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Citizens of any of the 30 countries in the European Economic Area can work at jobs in any of the other member countries. As of last Tuesday, March 22, they can participate in equally border-agnostic retirement savings plans, called Pan European Personal Pensions, or PEPPs.

Not to be confused with the “Pooled Employer Plans” in the US, Europe’s PEPPs don’t require sponsorship or supervision by an employer, and don’t use an employer’s payroll system. Instead, each participant chooses a PEPP provider and contributes to their account on their own.

Banks, insurance companies, and asset managers can offer PEPPs. They must register their offerings with a central registry at the European Insurance and Occupational Pension Association (EIOPA), and agree to maximum 1% annual investment fees. Annuities may entail additional fees. Participants can switch providers, but only once every five years.

Europe’s retirement regulations are just now catching up with European labor trends. “In 2015, 11.3 million Union citizens of working age (20 to 64 years old) were residing in a Member State other than the Member State of their citizenship and 1.3 million Union citizens were working in a Member State other than their Member State of residence,” according to a July 2019 article in the Official Journal of the European Union. About 447 million people live in the EU. 

“[EU] households are amongst the highest savers in the world, but the bulk of those savings are held in bank accounts with short maturities,” the Journal added. “More investment into capital markets can help meet the challenges posed by population aging and low interest rates.”

PEPPs can be offered by credit institutions, direct life insurance companies, institutions for occupational retirement provision (IORPs, which are authorized and supervised to provide also personal pension products), investment firms, asset managers, and EU alternative investment fund managers.

But there was a sign this week that insurance companies, for one industry category, may choose not to implement PEPPs. Hugh Prenn of the Capital Markets division of UNIQA Group, a major insurer in central and eastern Europe, who appeared in a webinar introducing PEPP this week, told RIJ that “There will be no PEPP from our side.”

He added, “I guess my opinion is representative for many if not all insurance companies.” Asked why he was on the webinar, he said, “Because I have been a member of the expert panel at EIOPA.” On EIOPA’s registry, no PEPP offerings are listed. Prenn noted an industry study showing that the consumer protections required on PEPPs will make it difficult to offer a product. [Note: We will update this story as more information becomes available.]

“Certainly higher interest rates could help us to become more interested,” Prenn said in the webinar. “That would make complying with these rules much easier. We would need benchmark rates of about 2%, and we are halfway there.” Without more yield, he noted, it would be impossible for an insurance company to meet the PEPP’s specific requirements for minimum returns and maximum losses. 

He also expressed concern about potential legal liabilities. “How will a civil court see this regulation? In a negative market scenario, we will have unhappy customers pursuing us with skillful lawyers. This creates legal risks that will have to be covered by the 1% return on this product.”

European investors are famously averse to market risk. So a capital preservation feature was added to the default version of PEPP (Basic PEPP). “For the Basic PEPP with a guarantee, PEPP savers will have a legal obligation to ensure that PEPP savers recoup at least the capital invested. The guarantee on the capital shall be due only at the start of the decumulation phase and during the decumulation phase,” according to a PEPP fact sheet. Such guarantees will be difficult for providers to offer when yields are low.

In an aging, low birth-rate Europe, where a declining worker-to-beneficiary ratio is putting pressure on social insurance programs with tax-based, pay-as-you-go funding mechanisms, governments want to encourage individuals to save more on their own. European workers face many of the same retirement challenges that Americans do—insufficient savings, incomplete access to savings plans, and unconventional careers. 

Contributions to PEPP funds could also help the investment industry in Europe. Europeans traditionally save at banks, and PEPPs could draw savings toward capital markets investments in exchange-listed companies. A larger market could also give PEPP providers greater efficiencies and economies of scale.

The idea for Europe’s PEPPs was hatched in July 2012 when the European Commission, eager for individual savers to shoulder more of their own pension burden, asked EIOPA to gather information on a personal, private pension option for EU workers. The project advanced slowly through the European bureaucracy until, in 2020, a package of new regulations and services was submitted for the European Commission’s approval.

RIJ submitted the following questions to the EIOPA this week and received the following answers:

Q. How do PEPP participants make contributions, especially if contributions aren’t facilitated by employer payroll mechanisms?  

A. The PEPP is a pillar three product. It is separate from the state pensions and the occupational pensions. Savers make contributions on their own without facilitation by payrolls.

Q. Is there any limit to the number of companies that can offer plans?

A. No. Eligible providers are credit institutions, insurers, institutions for occupational retirement provisions as well as investment or management companies. Each provider can offer as many PEPPs as they want. There is a limit on the number of investment options. Providers can offer basic PEPP and six other investment options.

