In the case of private accounts, we are not looking at a blank slate. Several countries -- Sweden, the United Kingdom and Chile -- have incorporated private accounts into their public pension systems, and the United States now has 20 years of experience with 401(k) plans. Based on what we know about those experiences, two things seem clear: First, most people are pretty clueless with regard to investment decisions. Second, the costs of operating a system of private accounts turn out to be quite high, and it's the investors who inevitably end up footing the bill.
After the U.K. allowed workers to opt for private accounts in 1986, many insurance agents persuaded older workers to trade their secure government plan or generous employer-provided pensions for less favorable private accounts. This sparked the famous "mis-selling" scandal that resulted in the insurance companies paying $20 billion in damages for providing misleading advice. In Chile, which has had an individual account system since 1981, the government recognized the vulnerability of poorly informed investors by imposing strict controls on acceptable assets and by introducing a substantial minimum benefit. When individual accounts were introduced in Sweden in 2000, two-thirds of all participants opted to choose their own portfolios from about 460 mutual funds, with the remainder placed in the centrally managed default portfolio. Those who chose their own assets invested more than 90 percent in equities, making them vulnerable to stock market downturns.
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The experience with 401(k) plans in the United States is even more telling. People make bad decisions at each step. A quarter of those eligible to participate choose not to do so. Less than 10 percent of those who do participate contribute the maximum. Over half fail to diversify their investments, many over-invest in company stock, and almost none re-balance their portfolios in response to age or market returns. In addition, the majority of participants "cash out" their balances when they change jobs. As a result, many employees end up with inadequate balances at retirement -- for individuals aged 55 to 64, total assets in 401(k)-type plans average only $42,000. That would buy an annuity that would pay about $300 a month, not even enough to cover utility bills.
Costs are also dramatically higher in private accounts than in a pooled system like Social Security. A recent Congressional Budget Office study showed that administrative costs reduce Social Security benefits by 2 percent, while the costs associated with 401(k)-type plans cut the ultimate benefit by about 20 percent. The cost of running the Swedish system clocks in at a rate that reduces the ultimate benefit by 15 percent. And in the U.K., fees often absorbed a quarter or more of the assets for workers who shifted fund managers within a few years of opening an account.
In short, if we want to introduce a successful private account system, we must make it easy, so that people avoid costly investment mistakes, and cheap, so that benefits are not eroded by administrative costs. A spartan system with government administration would hold down costs. Limiting investment options would control costs and lead to better investment choices. And life-cycle funds that automatically rebalance would prevent individuals getting stuck near retirement with too much in equities if the market suddenly tanks. Ignoring the lessons to date would be a costly mistake.
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By Alicia H. Munnell, Peter F. Drucker Professor at Boston College's Carroll School of Management and director of the Center for Retirement Research at Boston College.