Pricing schemes and market efficiency in private retirement systems

• DOI: http://doi.org/10.1111/jpet.12419
• Date: 01 August 2020
• Author: Melati Nungsari,Marcela Parada‐Contzen,Sam Flanders
• Published date: 01 August 2020

J Public Econ Theory. 2020;22:1041–1068. wileyonlinelibrary.com/journal/jpet © 2019 Wiley Periodicals, Inc.

|

1041

Received: 24 April 2019

|

Accepted: 17 November 2019

DOI: 10.1111/jpet.12419

ORIGINAL ARTICLE

Pricing schemes and market efficiency

in private retirement systems

Sam Flanders

1

|

Melati Nungsari

1

|

Marcela Parada‐Contzen

2

1

Department of Business, Asia School

of Business and MIT Sloan School of

Management, Sasana Kijang,

Kuala Lumpur, Malaysia

2

Departamento de Ingeniería Industrial,

Universidad de Concepción, Concepción,

Chile

Correspondence

Marcela Parada‐Contzen, Departamento

de Ingeniería Industrial, Universidad de

Concepción, Edmundo Larenas 219,

Concepción, Chile.

Email: mparadacontzen@gmail.com

Funding information

Fondo Nacional de Desarrollo Científico

y Tecnológico (Fondecyt),

Grant/Award Number: 3180155

Abstract

We study the effects of different pricing schemes on the

overall surplus in a privately managed retirement

system with multiple service providers and switching

costs. We develop a theoretical model based on the

Chilean retirement system and consider a repeated

auction for monopoly rights over new enrollees. We

consider a dynamic model solved by pension fund

administrators and by consumers. We compare three

different pricing schemes: (a) fees on contributions, (b)

fees on returns, and (c) a two‐part tariff including an

auction over a guaranteed rate of return and allowing

the firm to keep a portion of returns generated above

this guaranteed rate. We also consider heterogeneity

across individuals where agents earn high or low wages

and high‐wage customers have proportionally lower

switching costs due to more cost‐effective access to

financial planning services. We find that auction

participants subsidize consumers. We also treat savings

as a durable good. In this case, pricing over returns

worsens the switching related inefficiencies just de-

scribed relative to pricing over contributions, despite the

better incentives it provides. These inefficiencies can be

resolved by allowing firms to price discriminate.

1

|

INTRODUCTION

In privately managed, defined contribution (DC) retirement systems, savings are usually

managed by firms known as pension fund administrators (PFAs). For their services, PFAs

charge a fee that might be defined as a share of contributions, benefits, or assets managed or as

an annual fixed amount (Creighton & Piggott, 2006). In this paper, we theoretically study the

efficiency‐maximizing pricing scheme in a privately managed DC system. We consider the main

institutional settings of the Chilean system, which has served as an archetype for the

implementation of private systems around the world (Orszag & Stiglitz, 2001). We compare

total market surplus under three pricing schemes: (a) the current structure with fees on

contributions, (b) an alternative scheme with fees on returns, and finally, (c) a two‐part tariff

(i.e., fee on contributions and returns) in which firms bid on a guaranteed rate of return.

Fee levels have been of continuous debate and concern policymakers (Barr & Diamond, 2016;

Tuesta, 2014). Countries in Latin America, together with the United States and transitioning

economies in Europe, have argued that fee levels are perceived to be too high (Tuesta, 2014).

Previous evidence shows that fees substantially reduce replacement rates (Modigliani &

Muralidhar, 2004) and pension returns (Bateman, Kingston, & Piggott, 2001) and may have

undesirable distributional impacts (Baily & Kirkegaard, 2008). Despite the evidence on the

effect of fees on pension outcomes, its effects on the efficacy of the retirement system have

received limited attention (Creighton & Piggott, 2006).

The architecture of DC systems varies across countries. Specifically, the fee structure

depends on the maturity of the financial sector and the PFA market upon introduction. For

example, in Latin America, because there was a concern that entry and competition were going

to be insufficient (Dobronogov & Murthi, 2005), because financial markets were still

undeveloped (Tuesta, 2014), and because it was not clear whether the industry would have

the initial capacity to charge fees on assets (Lasaga & Pollner, 2003), an upfront fee on

contributions was implemented. In Eastern Europe, where well‐established Western European

financial companies are interested in operating in the market, there is a bigger presence of fees

on returns (Dobronogov & Murthi, 2005).

We focus on the Chilean retirement system. Thus, our contribution is directly related to the

Chilean model and policies within this system. The application of results could also consider

other very similar systems (e.g., Mexico and Peru). Because we treat the modeling assumptions

as generally as possible, the model could be extended to other systems. Our model considers

alternative pricing schemes and competitive settings with many firms competing for consumers,

as well as the context of duopolic markets. Many Latin American countries have implemented

structural reforms, similar to the Chilean one (e.g., Bolivia, Colombia, Dominican Republic, El

Salvador, Mexico, Peru, and others). There are also mixed models with public systems

coexisting with private systems with similar characteristics to the Chilean model (e.g.,

Argentina, Costa Rica, and Uruguay; Mesa‐Lago, 2008). Mixed models with a private portion

that shared features with the Chilean system are the models that have been most extended

outside of Latin America, mostly in Eastern Europe (e.g., Hungary, Poland, Czech Republic,

Latvia, Bulgaria, Croatia, and Estonia; Mesa‐Lago & Hohnerlein, 2002). Developed countries

such as the United States have also discussed the implementation of such a system (Joubert,

2015; Joubert & Todd, 2016).

A novelty of this paper is that we explicitly model the auction dynamics for monopoly

rights, implemented in Chile, to new enrollees and incorporate switching costs for consumers

to switch between PFAs (both homogenous and heterogeneous switching costs). Auctions to

assign monopoly rights over enrollees have been recommended for increasing competition

and decreasing fees (Fischer, González, & Serra, 2006; Kurach, Kusmierczyk, & Papla, 2017).

After the Chilean experience, auctions were also implemented in Peru and have received

the attention of policymakers in Mexico, Australia, New Zealand, and Poland (Chomik &

Piggott, 2015; Heuser, Kwok, Snethlage, & Watts, 2015; Kurach, 2019; Kurach et al., 2017;

1042

|

FLANDERS ET AL.