February 26, 2002 | Lecture on Social Security
The ongoing congressional debate over Social Security reform will inevitably accelerate this year. Its outcome will profoundly affect the quality of life for every American, especially young American families who today are working and saving for retirement.
The President's Commission to Strengthen Social Security, spearheaded by former Senator Daniel Patrick Moynihan (D-NY), recently concluded that the prosperity of future generations of retirees will be determined by their ability to create wealth during their working years. To that end, the commission recommends that younger workers be allowed to invest a portion of the payroll taxes that they now pay into the Social Security system in a personal retirement account, and it outlines three options Congress should consider to accomplish that objective.2
Before deciding on the course that Social Security reform will take to improve retirement security for all Americans, Congress should take note of lessons learned from the pension reforms that have occurred in various countries in Europe. The experiences of these countries in moving from an unfunded system to fully funded pension programs well illustrate the opportunities as well as the problems involved in making these changes. Moreover, Congress can learn from them about the high price of delay and indecision.
A Global Challenge
While America faces a serious challenge in its efforts to provide a safe and secure retirement for the next generation of Social Security beneficiaries, the pension problems facing America's friends and allies in Europe are even deeper and more severe. Like the Social Security system in the United States, most European public pension programs are financed on a pay-as-you-go (or pay-go) basis: That is, today's workers pay taxes to support today's retirees. The problem facing both Europeans and Americans is that this kind of social insurance system was created on the assumption that there would be a relatively large and growing class of younger workers who, through payroll taxes, would support a relatively small class of retirees or beneficiaries.
New realities, in both America and Europe, belie the demographic assumptions of the old social insurance system. While the ratio of workers to retirees in the United States is now slightly more than 3 to 1, it is expected to decline to little more than 2 to 1 by 2030. In Europe, the situation is considerably more grave. In Italy, for example, the ratio will fall to 3 workers for every 2 pensioners by 2030, when today's baby boomers are well into their retirement years.
Learning from the European Experience
While there clearly are differences in the nature and degree of the pension problems facing America and Europe, Americans nonetheless have a lot to learn from what Europeans are doing to cope with the pension crisis. Perhaps they may have even more to learn from what European countries are not doing, for in this arena, inaction can have even more dramatic consequences than taking the risks involved in change and reform.
For these reasons, The Heritage Foundation--with the assistance of Hardy Bouillon, President of the Centre for the New Europe (CNE), a prominent public policy institution based in Brussels, Belgium--convened an international conference in Washington on precisely what Americans can learn from the European experience in pension policy.3 The presentations at the Heritage-CNE conference offer American policymakers, particularly Members of Congress, an overview of:
Opinions differ. But the conference presentations are both provocative and rich in data and analysis. Peter G. Peterson--former Secretary of Commerce in 1972, now the President of the Concord Coalition, and author of an excellent book on this topic titled Gray Dawn--provides an overview of the impact of an aging population and the gravity of the challenges it presents to U.S. policymakers in managing Social Security and Medicare reform. Dr. Wilfried Prewo--chief executive of the Hanover Chamber of Industry and Commerce in Hanover, Germany--offers his perspectives on the European pension crisis, with particular attention to German problems. David O. Harris, a research associate at Watson Wyatt Worldwide in the United Kingdom, recounts the progress of pension reform efforts in Britain, Switzerland, and Sweden. Michal Rutkowski--a pension expert at the World Bank and a former Director of the Office of Pension Reform in Poland--describes the intensity and variety of public pension reform efforts in Central and Eastern Europe. Finally, Estelle James, a consultant to the World Bank and author of Averting the Old Age Crisis, outlines the components of European pension reform policies with reference to their economic impacts.
President George W. Bush's bipartisan commission put forward options for Social Security reform. Members of Congress can draw on the experience of other nations in developing their approach to reform or their refusal to make the tough choices for serious reform. They may have time to discuss the issue. But for many Americans, they have no time to waste.
Robert E. Moffit is Director of Domestic Policy Studies at The Heritage Foundation and served as host for the conference on "What Americans Can Learn from the Coming European Health Care and Pension Crisis."
The list of great hazards facing the world in the 21st century--take global warming as but one example--is long and generally familiar. Yet there is a less understood challenge--the graying of the developed world's population--that may actually do more to reshape our future than any of the others.
