In the best of times, consumers do badly in personal financial decisions. Here is a stark example of what goes wrong. Mark Hulbert wrote in the New York Times, about research by Choi, Laibson and Madrian, 2010:
MANY index funds track the Standard & Poor's 500, but they differ from one another in one major respect: their fees. You'd think that it would be obvious to investors to pick the fund that charges the least. But you'd be wrong.
In fact, this truth was anything but obvious to a group of elite students. In an elaborate simulation created by several researchers, many students at Harvard and the Wharton School of the University of Pennsylvania failed to select the lowest-cost index fund for their portfolios, even when they were all but spoon-fed the right answer.
There is a problem of consumer protection here. Financial policy cannot and must not be designed on the premise of caveat emptor, that the individuals making choices are the ones best equipped to look out for themselves. The great bulk of financial regulation is about making the world safer for the individuals making those choices.
These problems are present with insurance and mutual funds in India, where sales practices and product features have been a scandal for a long time, until C. B. Bhave's SEBI started trying to do something about it. These problems would be present to an even greater degree in a nationwide pension system, where participation has two features: (a) To some extent, it would be involuntary; many people would be pushed into pension system participation without self-selecting themselves as is the case with products such as mutual funds, and (b) Whether participants come into a nationwide pension system through voluntary choice or not, they are likely to be less sophisticated than the `elite students' described above, and thus face even more difficult problems of household financial choice.
The key insight of what I term the `second generation pension reforms' is that while we must do defined contribution (DC) pension system so as to keep pension planning away from the balance sheet of the State, we should use public policy decisions about design of the pension system in order to further the goals of consumer protection. One big insight in this is on pricing. Households are seldom able to understand the charges of fund managers. The `elite students' that do fine in comparing an iphone versus an Android phone on features and pricing tend to fumble when it comes to financial products.
The clean answer to this is: Standardise fund management into a group of index funds (one for equities, one for government bonds, etc) and procure fund managers through an auction. This has two consequences: economies of scale (a small number of very large AUMs) and low prices (since fund managers compete with each other in an auction). This idea is found in the original Project OASIS report which designed the New Pension System (NPS), it was successfully implemented by PFRDA when the NPS began, it has been used in other places such as the EPFO, the civil service pension of the US (which is named the Thrift Savings Plan (TSP)), etc. For the back story of the NPS, see link and link. To use Raju Chitale's phrase, we are using public procurement to overcome the market failures of the fund industry.
In this setting, I was disappointed to learn that PFRDA has just announced that they have given up on this key idea of the NPS:
19.1 The PF can fix the Investment Management Fee to be charged to the subscribers subject to a ceiling/cap, as may be prescribed by the Authority from time to time.
I disagree. This loses one of the essential features of the NPS. This makes the NPS closer to the fund management products run by mutual funds and insurance companies. To this extent, the value added of NPS is contaminated: why construct the NPS if households can do this same thing through mutual funds?
It is important to worry about the political economy of finance. The financial industry will generally tend to achieve dominant mind-share within regulatory agencies. The great unwashed masses, the greatest beneficiaries of sound economic policy, will never have a voice in the policy discourse. In India, our puzzle is that of avoiding both extremes: of socialist stagnation (to use Arvind Virmani's phrase) at one extreme, and crony capitalism at the other. PFRDA runs the risk of veering towards the latter.
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