Exploitative Contracting in a Life Cycle Savings Model

Abstract

Pension reforms in OECD countries endow individuals with more responsibility for their financial security in retirement, raising concerns about their ability to select appropriate pension arrangements and save adequately. This paper analyses the interaction between a present-biased individual and a profit-maximising financial provider in order to examine the properties of exploitative savings contracts and the impact of common policy interventions. Using a tractable theoretical model, I find that naive present-biased agents are offered contracts that are `inefficiently cheap' (low-yield, low-fee) when the income effect of an interest rate change dominates in the agent's utility function, and `inefficiently expensive' (high-yield, high-fee) otherwise. Subsequently, I embed the interaction with a pension provider in a numerical life-cycle framework with hyperbolic discounting. Under the benchmark calibration of the model, the savings contract prevailing in market equilibrium is Pareto inefficient and reduces the agent's pension wealth by 10%, lowering expected annual consumption in retirement by 3%. This generates a loss of consumer welfare corresponding to 0.18% of annual consumption.