Optimal Decisions on Pension Plans in the Presence of Information Costs and Financial Literacy

• DOI: http://doi.org/10.1111/jpet.12121
• Author: LUCA SPATARO,LORENZO CORSINI
• Date: 01 June 2015
• Published date: 01 June 2015

OPTIMAL DECISIONS ON PENSION PLANS

IN THE PRESENCE OF INFORMATION COSTS

AND FINANCIAL LITERACY

LORENZO CORSINI

Universit`

adiFirenze

LUCA SPATARO

Universit`

a di Pisa and CHILD

Abstract

Pension reforms are on the political agenda of many

countries. Such reforms imply an increasing responsibility

on individuals’ side in building an efficient portfolio for re-

tirement. In this paper, we provide a model describing work-

ers’ choices on the allocation of retirement savings in pres-

ence of (1) mandatory pension contribution; (2) different

pension plans; and (3) information costs and financial liter-

acy investment decisions. In particular, we characterize the

results from both a positive and normative standpoint, by

highlighting the determinants of individuals’ choice, with

special focus on information costs, on the role of income

and preferences, and by characterizing the optimal contri-

bution rate to mandatory complementary pension plans.

We also introduce endogenous financial literacy and ana-

lyze how its optimal level is determined and how it affects

the decisions on pension plans.

1. Introduction

In recent decades, pension systems of both developed and developing

economies have been undergoing major reforms. Among the common fea-

tures of these reforms, there is the possibility given to workers to choose how

Lorenzo Corsini, Dipartimento di Scienze per l’Economia e l’Impresa, Universit`

adi

Firenze, Via delle Pandette 9, 50127 Firenze, Italy (lorenzo.corsini@unifi.it). Luca Spataro,

Dipartimento di Economia e Management, Universit`

a di Pisa, Via Ridolfi 10, 56124 Pisa,

Italy (luca.spataro@unipi.it).

Received April 21, 2014; Accepted May 4, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (3), 2015, pp. 383–414.

383

384 Journal of Public Economic Theory

to invest a fixed part of their retirement savings between different opportu-

nities. This is particularly true, for example, for Australia, the Netherlands,

Norway, Sweden, and the United Kingdom where a certain share of pen-

sion contributions can be directed toward alternative plans/schemes (usually

called second pillar or complementary social security) but also for Argentina

and Peru where mixed private/public schemes are present and workers are

called to choose between them. Even New Zealand and the United States

to some extent fall in this category as the KiwiSavers and 401(k) plan, re-

spectively, can be considered a possible option in which to invest retirement

savings. Moreover, several countries undergoing important pension reforms

(for example, Hungary, Poland, and Uruguay) have given workers the pos-

sibility to choose between the old and new system. Finally, on the extreme

edge, there is Mexico whose whole pension system is run by private com-

panies so that workers have directly to choose between alternative pension

funds. In all these cases, individuals have some degree of choice on how to

invest part of their mandatory contribution.

More detailed information of the pension systems of the countries men-

tioned above and of the dimension of the compulsory savings over which

individuals have some degree of choice is summarized in Table 1. Given the

working of the systems described in the table, we can say that, even if the

alternatives provided to workers are different from country to country, there

is a common trend in recent reforms that entails increasing responsibility

on the workers’ side in building up an adequate portfolio for facing retire-

ment needs. In this scenario, the issue of obtaining an adequate degree of

information and financial literacy has been raised by several researchers, in

that the choice of both the amount and the composition of the retirement-

saving portfolio implies the understanding and the evaluation of the differ-

ent opportunities that are now offered. However, although several papers

have produced a solid piece of evidence on the relevance of financial liter-

acy in determining the “planning attitude” or the degree of farsightedness

of individuals,1to the best of our knowledge scarce effort has been put on

1The literature on financial literacy has stressed the importance of this factor in the finan-

cial decisions of individuals and in particular in saving behavior and retirement decisions

(for an overview of this issue, see OECD 2005). Most works approach this issue from a

behavioral perspective or through empirical analyses: for example, Clark and D’Ambrosio

(2002) compare questionnaires about retirement goals filled by individuals before and

after attending a financial seminar and note how retirement decisions change after such

an event. Lusardi and Mitchell (2009) perform an analysis with a U.S. data set containing

detailed information on both the retirement planning decisions and financial knowledge

of individuals and find a strong influence of the latter. Still on the U.S. case, but with a

different database, Lusardi and Mitchell (2011) analyze how the lack of financial literacy

is particularly relevant in the decision of some categories of individuals, while Fornero

and Monticone (2011) explore this issue for Italy, finding evidence that financial literacy

is usually scarce and that participation to pension plans in general and to riskier options

in particular, is significantly influenced by it.

Optimal Decisions on Pension Plans 385

Table 1: Complementary social security around the world: Some examples of pension systems entailing freedom of choice and

mandatory contribution

Fixed Amount of Presence of

Mandatory Savings with Further Mandatory

Some Degree of Choice Savings with No

(Share of Total Earnings) Workers’ Options Degree of Choice Notes

Argentina 11% DB plan run by the state

or DC private pension

funds.

Yes The possibility to choose

ended in 2009.

Australia 9% Several pension plans

run by private

pension funds.

No

Hungary 33.5% Choice between old DB*

system and new mixed

DB/DC system.

No The choice had to be done in

1998 and it applied only to

individuals who were

already working at the time.

Mexico 11.5% plus extra savings

depending on wage

bracket.

Several pension plans

run by private

pension funds.

No

The Netherlands Usually around 16% Several pension plans

run by occupational

pension funds.

Yes Contribution to occupational

plans is quasi-mandatory

being compulsory for 90%

of workers.

New Zealand 4% or 8% Several pension plans

run by private

pension funds.

No Can choose to opt out from

mandatory contribution.

Norway Depends on employer,

but minimum is 2%

Several pension plans

run by occupational

pension funds.

Yes

Peru 13% Choice between a public

pension and private

pension funds.

No

(Continued)