A demographic iceberg looms ahead in the future of the largest and most affluent economies of the world: the challenge of global aging. What's visible above the waterline is the unprecedented growth in the ratio of elderly to working-age people, whose numbers are projected to shrink dramatically. What lurks beneath the surface are the wrenching fiscal and economic costs that threaten to bankrupt even the greatest of powers, the United States included. To date, the developed countries have accumulated roughly $70 trillion in unfunded liabilities for pension and health benefits--an unsustainable lien on the future that is six times greater than their official public debt.
Unlike many other predictions about the future, global aging is not a mere hypothesis. It is as close as social science comes to a certain forecast. Absent a Hollywood catastrophe--a colliding comet or an alien invasion--it will surely happen. The elderly of the first half of the 21st century have already been born and can be counted, and the future costs of current retirement systems can therefore be projected with a fair degree of certainty.
What remains to be seen is whether humankind can gracefully accommodate the new realities global aging brings in its wake. Global aging will not adjust to our visions. We will have to adjust to it. The likely adjustments, as I explain in my recent book, Gray Dawn, threaten to restructure the economy, reshape the family, redefine politics, and even rearrange the geopolitical order of the next century. But nowhere, I suspect, will they raise more daunting questions--economic, political, and ethical--than in the arena of health care.
Like many others, I once associated the coming age wave with the retirement of America's baby boom generation. But in fact, it is a global phenomenon brought about by two more fundamental demographic trends: rising longevity and falling fertility. The entire developed world is aging, and the crisis is due to hit Japan and Europe sooner and harder than it hits the United States. Consider, for example, the following "demographic tidbits."
A Falling Ratio of Workers to Retirees. To express the phenomenon of aging in graphic terms, I use the phrase the "Floridization" of the world's population. In my research, I calculated the dates at which the percentage of various countries' populations that is made up of the elderly would equal what it is in Florida today. The U.S. population won't reach its point of Floridization until 2023, but Italy will be there in 2003, and Germany in 2006.
These aging trends will soon put an unprecedented burden on working-age people. In Japan, which did not experience a baby boom, the number of workers who are under 30 years old will fall by a stunning 25 percent by 2010. By the 2020s, the total working-age population will be shrinking in every developed country, with the possible exception of the U.S.
This has profound implications for the economy. Because health care and pension systems almost everywhere are designed on a pay-as-you-go basis, it is very important to look at the ratios of workers (who pay taxes) to retirees (who receive the benefits). The average ratio in the developed world as a whole today is about 3 to 1. In countries such as Germany and Italy, this ratio may well fall to 1 to 1, or even less, by the 2030s.
Explosive Growth in "Old" Old. Consideration should also be given to a statistic that is heartening in humanistic terms but daunting in its fiscal impact: a population explosion of the "old" old (those who are over 85). The official projections--which do not include the possibility of revolutionary biomedical breakthroughs--indicate that, over the next 50 years, there will be a six-fold increase in the number of people who are over 85 and a 16-fold increase in those over 100.
The implications for health care spending of this "aging of the aged" are truly staggering. Overall in the United States, per capita health spending on the old elderly (aged 85 and over) is three times greater than spending on the young elderly (aged 65 to 74); for nursing home care, the ratio is over 20 to 1. Already today, before the age wave rolls in, the roughly 15 percent of the population that is elderly consumes roughly 40 percent of all health care dollars.
Declining Fertility Rates. Another demographic trend that aggravates the situation is the very large drop in fertility rates. Thirty years ago, the average global fertility rate was about 5.0 births per woman. Today, it is barely half this rate.
The reasons for this decline may not be fully understood, but they include a combination of affluence, urbanization, an increase of women in the work force, and the legalization of abortion and birth control. In order to keep a population stable, a replacement rate of 2.1 births per woman is necessary. Today, the average fertility rate for the world's developed countries is about 1.6, and the rates for many of the European countries are well below that number. For example, Germany has only 1.3 births per woman. The fertility rate in Italy is just 1.2, and in the north of the country, it is less than 1.0.
The United States finds itself in quite a different situation. Its higher fertility rate--now 2.0--together with our higher immigration rate means that America, alone among the major developed countries, will see significant population growth in the decades to come.
