Archive for February 18th, 2009

India Pension authority takes cue from Behavioral economics

February 18, 2009

Pension Fund Regulatory and Development Authority (PFRDA) is a body set up to develop and regulate India’s pension sector. I have always been interested in economics of  personal finances/ pensions (especially from the behavioral economics angle) but thanks to this crisis, get time to do nothing.

PFRDA has initiated what is called as New Pension System (NPS). It has many innovations- defined contribution plans, professional fund managers, web based system to track investments etc. One can see the PFRDA website for details.

They released a regulation document for investments in NPS. It is an excellently written policy report. The aim is to answer these questions:

  • What are the defined investment choices available to an NPS contributor
  • There is considerable evidence from pension systems world-wide that pension contributors tend not to make an explicit choice for their pension investment.Thus, one of the central discussions in pension fund management has been the definition of the “default” -where the contributions are invested when the pension participant does not make an explicit choice.
  • Once the default option was designed, who manages the funds in the default choice funds”?
  • What would be framework for evaluation of the “default choice” PFMs?
  • What would be the framework governing changes in the set of PFMs?

PFM means Pension Find Manager; it also calls “default option” as “auto choice”. 

What interested me immediately is the usage of auto choice architecture for pension plans. The report is quite honest in admitting that maximum choice would be auto which is great to begin with. It goes with the basic assumption that people do not understand basics of finance as well and need a nudge. I have been a big fan of this very useful tool and is extremely satisfying to see it being applied in India.

Again, it is easy to suggest make a default plan, but how do you design it? And that too for a whole country. This report helps answer few of those questions.

Defined Contribution means people will have to choose their own pension plans (which assets – equity, debt to invest in and in what proportion). It first lists eligible assets for investments and puts them in categories like E (equities it suggests only index finds, an excellent idea), G (Govt Bonds, Fixed Deposits at Banks), C (Corporate Bonds, State Govt Bonds etc).

Once we have these next case is to distinguish between someone who can allot weights across assets (active investor) and someone who cannot. For all falling in latter, they are allotted auto choice and a plan is to be designed for them.  Should we have one default choices for all?

No. NPS classifes default strategy on the basis of age. Young people should have higher weight towards equity and older towards G. It chooses age bracket of 35 -60 when the shoft would start from equity to debt.

1. The highest risk-tolerance weight set at the start (wEs ;wGs ;wBs)

2. The lowest risk-tolerance weight set at retirement (wEe ;wGe ;wCe). In NPS, these weights are proposed to be set to wEs = 10%;wGs = 80%;wCs = 10%”

3. The rate at, and the frequency with, which each weight (wEs ;wGs ;wBs) decreases. In NPS, the weights will be adjusted every year from the age of 36. If we start with an equity weight of 65%, government bond weight of 10% and credit bond weight of 25%, the adjustments will be linear as follows:

(a) Each year (from age 36) wE will decrease by 2.2.
(b) Each year (from age 36)
wG will increase
by 2.8.
(c) Each year (from age 36)
wC will increase by 0.6.
wEs ;wGs ;wCs). In NPS, these are proposed to be set to wEs = 65%;wGs = 10%;wCs = 25%

There is an example on page 22-23. It also suggests that funds that fall under auto choice should be distributed equally amongst PFMs and those that perform  better (low costs higher returns) should be replaced. (However, behavioral finance research has shown that it is not necessary winning fund manager for year one would be a winner next year as well. The evidence is quite contrary)

It also provides an analysis of why it chose the above asset allocation for auto choice. They do portfolio simulations based on previous data.  They find though portfolio value is much higher if more equity is taken (say 80%) it is also the case that the losses could also be higher. Likewise, it provides a reason for shifting portfolio from 35 yrs onwards as well.

Great to see Indian policymakers taking lead to apply behavioral economics. Earlier RBI Deputy Governor had mentioned usage of Nudges for selling/choosing financial products. And now this direct application in managing pensions.

Excellent stuff.

Time to reassess Financial Innovation

February 18, 2009

This is the title of my new paper on financial innovation. Comments are welcome.

Why weren’t Credit Default Swaps named as Credit Default Insurance?

February 18, 2009

I was reading this (HT: Mahalonobis) crisis solution document from Harry Markowitz (Father of Portfolio Management).

 He says:

Presumably, credit default swaps are called “swaps” rather than “insurance” to avoid the level of reserves required by regulators to back insurance policies. But CDS  are insurance and, in fact, should require greater reserves than does life insurance.

Deaths are fairly uncorrelated events, but business risks are usually correlated. If Ford Motor Company does badly, General Motors Corporation probably will too, as will their dealers and suppliers. When risks are uncorrelated, sufficient diversification drives volatility toward zero. When risks are correlated, no amount of diversification will eliminate risk. A substantial amount of risk remains even in a broadly diversified portfolio of correlated risks.


Assorted Links

February 18, 2009

1. ASB points to investment plan of India’s New Pension Scheme

2. TTR points another independent director failure- Subhiksha (a retail firm)

3. Urbanomics says duty cuts are a wastage of money

4. Indicus Blog says current Indian govt is a failure be all measures

5. MR points bankruptcy is better than nationalisation

6. Krugman asks why it took so much time for policymakers to realise the problem. He also dfferentiates between recessions

7. WSJ Blog points Greenspan criticising his own theory. It also points to St Louis Fed President speech who raises deflation risks

8. NB points nudges getting fan following from beauty queens

9. Mankiw on economics profession and debates

10. Finprof points to mistakes of Japan which US is repeating

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