institutional investments - what is the most efficient way to set up individual accounts in a social security system?

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  • James, Estelle
  • Ferrier, Gary
  • Smalhout, James
  • Vittas, Dimitri

Abstract

One of the main criticisms of the defined-contribution, individual-account components of social security systems is that they are too expensive. The authors investigate the cost-effectiveness of three options for constructing funded social security pillars: * Individual accounts invested in the retail market with relatively open choice. * Individual accounts invested in the institutional market with constrained choice among investment companies. * A centralized fund without individual accounts or differentiated investments across individuals. The authors asked several questions: What is the most cost-effective way to organize a system with mandatory individual accounts? How does the cost of an efficient individual account system compare with that of a single centralized fund? And are the cost differentials great enough to outweigh other important considerations? The authors concentrate on countries with well-functioning financial markets, such as the United States, but make comparative references to developing countries. Based on empirical evidence about U.S. mutual and institutional funds, the authors found that the retail market (option 1) allows individual investors to benefit from scale economics in asset management - but atthe cost of the high marketing expenses needed to attract large pools of small investments. By contrast, a centralized fund (option 3) can be much cheaper because it achieves scale economies without high marketing costs. But it gives workers no choice and is subject to political manipulation and misallocation of capital. The system of constrained choice (option 2) is much cheaper than the retail option and only slightly more expensive than a single centralized fund. It allows scale economies in asset management and record-keeping while incurring low marketing costs and allowing significant worker choice. It is also more effectively insulated from political interference than a single centralized fund. The authors estimate that option 2 would cost only 0.14 percent-0.18 percent of assets annually. Such large administrative cost savings imply a Pareto improvement - so long as choice is not constrained"too much".

Suggested Citation

  • James, Estelle & Ferrier, Gary & Smalhout, James & Vittas, Dimitri, 1999. "Mutual funds and institutional investments - what is the most efficient way to set up individual accounts in a social security system?," Policy Research Working Paper Series 2099, The World Bank.
  • Handle: RePEc:wbk:wbrwps:2099
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    References listed on IDEAS

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    Cited by:

    1. Whitehouse, Edward, 2000. "Administrative charges for funded pensions: An international comparison and assessment," MPRA Paper 14172, University Library of Munich, Germany.
    2. Whitehouse, Edward, 2000. "Paying for pensions: An international comparison of administrative charges in funded retirement-income systems," MPRA Paper 14171, University Library of Munich, Germany.
    3. James E. Pesando, 2001. "The Canada Pension Plan: Looking Back at the Recent Reforms," The State of Economics in Canada: Festschrift in Honour of David Slater, in: Patrick Grady & Andrew Sharpe (ed.),The State of Economics in Canada: Festschrift in Honour of David Slater, pages 137-150, Centre for the Study of Living Standards.
    4. Luciano Greco, 2005. "The Optimal Design of Funded Pension Plans: Unbundling Financing and Investment," "Marco Fanno" Working Papers 0003, Dipartimento di Scienze Economiche "Marco Fanno".
    5. Mr. Rene Weber & David S. Gerber, 2007. "Aging, Asset Allocation, and Costs: Evidence for the Pension Fund Industry in Switzerland," IMF Working Papers 2007/029, International Monetary Fund.
    6. Greco, Luciano G., 2006. "The optimal design of funded pensions," LSE Research Online Documents on Economics 24519, London School of Economics and Political Science, LSE Library.
    7. Ebrahim, M. Shahid & Mathur, Ike & ap Gwilym, Rhys, 2014. "Integrating corporate ownership and pension fund structures: A general equilibrium approach," Journal of Banking & Finance, Elsevier, vol. 49(C), pages 553-569.
    8. Estelle James & Alejandra Cox Edwards & Rebeca Wong, 2012. "The Gender Impact of Pension Reform," World Bank Publications - Reports 13046, The World Bank Group.
    9. James,Estelle & Smalhout, James & Vittas, Dimitri, 2001. "Administrative costs and the organization of individual retirement account systems : a comparative perspective," Policy Research Working Paper Series 2554, The World Bank.
    10. James, Estelle & Edwards, Alejandra Cox & Wong, Rebecca, 2003. "The gender impact of pension reform : a cross-country analysis," Policy Research Working Paper Series 3074, The World Bank.

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