The outlook for developing countries is radically different from that of most developed countries. Although the average birth rate for developing countries has fallen, it is still substantially above the replacement rate. In 1950, of the 12 most populous nations in the world, seven were developed countries. By 2050, only the United States will remain on that list. Replacing the others will be Nigeria, Pakistan, Ethiopia, Congo, Mexico, and the Philippines.
Graying means paying. Spending on public pensions is due to rise by 4 percent to 6 percent of GDP in most developed countries over the next 30 years, and this may be a conservative estimate since the official projections assume that the historical pace of improvement in longevity will slow and that fertility rates will rebound from today's low levels. Pensions, moreover, are not the only public cost that will be rising. Add in health benefits, and the fiscal burden is due to rise by 9 percent to 16 percent of GDP in most of the developed countries.
In the United States, programs like Social Security are discussed euphemistically with language that suggests that they are funded when, in fact, they are not. The term "Social Security trust fund" should be near the top of the list of oxymorons of our time. There are, in truth, no assets in trust: There are only liabilities. The concept of a trust fund may be a remarkably convenient accounting and political fiction, but it has no impact in the fiscal or economic arenas. For all practical purposes, when pension payments are due, the options for action are identical, with or without a "trust fund:" Benefits must be cut, taxes must be increased, or money must be borrowed.
It is often claimed that Americans have no need to worry because the trust fund will keep Social Security "solvent" until the year 2038. Granted, that's a year that seems to be too far away to be worried about, but the real-world situation is clearly different from that claim.
Simply put, the government is faced with the challenge of financing the operating deficits of a pay-as-you-go system. In the period between 2016 (when the boomers retire) and the 2038 "magic date," the nation will owe more than $12 trillion in aggregate Social Security deficits. Even in today's dollars, that's nearly $5 trillion--a figure that would be at least twice as large if we include Medicare.
Spending Cuts: Not Enough to Meet the Need
The projected growth in benefits--between 9 percent and 16 percent of GDP by 2030 in most of the developed countries--is several times what the United States currently spends on defense alone.
Some people assume that this increase in spending can be balanced by cutting expenditures in other areas, but the idea of solving the crisis by cutting other spending is not realistic. By the 2020s, the projected expenditures for senior benefit programs would, in many countries, crowd out all other government spending.
Tax Increases: Also Not Enough
Another way of looking at the problem is to determine the level of tax increases that would be required to pay current benefit promises. A country-by-country analysis reveals that increases in the payroll taxes in each of the developed countries would have to be between 25 percent and 35 percent of payrolls.
In Europe, this increase would be added to payroll taxes that often approach 40 percent already. In the case of Italy, for example, payroll taxes would claim nearly 70 percent of a worker's pay. This is unthinkable--politically, economically, and morally.
Borrowing to Pay for the Age Wave: Also Not an Option
Needless to say, all developed countries cannot simultaneously run deficits equivalent to 9 percent to 16 percent of GDP. By the 2030s, government borrowing to finance rising pension and health benefit costs would consume the total savings of the developed world, leaving nothing for private investment. Long before then, global financial markets would bring the experiment to an unpleasant halt.
Some people claim that these projections are too pessimistic. In fact, they are optimistic. Many biogeneticists who have reviewed the aging trends have said that the official estimates on longevity are, in fact, extremely low. Recently, a group of experts of the Organisation for Economic Co-operation and Development studied longevity trends in a number of developed countries and concluded that the odds are very high that longevity, indeed, is going to be much greater than official estimates indicate. For example, they projected that the average life span in Japan in 2050 will be eight years longer than the official estimates upon which the above fiscal projections were made.
Another factor that could influence the accuracy of projections is the fertility rate. Nearly all of the official estimates assume, for reasons that are not clear, that the fertility rate is going to go up in the developed world from 1.6 to between 1.8 and 2.1. In light of current sociological trends, this is not necessarily a prudent assumption.
"Growing Our Way Out" vs. the Facts
Lacking an adequate response to the crisis, there are those who simply say that we will "grow our way out of this problem." They had better confront the following facts.
When confronted with these projections, many people complain that they are unsustainable. But that is exactly the point. A humorist in the Nixon era, economist Herb Stein, once said, "If something is unsustainable, it tends to stop," and, taking it a step further, "If your horse dies, we suggest you dismount."