Q. How are plans distributed and payments made? Purely online? Is there an emphasis on smartphones?

A. It is not prescribed to use online distribution only. However, the PEPP Regulation aims to put ‘digital first’ and allows a fully digital disclosure and distribution. Digital disclosure may include more engaging forms of media (such as video) or interactive elements which makes it more appealing and easier to understand for consumers.

PEPP providers and distributors are obliged to give advice. The PEPP Regulation, in addition to traditional advice, allows either fully automated or semi-automated advice. Content of the pre(contractual) information to consumers has to be presented in a way that is adapted to the PEPP saver’s device used for accessing the document. Font size, size of the different elements should be adjusted depending on the device being used for accessing the information.

Q. Is there any limit to the kinds of savings vehicles—such as annuities, mutual funds, collective investment trusts—that PEPPs can offer? 

A. Providers can offer different forms of out-payments, which can be modified by savers free of charge one year before the start of the decumulation phase, at the start of the decumulation phase and at the moment of switching providers. The forms of retirement income can be an annuity and life-long pay-out, a lump sum payment, drawn down payments or a combination of the aforementioned.

Q. How is the conversion to decumulation handled?

A. PEPP providers should inform PEPP savers two months before the dates on which PEPP savers have the possibility to modify their pay-out options about the upcoming start of the decumulation phase, the possible forms of out-payments and the possibility to modify the form of out-payments. Where more than one sub-account has been opened, PEPP savers should be informed about the possible start of the decumulation phase of each sub-account.

National competent authorities are required to publish national laws, regulations and administrative provisions governing the conditions related to the decumulation phase. These also are published on our website. 

Tuesday’s webinar panelists included Til Klein, founder of Vantik, which puts credit card rewards into a personal pension, Christian Lemaire of the Occupational Pensions Stakeholder Group, Hugo Prenn of Uniqa Insurance, Tim Shakesby of EIOPA, and Peter Ohrlander, Directorate General for Financial Stability, Financial Services and Capital Markets Union at the European Commission. 

© 2022 RIJ Publishing LLC. All rights reserved.

The most provocative of the five research papers in this March edition of RIJ’s Research Roundup has to be Michael Doran’s “The Great American Retirement Fraud.” A professor at the University of Virginia School of Law, Doran faults US tax policy for subsidizing what, in his opinion, is a deceptively regressive defined contribution system of thrift. 

We also feature recent research by the Urban Institute, whose economists show that millions of Americans won’t have adequate income in retirement if the Social Security system doesn’t avoid its anticipated insolvency in 2034. Another paper, co-authored by the principal economist at the Federal Reserve, measures how the cost of managing interest rate risk and offsetting “adverse selection” affects the prices of income annuities.

Two Harvard economists, David M. Cutler and Noémie Sportiche, show that the mental and emotional stresses of the Great Financial Crisis in the US were not evenly distributed across demographic groups. Finally, Danish economists, collaborating with an American, try to solve a mystery: Why do so many people gain wealth during their “decumulation” years?  

Preparing for Retirement Reforms, by Karen E. Smith, C. Eugene Steuerle, and Damir Cosic of the Urban Institute, October 2021. 

Unlike the helmsmen of the ill-fated HMS Titanic, who didn’t foresee any icebergs ahead, economists watching over Social Security know that the program approaches a political-regulatory-financing iceberg of its own, circa 2034. 

That’s the year that actuaries predict the Social Security program will have enough payroll tax revenue to pay only about 75% of its promised benefits. If Congress doesn’t change the rules of the program before then, every beneficiary of the Old Age and Survivors Insurance program would take a 25% benefits haircut.  

In this study, economists at the Urban Institute in Washington, DC, use their Dynamic Simulation of Income (DYNASIM) microsimulation model to forecast the impact of such a reduction on the America’s overall financial readiness for retirement. The authors defined readiness as the ability to replace 75% of pre-retirement income in retirement. 

The share of Social Security beneficiaries with inadequate income will increase from 26% in 2020 to 45% by 2090 without any reforms to the program, they found, and to 39% if Congress enacted reforms proposed by the Bipartisan Policy Center. The BPC proposes a roughly equal blend of benefit cuts and tax increases to restore Social Security to solvency.

Americans can prepare for the worst by working longer or saving more. “Working longer by one year, by two years, or in line with increases in life expectancy, would reduce the share of Social Security beneficiaries unable to replace 75% of their preretirement earnings by two to five percentage points. A person with a 50% replacement rate, for example, might increase that number to 54% with an extra year of work,” the economists wrote.

Among top-quintile lifetime earners, one more year of work could close 25% of the savings gap, while saving 10% more of earnings could close 60% of the savings gap. For bottom-quintile lifetime earners, one more year of work could close 9% of the savings gap, while saving 10% of earnings more could close 19% of the gap.

