1 Administrative Costs—how to compare them and control them By Estelle James

2 Administrative costs matter Many countries are adding a funded privately managed pillar to their old public social security systems. Critics argue they have higher costs. How can we compare the costs of public and private systems? How can we make costs lower? Admin costs matter. They: –Raise fiscal costs in public systems, –Reduce net returns & pensions in private systems –Increase contingent liability of government guarantees Government responsibility to keep costs low in mandatory system Which cost determinants are exogenously given (by size of system, stage of development) and which can be manipulated by policy?

3 Pitfalls in comparing costs of public and private plans Public plans often understate real costs—inputs are given to system free or at subsidized rates –rent, depreciation, fringe benefits –contributions collected by tax agency without charge –Costs exist, but not reflected on social security books Private plans usually must pay full market price for these services—so all costs are counted Important to count all costs in both cases

4 Comparing costs of public and private plans (cont’d) Different services provided –Private plans usually funded and incur investment costs while public plans usually pay-as-you-go, no investment costs, but also no investment returns –Private defined contribution plans require better records because date of contribution and investment matters, while for public PAYG plan exact date is less important –Private funds have incentive to provide better service, which costs more

5 Easier to compare costs of different public plans—but problems here too Costs are sometimes measured as % of benefit expenditures—biased against new schemes with few retirees receiving benefits Sometimes measured as % of contributions— biased against systems with low contribution rates Cost per participant is most valid, because most costs are incurred in collecting, keeping records and communicating with participants Often normalized by per capita income as measure of efficiency—lower for more developed countries because capital and skilled labor are major inputs

6 Cost per participant/per capita income in public DB schemes Zambia4.49% Morocco.89% Costa Rica.41% Switzerland.09% US.07% Rich countries offer higher quality service (better records, fewer errors, faster benefits) at lower cost because they have more capital, educated labor. Stage of development is exogenous--Poor countries can’t suddenly become rich. But they can: 1) be cautious about starting contributory DB systems--low quality and high cost 2) Use simple plans, in large firms, urban areas

7 Costs in privately managed funded schemes Costs reduce gross returns to funds. If net returns fall by 1 percentage point due to administrative expenses, pension falls by 20% Costs of private schemes appear higher than public because: –Costs more transparent (an illusion) –Incur investment costs (higher costs, higher returns) –More precise record-keeping needed –Start-up costs needed in new systems (short run effect) Competition in financial markets does not always reduce costs, but policies can. Important to shape system to keep costs low, especially during startup of new mandatory system

8 4 determinants of costs in private funded systems: 1.Record-keeping and communication (R&C) cost 2.Investment cost 3.Marketing cost 4.Start-up costs Costs may be expressed as: –$ per participant –% of assets in each account—tells how much gross return is reduced to get net return –charge ratio (tells % that pension is reduced by costs) Centralization leads to scale economies, but less incentive for efficiency and danger of political manipulation—what is best mix?

9 Start-up costs Costs as % of assets high at first because new IT system, staff hired before revenues, marketing to get new clients, no scale economies Costs as % of assets fall as system grows In Poland costs were 20% of contributions in 2000 of which half was for marketing, but only 8% of contributions in 2002 of which 1/4 for marketing Therefore deceptive to compare costs of new and old systems or to focus on early years of system; lifetime costs to worker matter Important policy issue: who should pay for start- up costs—first generation or amortized over future generations?

10 Record-keeping & communication expenses (R&C) Total R&C cost per account depends on level of service, efficiency of system, # participants More participants means lower cost per member Once these are set, R&C cost per account is fixed, regardless of how large account is ($20-30 per year in US IRA accounts) $20 is 10% of $200 account, only 1% of $2,000 account. Costs as % of assets fall as account grows. –R&C will take large share of investment returns if account size is small—danger in small accounts –Policy issue: Should flat fee be charged or should large accounts cross-subsidize small accounts via asset-based fee?

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12 Policies to keep R&C costs low Avoid setting up system with very small accounts --R&C will consume investment returns Use tax system to collect contributions (Sweden, Latvia, Estonia) –Providing tax system functions well and is willing to take on this task; facilitates compliance –Usually take a year to reconcile while decentralized system reconciles in days—trade-off between time and money Separate centralized clearing house used in Croatia, Kazakhstan Modest level of service (limit statements, switching) helps keep costs low

13 Investment expenses Total investment costs rise as funds increase. But cost per unit of assets falls as total money given to asset manager rises—scale economies Investment cost also depends on type of assets Costs much lower in countries with well developed financial markets Lower for passive investment--replicates the market, without investment research or management choice. This works well in efficient market but not in primitive markets

14 Policies to keep investment costs low Aggregate assets and use international competitive bidding process to choose limited number of asset managers (Bolivia, Kosovo) Invest part of funds in foreign countries with efficient markets—reduces cost and risk but trade- off with domestic financial market development Use passive investment where available Choose assets with low transactions costs Difficult to implement in developing and transitional economies unless they invest abroad These policies can lead to very low investment costs (.01% of assets for Thrift Saving Plan in US,.15% in Kosovo)

15 Marketing expenses (sales commissions) 50% of total expenses in some private systems (US mutual funds, Poland, Chile in early years) Marketing communicates information and gets workers into system, but much is 0-sum game Some countries use price controls to reduce commissions (Sweden, Kazakhstan). But difficult to get price right (quantity & quality) Best way to reduce marketing cost is through use of institutional rather than retail market.