The point that I'm trying to make is that we're going to have to reform these programs in order to make them sustainable. The question is not "Should we reform them?" but "How? When? And under what circumstances?"
I am a strong supporter of moving Social Security toward a system of funded personal accounts, but some of the advocates of such reform in America tend to minimize the huge transition costs that such a move would entail. In the process of transition, there will be a period in which two systems--the old system and the new system--must be funded at the same time. Thus, while I favor moving toward personal accounts of the type that Chile and Singapore and several other countries have, I want to ensure that they are funded.
Funding will require hard choices. Diverting a small percent of the existing payroll tax cannot provide adequate funding. The hard truth is that some combination of benefit reductions and new contributions is required. In the case of Social Security, these reductions can be humane and gradual, such as a staged increase in the retirement age or an "affluence test."
Unfortunately, any discussion of even the most gentle benefits cuts tends to generate an outcry. For my suggestions of reforming Social Security and other programs, I have been called an "intellectual Dr. Kevorkian" and my plan, the "intellectual bridge to the 16th century."
Regarding the issue of health care in the United States, the reform of Medicare is an even more thorny issue than the reform of Social Security. This is because health care reform raises deeply ethical, moral, and philosophical issues, not just fiscal ones.
Much of what has been said about health care reform is based on rather fallacious assumptions. One assumption is that there is currently a lot of waste in this system. But what appears to be waste in the eyes of a stranger tends to be essential care from the perspective of a loved one. One physician's idea of waste is another's idea of good medicine. While eliminating waste may be one aspect of solving the problem, it is only one among many. There are more fundamental reasons why heath care costs are going up so rapidly--above all, new technologies and rising expectations about care and cure.
Public opinion policy specialist Dan Yankelovitch has coined the phrases "maximum rights" and "minimum rights" in discussing the public benefits offered in America. Although Americans consider it unconscionable to let people go hungry (all people have a minimum right to sustenance), we don't say that the needy should dine at the Four Seasons.
Yankelovitch says that, with regard to health care, the nation is moving close to a "maximum rights" concept. We switch on multimillion-dollar MRI units more or less at random. Our terminally ill patients are in intensive care units getting all sorts of heroic intervention. We perform heart bypasses on septuagenarians at rates no other country does. Compared with Canada, the United States has seven times the radiation therapy units and eight times the MRI units per capita. Compared with Germany on a per-capita basis, it has four and a half times as many open-heart surgeries.
A comparison of an intensive care unit in Europe and the United States reveals sharp differences. From what I have witnessed, the intensive care units in Europe account for between 1 percent and 5 percent of hospital beds; in the United States, between 15 percent and 20 percent. As one health care expert wrote, "The common patient in an American ICU unit is an 85-year-old whose heart is failing, whose lungs are failing, and who is in need of artificial respiration."
It strikes me that Americans are inverse Victorians. We're very happy to talk about our sex lives and the most private details of our lives, yet we have great trouble discussing the issue of dying. The British, in contrast, have developed a whole profession around wills and discuss the issue of death freely, but they don't discuss their sex lives with nearly the same abandon that many Americans do.
Leo Durocher once said, "I don't want to achieve immortality by being inducted into the Hall of Fame. I want to achieve immortality by not dying." We have almost reached the point in America where we think there's an option not to die.
The vast majority of experts say that new technologies (and the more intensive use of existing technologies) accounts for the unprecedented rise in health care costs in America, where approximately 15 percent of GDP (nearly double the percentage in other developed countries) is spent on health care.
The issue of senior benefits--and especially health benefits--involves a difficult combination of sociological, cultural, psychological, philosophical, and ethical considerations. I do not pretend I know the answers, but I do want to clarify the questions that the experts must deal with.
One of the first decisions that must be made is how the size of the overall health care budget should be determined. How do we make the trade-offs between public spending on health care and public spending on other collective national priorities? What criteria do we use to decide that it is more in the national interest to spend an additional dollar on health care than on education, cleaning up the environment, or defending democracy?
In an aging society, health care expenditures will surely grow as a percentage of the national product, but just as surely, we are also going to have to devote more resources to educating the young workers whose productivity we expect will support us in our old age.