Alternately, a person could save more over the course of their working lives. But they would have to save substantially more. “The average projected income gap among those Social Security beneficiaries with income below our adequacy standard in 2065 is $13,330 in 2018 price-adjusted dollars. To fill this gap, vulnerable workers would need to save about $272,700 more on average to close their income gap for 20 to 25 years of expected retirement,” the study said. 

For those, such as women who raised children at home, who had too few years of earned income to qualify for benefits, the authors noted the possibility of a minimum Social Security benefit equal to the 2025 single-person poverty income level. If enacted, it would close 41% of the savings gap among bottom-quintile lifetime earners and 25% of the gap for second-quintile lifetime earners in 2065, the report suggested. 

Does Social Security face an existential financial crisis? Not necessarily. Unless offset by higher immigration or changes in the way the program is financed, a falling worker-to-retiree ratio in the years ahead will require higher taxes per worker or lower payments per beneficiary. But defenders of the program say that simple remedies, such as raising the amount of earned income subject to the payroll tax, would solve the problem. That might raise costs for highest earners, but they benefit disproportionately from tax expenditures [a tax expenditure is a tax the government doesn’t collect or defers collection of] on defined contribution plans.

The Great American Retirement Fraud, by Michael Doran, University of Virginia School of Law.

Most Americans save for retirement by buying mutual fund shares with tax-deferred contributions to accounts in employer-sponsored, defined contribution plans. But the program has a weakness. Millions of workers whose employers don’t choose to sponsor plans are left out. 

In a recent paper, a University of Virginia law professor calls the defined contribution system  a “fraud.” He argues that its benefits accrue mainly to the wealthy: Because they save the most and pay the highest marginal tax rates, they benefit the most from tax incentives for saving. 

“Over the past twenty-five years, the retirement savings of middle-income earners have remained flat or increased only modestly, and the retirement savings of lower-income earners have actually decreased,” writes Michael Doran. “But the increases in retirement savings among higher-income earners have been so large that average retirement savings as a whole have increased, making it appear that retirement security has improved across the board.” 

“The supposed interest in helping lower-income and middle-income earners has been a stalking horse for the real objective of expanding the tax subsidies available to higher-income earners. The legislation has repeatedly raised the statutory limits on contributions and benefits for retirement plans and IRAs, delayed the start of required distributions, and weakened statutory non-discrimination rules—all to the benefit of affluent workers and the financial services companies that collect asset-based fees from retirement savings.

“The result has been spectacular growth in the retirement accounts of higher-income earners but modest or even negative growth in the accounts of middle-income and lower-income earners. Despite the benign but misleading rhetoric about enhancing retirement security for everyone, the real beneficiaries of the retirement-reform legislation have been higher-income earners, who would save for retirement even without tax subsidies, and the financial-services industry, whose lobbyists have driven the retirement-reform legislative agenda.”

Doran argues that the system isn’t making America more retirement-ready. “The most recent update of the National Retirement Risk Index, published in January of 2021, indicates that approximately 49% of all households are at risk of being unable to maintain pre-retirement living standards during retirement,” he writes. “And the distribution of at-risk status is not even across different levels of household wealth: among low-wealth households, 73% are at risk; among middle-wealth households, 45% are at risk; and among high-wealth households, 29% are at risk… The number of at-risk households has increased since 2004, the first year for which the National Retirement Risk Index was calculated.”

What’s Wrong with Annuity Markets?,  by Stephane Verani, the Federal Reserve Board, and Pei Cheng Yu, University of New South Wales, Australia.

It’s a truism in the annuity industry that when prevailing interest rates go down and stay down for long periods, that life/annuity companies earn less on their bonds and must raise the prices (i.e., lower the payout rates) of single premium immediate annuities (SPIAs). (Variable annuities and index-linked annuities are not as rate-sensitive.)

It’s also known that healthier people buy life annuities. Known as “adverse selection” (AS), this phenomenon compels annuity issuers to charge more for SPIAs than they would if more people with average longevity expectations purchased life annuities. 

The principal economist at the Federal Reserve in Washington, DC, Stephane Verani, and an Australian business school professor, Pei-Cheng Yu, assert that the frictions from managing these two risks—interest rate risk and AS—raises the cost and lowers the supply of lifetime income annuities. Indeed, the two risks interact; rising annuity prices discourage all but the healthiest customers. 

“A large share of the notoriously high life annuity price markups can be explained by the cost of managing interest rate risk. We propose a novel theory of insurance pricing that reflects both informational frictions and interest rate risk. 

“We develop an algorithm for annuity valuation to decompose the contribution of demand- and supply-side frictions in annuity markups using over 30 years of annuity price data and a novel identification strategy that exploits bond market shocks and the US insurance regulatory framework. 

