Academic journal article Contemporary Economic Policy

Does the Right to Choose Matter for Defined Contribution Plans?

Academic journal article Contemporary Economic Policy

Does the Right to Choose Matter for Defined Contribution Plans?

Article excerpt

We find that sensitivity of fund flows and fund performance are both related to participants' right to choose their investments in defined contribution plans. Under the Mandatory Provident Fund system of Hong Kong, both employers and employees are required to contribute to a retirement account. Originally, employees' investment choices were restricted to a subset of funds chosen by their employers. The system was later modified so that employees are allowed to invest in any fund within the system. We present evidence that flows of fund have become more sensitive to past fund performance after this policy change, and that average fund performance in the system has also improved. Based on the improvement in fund performance, we estimate the accumulated cost of the lack of choice to be around 10% of the current total asset value of the system. (JEL G14, G18)

I. INTRODUCTION

Defined contribution plans are one of the main components of retirement systems (World Bank 1994). For a retirement system to be effective in providing support to retirees, it is crucial to understand how the design of the defined contribution plan is related to its performance. In this paper, we study one aspect of this relationship.

Similar to the 401(k) plans in the United States, the original design of the Mandatory Provident Fund (MPF) system in Hong Kong requires participants to choose their investment in a two-stage process. In the first stage, employers select defined contribution plans. Then, participants (i.e., the employees) invest their contributions to funds provided by the plans chosen by their employers. In response to the long-standing criticism on the unsatisfactory performance of the MPF system, a regulatory reform called the Employee Choice Arrangement (ECA) was implemented in 2012. Under the ECA, participants' right to choose investment is expanded from funds in the employers' chosen plans to any defined contribution plans available in the system. This policy change provides a unique opportunity to study the effect of an expansion of participants' right to choose investment on the performance of defined contribution plans.

One way participants' right to choose could improve performance is that participants are able to "vote with their feet." Studies on participants' fund choice in the defined contribution plans, however, suggest that the investment choice of participants could be sticky. (1) For example, Choi et al. (2002) find that participants seldom opt out of the default investment funds chosen by their employers even when they are given the right to do so. If participants do not vote with their feet to invest their savings in funds with better performance, it is unlikely that participants' right to choose could provide sufficient incentive for investment managers to compete on performance. To shed light on this, we study the change in sensitivity of fund flows in the MPF system to performance when participants are given greater autonomy to make investment decision.

Does competition lead to better performance in the mutual funds? Using the number of funds and the concentration index as proxies of competition intensity, Keswani and Stolin (2006) find that fund performance is less persistent in more competitive sectors. (2) Del Guercio and Reuter (2014), on the other hand, study how investment managers behave under different rules of competition, using the fact that different clienteles of funds are being sold directly to retailers and indirectly through brokers. Investors in the broker-sold segment are looking for other services rather than performance. They show that the funds in the direct-sold segment report significant higher alphas than funds in the broker-sold segment. Similarly, Massa (2003) shows that the more a fund is perceived by investors as a differentiated product, the less incentive there is for its manager to generate performance. Gaspar, Massa, and Matos (2006) suggest another reason for the underperformance of funds in a sector where performance is a less important criterion of competition. …

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