Allocation of Resources
Second, within the budget, how do we allocate limited resources? How do we go about thinking of the health of the young versus the old--how much to invest in prevention versus treatment, how much to invest in acute care versus chronic care, and, once we've made these decisions, who pays? Today, most public health benefits for the elderly are paid by young workers. Can we continue to move further and further in that direction?
Third, how will we implement any concept of a global budget when it comes to real-life decisions? Who will have the most say--the patients, the providers, or the bureaucrats? If we adopt a government-managed program, will there be an explicit list of maladies and treatments that will be covered? If we move toward a pure voucher system, will we insist on requiring and enforcing minimum standards of care? And, under any system that allows individual choices, how will we deal with the vexing problem of adverse risk selection?
Fourth, the transition to global budgeting is going to be very difficult unless we change the culture of the providers. How do we do this? How do we get professionals who have been steeped in the admirable and idealistic idea of the Hippocratic Oath to make cost-effectiveness an important criterion?
Study after study in America has shown that physicians respond to identical symptoms in very different ways with very different price tags. The history of technology in health care reveals that we rarely get rid of old diagnostic and treatment techniques. New ones are simply added to the old ones. One of the reasons for this is the potential for litigation. A doctor who had the option of using two tests, one of which may be more accurate, may still be sued if he did not use both.
Public acceptance is another issue to be faced. Any transition to global budgeting is going to be slow and difficult and may even result in a political crisis. Americans, as I suggest, are blessed and cursed by their refusal to accept limits. We expect our doctors to do everything that can be done. In European countries and elsewhere, citizens entrust their doctors to decide what the appropriate treatment should be.
Probably the most toxic phrase in American politics is "health care rationing." Former Governor Richard Lamm of Colorado dared to ask why we spend such extraordinary amounts without significantly improving quality of life in the last few months of life. Claude Pepper, I think it is fair to say, "nuked" him very effectively. We haven't heard a word about the issue since.
In George H. W. Bush's presidency, the state of Oregon came up with a list of 714 diagnostic categories that had been ranked by doctors, labor unions, clergy, nurses, and business people. The idea was to prioritize runaway Medicaid spending. In essence, the reaction from the White House was, "My God, that is rationing!"
But this is inescapable. Rationing can be done in a variety of ways: implicitly through vouchers, and explicitly through Oregon-like lists. But at some point, we have to give up some potentially beneficial medical services if we are to address the problem of skyrocketing costs.
Nobel Prize winner George Stigler once observed curtly, "If you have no alternative, you have no problem." It does seem to me that we have no alternative but to reform our old-age benefit systems. Sooner or later, we will have to invest ourselves, our energy, and our expertise in making some very tough, but very necessary, choices.
Peter G. Peterson is Chairman of The Blackstone Group in New York. He is also President of The Concord Coalition and author of Will America Grow Up Before It Grows Old? and Gray Dawn: How the Coming Age Wave Will Transform America--and the World.
Over the next 30 years, the proportion of the world's population that is over the age of 60 will nearly double, from 9 percent to 16 percent. This phenomenon of "population aging" is due to a sharp drop in the birth rate; hence, relatively fewer young people combined with an increase in life expectancy in recent years.
In industrialized countries that are members of the Organisation for Economic Co-operation and Development (OECD), nearly 30 percent of the population will be over age 60 by 2030. The population of the United States is still young compared with most European countries, but the portion of its population that is over 60 will increase from 17 percent to 28 percent within this period.
Cross-sectional analysis shows that public spending on formal pension plans increases exponentially as populations age. In developing countries today, only 2 percent to 3 percent of GDP is spent on old age security; but in many industrialized countries, this figure now exceeds 10 percent, and it will grow still higher in the years ahead. Because of its young demography, expenditures in the United States on old age security are now only 6 percent of GDP, but this number will escalate when the baby boomers start to retire. Programs for the old are, by far, the nation's largest civilian public programs, and they are destined to expand further in the future.
With such large sums involved, how this money is generated and spent can affect the entire economy--influencing the quantity and productivity of labor and capital and, therefore, the size of the GNP pie. For example, high payroll taxes for old age pensions can discourage employment or the work effort among the young, and subsidized early retirement can reduce the supply of experienced labor, which will be especially harmful as populations age. Both high payroll taxes and subsidized early retirement would have a negative impact on economic growth. In contrast, pension plans that accumulate retirement funds in advance help to remove these distortions and to increase long-term national saving, which enhances economic growth.