16 Two models have developed: 1) retail market aimed at individuals Examples: Latin America, Poland, Hungary, Kazakhstan, UK, US mutual funds Open entry, unrestricted fee, usually decentralized R&C, pension fund managers sign up workers Retail funds incur high marketing costs to attract individual investors (commissions to salesmen) Total administrative costs 1-2% of assets in long run, reduce future pensions 20-30%, unless special measures are taken

17 2) institutional (group) market Bolivia, industry funds in Australia, US Thrift Savings Plan (pensions for federal workers) Contributions are aggregated into large blocs Investment portfolios are limited to low cost assets; workers choose among these portfolios Government holds competitive bidding process to choose small number of fund managers, based on low fees—keeps investments costs low Contributions are collected and records kept centrally and allocated to asset managers according to worker choice—keeps R&C costs low Low fees leave no money for sales commissions; often funds don’t know individual names so can’t pay commissions—keeps marketing costs low

18 Large cost saving possible in institutional market because: Less excess capacity at start-up Lower marketing expenses Investment expenses low because scale economies, more bargaining power, less oligopoly profit R&C costs low because service limited, scale economies through centralization Costs are half as much as in retail market cuts pensions by < 10% instead of 20-30%

19 Trade-offs and caveats Choice restricted--may choose wrong number and type of funds Performance incentives hard to specify Less flexibility, slow to adapt to new conditions, difficult to handle unforeseen contingencies Greater danger of political manipulation Possible corruption, collusion, regulatory capture Credible rebidding strategy needed or first entrants have long run monopoly advantage Less marketing means fewer workers may join

20 Examples from retail market: 1) Latin American private pillars Costs are 1-9% of assets, $21-$98 per account Low in systems with large assets, many accounts, falling through time as systems grow –Chile (oldest, scale economies, industry concentration) –Expenses have fallen through time in Chile –Expenses smaller in Bolivia (institutional approach) High in new small systems (Mexico, El Salvador-- start-up costs)

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23 2) U.S. Mutual funds Many years of operation, very large, good service Average costs & fees higher than in Chile: 1.4% of assets R&C costs low because many participants, large account size, outsourcing for scale economies Marketing expenses about 50% of total cost Costs are lower and net returns higher for: larger funds, no-loads (no commissions), passive investments--but only minority of investors choose them—evidence that competition alone won’t cut costs, policies are also needed

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25 Examples from institutional market--1) U.S. Large pension funds pay % of assets for passive mgt, % for active mgt. Half retail costs, lower for large institutions. Reasons for lower fees: –Low investment costs--scale economies –Low marketing costs –Low R&C costs –Heavy use of passive investment (index funds) –Better information, bargaining power

26 Long Run Costs of Retail and Institutional Markets in US (in basis points, 1bp=.01% of assets)

27 2) Bolivia International bidding process, 2 winners, workers assigned to 1 pension fund, no switching (choice, switching, greater entry later) Fees in 2000: 3% of assets, $16 per account Expected to be.6% of assets per year in long run for full career worker Much cheaper than Chile, especially at start-up

28 Bolivia: caveats Is saving due to competitive bidding & no marketing or to lumping pension funds with large privatization assets & cross-subsidization? Potential problems: service, performance incentives, pension funds may control regulators, inflexible in face of unexpected contingencies, merger and rebidding problems

29 3) U.S. thrift savings plan Voluntary individual account plan for federal government employees with matching contributions Competitive bidding with 5 portfolios, all passive management Average account size $2,700 initially, now $27,000 Costs (mostly R&C): $20-30 per account; this was.7% of assets initially, now.11% of assets; Is saving due to competitive bidding, limited choice (index funds) or hidden costs?

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31 4) Employer-sponsored plans In Australian system industry funds have much lower costs than retail market (.5% vs. 1.9%)—more marketing and choice in latter. Cost also low in employer-sponsored plans in Switzerland and the Netherlands In US company group plans cost.3-.4% of assets depending on size. 401k plans aimed at individuals cost 1-2% of assets

32 5) Other countries--Sweden Sweden took special measures to keep costs low because of small accounts (2.5% of wages): –many mutual funds participate, –centralized collections through tax system, –workers choose fund, –money goes to funds in large blocs, –funds don’t know names of their affiliates (cuts marketing costs) Participating funds must agree to fee rebate schedule set by public agency—keeps fees low Current cost is.7% of assets,.5% in long run –lower than Chilean AFP’s or US mutual funds (no marketing, price controls) –higher than TSP or US pension funds (no indexing)

33 What does the evidence tell us? Strong economies of scale: Cost as % of assets falls as assets and average account size rise. If accounts are small, costs as % of assets will be high, net returns and pensions low Marketing expenses inevitable in retail model Good design of system can keep costs low, especially important in small systems These policies are relevant to individual account systems and funded civil service plans

34 Policies that reduce costs and fees Avoid very small accounts Limit choice and use competitive bidding Use tax system for R&C if possible Reduce incentives for marketing through competitive bidding, blind allocations Use passive investment—requires international diversification in developing economies Should price controls be used? May not work well Make competition work better by requiring disclosure and transparency

35 What is relevance to your country? As you choose your new systems, think about design features that will reduce costs. Don’t automatically choose the retail model. Reforming countries should consider the institutional approach to cut costs, especially in early years of plan when accounts and asset base are small and for civil service plans in long run.