Default options provided by governments should be safe, simple, and trustworthy. Governments should protect consumers through regulating truthful advertising and facilitating efficient pension markets. However, guarantees are not sufficient if the issuer could default, so the default option must be free from default risk.

1. Junk Science and Consumer Financial Protection Zvi Bodie Norman and Adele Barron Professor of Management Boston University June 3, 2010

2. Key Points Default options should be safe, simple, and trustworthy. Governments should protect consumers by enforcing trustworthy advertising. Governments should facilitate the efficient production of pension accounts by completing markets for building-block securities. Prices should be set by competitive markets that are closely supervised by trustworthy public organizations.

3. Junk science about investing You can lower the prefunding cost of a future objective by investing in assets which offer a premium for taking risk. Guarantees have a cost only when they pay off. Probability of loss is an adequate measure of risk. Diversification across asset classes always reduces risk. Investing in stocks is risky in the short run, but not in the long run. Stocks are a good hedge against inflation.

4. Consumer perspective The primary function of a pension system is to provide retirement income security. Citizens in industrialized societies expect their government to provide a social “safety net.” Paradox of too much power: Government cannot credibly commit to refrain from bailing out large pension plans that fail. Thus, even in the absence of explicit guarantees, there is an implicit one.

5. Guarantees as the default option A guarantee transfers investment risk from consumers to producers, who typically have far greater knowledge and skill in handling it. It increases trust, and therefore results in lower marketing costs. It makes it more transparent to consumers what they are buying, and therefore reduces the need for costly financial “education.” BUT, it is not enough to have guaranteed products if the issuer of such products can itself default.

6. A default option should be free of default risk The prospect of default can make unified and “simplified” products more risky and complex than individual stand alone non-unified products…. if everything is linked into a single package for simplicity, then failure to deliver on the promises of that product are far more devastating than failure on some stand-alone product which is part of the individual’s total portfolio.

7. Who should produce pensions? Economies of scale Government Employers Trade unions Other intermediaries Government guarantees invite hidden subsidies and moral hazard

8. Role for the government Issue “building-block” securities Long-dated inflation-indexed bonds Per capitaconsumption bonds even better Price government bonds and guarantees through competitive auctions Enforce truth in advertising