The demographic transition has brought pension reform to the forefront of the U.S. and European policy agenda, and its impact on growth of the economy and sustainability of the social security system is important for both the old and young. The wide-ranging impact of the pension system and the interrelationship of numerous factors support the argument for structural, rather than piecemeal, reform of social security systems. Several European countries have already adopted such reforms--and the countries that have done so, not coincidentally, have the strongest economies in Europe, as indicated by lower unemployment rates and higher growth rates than other European countries.
The second pillar is the newest and most controversial aspect of reform. It is based on the premise that a significant part of old age security can be provided by personal savings. Greater reliance on saving can reduce many of the incentive problems associated with tax-and-transfer systems, thereby having a positive impact on the overall economy. The use of part of the social security tax to establish personal retirement accounts, as proposed in the United States, is a typical form that such a structural reform might take.
Over the past few years, many countries have adopted multi-pillar old age security systems. Although structural change is always difficult, preliminary empirical evidence suggests a positive impact on efficiency and growth.
The move toward a multi-pillar system has taken different forms in different countries, but it usually involves transition costs that are spread over several generations. This can be accomplished through some initial borrowing, but with a repayment plan designed to ensure that the transition debt is eventually repaid; otherwise, the increase in personal saving could be canceled out by public dissaving.
During the past decade, with the pace accelerating during the past five years, more than 20 countries throughout the world have adopted variations on the multi-pillar theme. This includes several Western European countries such as the United Kingdom, the Netherlands, Switzerland, and Sweden, and countries as far afield as Australia, Hong Kong, and Chile. This number is likely to increase substantially as the movement toward reform spreads throughout Eastern and Central Europe and the former Soviet Union over the next few years. Examples now show that pension reform is possible, even in democracies and even in welfare states.
The term "privatization" of social security has been applied to these reforms because of the key role assigned private pension and investment companies. However, it would be more accurate to call them "public-private partnerships" since both sectors play an important role.
The public pillar in most reforming countries is publicly managed and largely unfunded but smaller and more focused on redistribution than traditional pay-go defined benefit plans (PAYG DB). Its primary responsibility is to provide a social safety net for the old, particularly the old whose lifetime income was low.
Although the general characteristics remain constant, there are significant differences among the public pillars of different countries. In some countries--for example, Chile, Mexico, El Salvador, and Kazakhstan--the first pillar simply provides a minimum pension guarantee (MPG), a promise that the government will top up the pension from an individual's retirement savings account if it fails to provide an annuity that is at least 25 percent of the average wage. Australia and Hong Kong offer a public benefit that is means- and asset-tested. It is similar to the MPG but takes all income and assets into account for eligibility. This may be fairer, but it is harder to administer.
In the Netherlands, Denmark, Argentina, and the United Kingdom, the benefit is flat (uniform for everyone or uniform per year of covered employment), while in Uruguay, Hungary, and Poland, the public benefit rises sharply with earnings, up to a limit. The first alternative is obviously the least expensive and chiefly targets low-wage earners. The latter alternative is more expensive, but it provides additional co-insurance for middle-class workers. In Denmark, Australia, Hong Kong, Chile, and Mexico, the public pillar is financed through current general tax revenues, while in Switzerland, it is financed by a payroll tax with no ceiling on taxable earnings.
In the United States, proposals abound for each variation of the public pillar. It should be kept in mind that the public pillar is the instrument that shapes the distributional impact of the entire system. Some proposals would put greater emphasis on the new funded pillar of personal savings accounts and would simply rely on the public pillar to provide a minimum pension guarantee.
The plan that would be likely to have the most public support would include a PAYG pillar that would be a downsized version of our current Social Security system--where benefits rise with earnings, but slowly, making it more progressive. This might be buttressed by measures such as a floor on benefits, which is not present in our current system, or possibly by raising the ceiling on taxable earnings.
The second pillar differs dramatically from traditional systems. Its most important characteristics are: It is mandatory; it links benefits actuarially to contributions, often through a defined contribution (DC) plan; it is fully funded and privately, competitively managed.
The funds of the second pillar are referred to in the United States as personal retirement accounts. Contribution rates to the second pillar vary widely, but they range between 7 percent and 12 percent of payroll in most countries. Since this is the newest and most controversial of the three pillars, it is worthwhile to examine the rationale for its fundamental characteristics.