“Our main result is that interest rate risk significantly constrains the supply of life annuities. A corollary is that the best time to sign up for a life annuity is during a time of overall financial market stress, as annuity prices are lower when investment grade bond spreads are higher!,” the authors write. 

“The average AS-adjusted markup is substantial and around 16%. We show that the cost of managing the interest rate risk associated with selling life annuities accounts for at least half of the AS-adjusted markup or eight percentage points,” they add. “That is, in addition to the well-known cost of adverse selection, the supply of private longevity insurance is constrained by life insurers’ own vulnerability to uninsurable aggregate shocks. 

“A substantial fraction of annuity markups reflects insurers’ cost of managing interest rate risk. The effect of interest rate risk, a supply-side friction, is likely to add to the adverse effects of other noted demand-side frictions on annuity demand including, for example, bequest motives, behavioral biases, and pre-existing annuitization, such as Social Security.”

Economic Crises and Mental Health: The Effects of the Great Recession on Older Americans, by David M. Cutler Noémie Sportiche. 

Can you remember your mental state during the Great Recession of 2008? Was your home foreclosed on? Did you lose your job? Were you distressed by the drop in the financial markets? Two Harvard economists searched the data to see if older people suffered more emotional pain or mental anguish that others during that difficult period. 

David M. Cutler and Noemie Sportiche searched through house price data in the Health and Retirement Study and studied rates of depression, chronic pain severity and functional limitations, and the use of medications to treat sleep, depression, and anxiety. They found no sign that the elderly suffered. They found ample evidence that homeowners of color did. 

“The mental health impacts of the Great Recession were heterogeneous and unequally distributed,” Cutler and Sportiche wrote. “We find that mental health was not impacted on average, either for older adults aged 51 to 61 or for seniors aged 65 to 74. 

“Instead, we find that falling house prices worsened only the mental health of those in economically vulnerable households… Black and other non-white homeowners show signs of worsened mental health across most measures. White homeowners did not exhibit worsened mental health but became more likely to take medication.” 

The authors were “not able to clearly identify the pathway through which house prices affected the mental health of populations.” They concluded, “The mechanisms underlying mental health effects extend beyond housing wealth or foreclosures.” 

“As the mental health of seniors aged 65 to 74 was not affected, it is possible that mental health effects are mediated through features of the labor market or have smaller impacts among seniors because of reasonably generous social insurance programs available to this age group.” 

Consumption and Saving After Retirement, by Bent Jesper Christensen and Malene Kallestrup-Lamb of Aarhus University, Denmark, John Kennan, University of Wisconsin-Madison. 

The wealth of retirees tends to go up rather than down, on average. That’s contrary to the life-cycle hypothesis, which holds that retirees will spend down their savings to maintain their pre-retirement consumption level. An American economist and two Danish economists decided to explore the inconsistency.

“One would expect that wealth accumulated before retirement would be used to augment consumption in later life, with the implication that wealth should decline over time,” wrote researchers Bent Jesper Christensen and Malene Kallestrup-Lam of Denmark’s Aarhus University, and University of Wisconsin’s John Kennan. 

So why, they ask, do “many people choose to work full-time for about 40 years, and not work at all for the remaining 15 years or so, rather than taking more time off when they are younger, and working more when they are older”

They had more than an idle interest in this topic. Social security systems around the world might cost trillions of dollars less to finance (in the long run) if more people worked longer, paid taxes longer, and received their pension payments for fewer years. That is: if it were known why so many people retire early, perhaps incentives for working longer could be developed. 

The trio analyzed data for Denmark’s 1927 birth cohort, for which the old-age pension (OAP) claiming age was 67. To simplify the research, they focused on single people neither married nor cohabiting. They followed at group from 1995, at which point almost all of them had retired, to 2016. 

Their conclusion: Some individuals are saving because they are currently in a low marginal utility state, but expect to move to a “high marginal utility state” in the future. In other words, they believed that they’d get more enjoyment out of their money by spending it later rather than sooner.

Note: The life-cycle hypothesis (LCH) is an economic theory that describes the spending and saving habits of people over the course of a lifetime, according to Investopedia. The theory states that individuals seek to smooth consumption throughout their lifetime by borrowing when their income is low and saving when their income is high. The concept was developed by economists Franco Modigliani and his student Richard Brumberg in the early 1950s. Its applicability for over-leveraged Americans in the 21st century is open to debate.

Marginal utility is the enjoyment a consumer gets from each additional unit of consumption. It calculates the utility beyond the first product consumed. If you are hungry and eat three Big Macs in a row, you are likely to enjoy the first more than the second and the second more than the third. And so on until you regret it. It’s akin to the principle of diminishing returns.

© 2022 RIJ Publishing LLC. All rights reserved.