Administrative Costs

1
Administrative Costshow 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 costsinputs
  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 servicesso all costs are counted
• Important to count all costs in both cases

4
Comparing costs of public and private plans
(contd)

• 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
plansbut problems here too

• Costs are sometimes measured as of benefit
  expendituresbiased against new schemes with few
  retirees receiving benefits
• Sometimes measured as of contributionsbiased
  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 efficiencylower for more developed countries
  because capital and skilled labor are major inputs

6
Cost per participant/per capita income in public
DB schemes

• Zambia 4.49
• 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
  cant 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

• Record-keeping and communication (RC) cost
• Investment cost
• Marketing cost
• Start-up costs
• Costs may be expressed as
• per participant
• of assets in each accounttells 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
  manipulationwhat 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 costsfirst generation or amortized over
  future generations?

10
Record-keeping communication expenses (RC)

• Total RC cost per account depends on level of
  service, efficiency of system, participants
• More participants means lower cost per member
• Once these are set, RC 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.
• RC will take large share of investment returns
  if account size is smalldanger in small accounts
• Policy issue Should flat fee be charged or
  should large accounts cross-subsidize small
  accounts via asset-based fee?

11
(No Transcript)
12
Policies to keep RC costs low

• Avoid setting up system with very small accounts
  --RC 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 daystrade-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 risesscale 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 marketsreduces 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 RC, 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 feeskeeps investments costs low
• Contributions are collected and records kept
  centrally and allocated to asset managers
  according to worker choicekeeps RC costs low
• Low fees leave no money for sales commissions
  often funds dont know individual names so cant
  pay commissionskeeps 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
• RC costs low because service limited, scale
  economies through centralization
• Costs are half as much as in retail market
  cuts pensions by lt 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)

21
(No Transcript)
22
(No Transcript)
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
• RC 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 themevidence that competition alone wont
  cut costs, policies are also needed

24
(No Transcript)
25
Examples from institutional market--1) U.S.

• Large pension funds pay .04-.08 of assets for
  passive mgt, .35-.65 for active mgt. Half retail
  costs, lower for large institutions.
• Reasons for lower fees
• Low investment costs--scale economies
• Low marketing costs
• Low RC 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 RC) 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?

30
(No Transcript)
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 dont know names of their affiliates (cuts
  marketing costs)
• Participating funds must agree to fee rebate
  schedule set by public agencykeeps fees low
• Current cost is .7 of assets, .5 in long run
• lower than Chilean AFPs 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 RC if possible
• Reduce incentives for marketing through
  competitive bidding, blind allocations
• Use passive investmentrequires 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. Dont
  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.