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Mutual funds and institutional investments - what is the most efficient way to set up individual accounts in a social security system?

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  • James, Estelle
  • Ferrier, Gary
  • Smalhout, James
  • Vittas, Dimitri

Abstract

One of the main criticisms of the defined-contribution, individual-account components of social security systems is that they are too expensive. The authors investigate the cost-effectiveness of three options for constructing funded social security pillars: * Individual accounts invested in the retail market with relatively open choice. * Individual accounts invested in the institutional market with constrained choice among investment companies. * A centralized fund without individual accounts or differentiated investments across individuals. The authors asked several questions: What is the most cost-effective way to organize a system with mandatory individual accounts? How does the cost of an efficient individual account system compare with that of a single centralized fund? And are the cost differentials great enough to outweigh other important considerations? The authors concentrate on countries with well-functioning financial markets, such as the United States, but make comparative references to developing countries. Based on empirical evidence about U.S. mutual and institutional funds, the authors found that the retail market (option 1) allows individual investors to benefit from scale economics in asset management - but atthe cost of the high marketing expenses needed to attract large pools of small investments. By contrast, a centralized fund (option 3) can be much cheaper because it achieves scale economies without high marketing costs. But it gives workers no choice and is subject to political manipulation and misallocation of capital. The system of constrained choice (option 2) is much cheaper than the retail option and only slightly more expensive than a single centralized fund. It allows scale economies in asset management and record-keeping while incurring low marketing costs and allowing significant worker choice. It is also more effectively insulated from political interference than a single centralized fund. The authors estimate that option 2 would cost only 0.14 percent-0.18 percent of assets annually. Such large administrative cost savings imply a Pareto improvement - so long as choice is not constrained"too much".

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2099.

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Date of creation: 30 Apr 1999
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Handle: RePEc:wbk:wbrwps:2099

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Keywords: Payment Systems&Infrastructure; Business Environment; International Terrorism&Counterterrorism; Economic Theory&Research; Agricultural Knowledge&Information Systems; International Terrorism&Counterterrorism; Economic Theory&Research; Business Environment; Business in Development; Agricultural Knowledge&Information Systems;

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References

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  1. Robert W. McLeod & D. K. Malhotra, 1994. "A Re-Examination Of The Effect Of 12b–1 Plans On Mutual Fund Expense Ratios," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 17(2), pages 231-240, 06.
  2. Livingston, Miles & O'Neal, Edward S, 1996. "Mutual Fund Brokerage Commissions," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 19(2), pages 273-92, Summer.
  3. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 57-82, March.
  4. Miles Livingston & Edward S. O'Neal, 1996. "Mutual Fund Brokerage Commissions," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 19(2), pages 273-292, 06.
  5. Shukla, Ravi K. & van Inwegen, Gregory B., 1995. "Do locals perform better than foreigners?: An analysis of UK and US mutual fund managers," Journal of Economics and Business, Elsevier, Elsevier, vol. 47(3), pages 241-254, August.
  6. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, University of Chicago Press, vol. 35(1), pages 45-70, April.
  7. D. K. Malhotra & Robert W. McLeod, 1997. "An Empirical Analysis Of Mutual Fund Expenses," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 20(2), pages 175-190, 06.
  8. Malhotra, D K & McLeod, Robert W, 1997. "An Empirical Analysis of Mutual Fund Expenses," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 20(2), pages 175-90, Summer.
  9. McLeod, Robert W & Malhotra, D K, 1994. "A Re-examination of the Effect of 12B-1 Plans on Mutual Fund Expense Ratios," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 17(2), pages 231-40, Summer.
  10. Chordia, Tarun, 1996. "The structure of mutual fund charges," Journal of Financial Economics, Elsevier, Elsevier, vol. 41(1), pages 3-39, May.
  11. Dermine, Jean & Roller, Lars-Hendrik, 1992. "Economies of scale and scope in French mutual funds," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 2(1), pages 83-93, March.
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Cited by:
  1. James E. Pesando, 2001. "The Canada Pension Plan: Looking Back at the Recent Reforms," The State of Economics in Canada: Festschrift in Honour of David Slater, Centre for the Study of Living Standards, in: Patrick Grady & Andrew Sharpe (ed.), The State of Economics in Canada: Festschrift in Honour of David Slater, pages 137-150 Centre for the Study of Living Standards.
  2. René Weber & David S. Gerber, 2007. "Aging, Asset Allocation, and Costs," IMF Working Papers 07/29, International Monetary Fund.
  3. Estelle James & Alejandra Cox Edwards & Rebeca Wong, 2012. "The Gender Impact of Pension Reform," World Bank Other Operational Studies 13046, The World Bank.
  4. Whitehouse, Edward, 2000. "Administrative charges for funded pensions: An international comparison and assessment," MPRA Paper 14172, University Library of Munich, Germany.
  5. Whitehouse, Edward, 2000. "Paying for pensions: An international comparison of administrative charges in funded retirement-income systems," MPRA Paper 14171, University Library of Munich, Germany.
  6. Luciano Greco, 2005. "The Optimal Design of Funded Pension Plans: Unbundling Financing and Investment," "Marco Fanno" Working Papers 0003, Dipartimento di Scienze Economiche "Marco Fanno".
  7. James,Estelle & Smalhout, James & Vittas, Dimitri, 2001. "Administrative costs and the organization of individual retirement account systems : a comparative perspective," Policy Research Working Paper Series 2554, The World Bank.
  8. James, Estelle & Edwards, Alejandra Cox & Wong, Rebecca, 2003. "The gender impact of pension reform : a cross-country analysis," Policy Research Working Paper Series 3074, The World Bank.

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