Welfare Loss by the Financially Illiterate and Ignorant: Value of Private Pension Savings and Allocation

Abstract

Population ageing requires adjustments to the traditional way of providing pensions though pay-as-you-go (PAYG) systems. Governments should prepare sound frameworks for a sustainable long-term shift towards private pensions, either in the form of second or third pillar or even better both of them. Namely, under demographic dynamics being driven by low fertility and increasing longevity both deteriorating the population's dependency ratio, private pension systems are more efficient than traditional PAYG. This paper makes two main points. First one is relatively straightforward. Fiscal limitations under current and projected demographic dynamics will dramatically reduce PAYG pensions. Without saving sufficient amounts during the active period, individuals will be increasingly ending up in poverty. Their savings will not be enough to support their desired old age consumption. Second point, highlights an impact of the asset allocation decision and related lacking awareness of general public regarding this issue. Under the assumption that people are literate enough and they save for their pensions, they might suffer opportunity losses because of the ignorance of appropriate allocation of their savings to various asset classes. Namely, we show in this paper there is a huge difference in outcomes under alternative asset allocation decisions. Those differences represent shortfalls in pension wealth. Therefore, we argue that both illiteracy about required saving on one hand and ignorance about the appropriate asset class decision on the other will play crucial role in determining well-being of masses in the not so distant future if the points we make in this paper are not taken to knowledge.