The rationale for mandatory second-pillar contributions is to address a combination of myopia and moral hazard. A significant number of people may be shortsighted, may not save enough for their old age on a voluntary basis, and may become a burden on society when they grow old. In countries that have adopted structural reforms, retirement savings pillars have been adopted as part of the mandatory scheme in order to keep the PAYG tax-and-transfer system small.
Why Defined Contributions?
"Defined contributions" is actually another term for personal saving accounts with a fixed contribution schedule. The worker simply accumulates his or her defined contributions, as well as any returns earned on investments, and eventually converts this into retirement income. In a DC plan, benefits depend linearly on the contribution rate; there is no intervening DB formula that cuts this link. This close link between contributions and benefits is designed to discourage evasion and labor disincentive effects.
Evasion and escape to the informal sector are big problems in many countries, especially developing countries. With DC plans, those who evade payments will bear the cost because they will have less funds accumulated and, therefore, lower benefits. This avoids passing the costs on to others and undermining the financial viability of the scheme.
Importantly, the pension that is eventually acquired through the market is likely to be actuarially fair, meaning that workers who retire early bear the cost themselves, in terms of lower monthly benefits. For this reason, DC plans are likely to discourage early retirement. In essence, this would raise the average retirement age automatically as longevity increases without requiring a legislative mandate that could be difficult for politicians to make.
Many economists believe that saving is too low in the United States and pre-funding could help to change this. Moreover, empirical analysis suggests that saving that is committed for the long term, as retirement savings are, is especially productive. Such savings can be invested productively at home and abroad, can enhance worker productivity and output, and can later be redeemed by individuals to finance consumer purchases. Thus, saving can be an important ingredient of a long-term strategy for increasing productivity and stimulating additional domestic consumption when the ratio of retirees to workers increases.
However, pre-funding retirement accounts will increase national saving only if it does not crowd out other private savings. If workers believe that a pre-funded system is more credible than a PAYG system, they may save less on a voluntary basis for their own old age or borrow more for current consumption, thereby offsetting some of the increased mandatory saving. In the United States, since few people save voluntarily, this offset is likely to be small, except among high earners. The fact that the saving constraint will be more binding for low earners is a reason for targeting the public pillar more closely toward this group.
If the build-up of pension reserves relaxes fiscal discipline, or if the government finances the transition by issuing additional bonds, increased public deficits will absorb the increased personal saving. The largest contribution to saving in the United States is likely to come from the use of the current Social Security surplus--and in the future, hopefully, from a budget surplus--to finance the transition, reducing the funds available for increased government spending or tax cuts.
Why Privately Managed?
Private-sector management of the pension funds will maximize the likelihood that economic rather than political objectives will determine the investment strategies and would help to ensure the best allocation of capital and the highest return on savings. Empirical data show that, throughout the world, publicly managed pension reserves typically earn low returns, far below the bank deposit rate or the growth of per-capita income. This is largely because public managers have been required to invest in government securities or other politically motivated loans that pay low rates of return.
Politicians are also subject to pressures to raise benefits if publicly managed funds are available, which is what happened in the United States in the early years of the Social Security system. Moreover, the hidden and exclusive access to these funds makes it easier for governments to run large deficits or to spend more wastefully than they could if funds were managed by an agent with more accountability.
Competitively managed funded pension plans are more likely to be invested in a mixture of public and corporate bonds, equities, and real estate, thereby earning a higher rate of return. (See Chart 2.) They enjoy the benefits of investment diversification, including international diversification, which enables them to increase their yield and reduce risk. They also build constituencies that help them resist political manipulation. In addition, they spur financial market development by creating a demand for new financial instruments and institutions, which are especially important in middle-income countries.
How the Investment Managers Are Chosen
The most important difference among countries regarding the private pillar is in the arrangements they make for choosing investment managers. Three different patterns have emerged:
If a system of mandatory retirement accounts is set up in the United States, the key decisions that would have to be made are: Who should choose the investment managers, how much should we constrain worker choice, and what are the criteria for firms to enter that market?
How Pre-Funding Increases the Private and Social Rate of Return
The rate of return in a PAYG system is approximately the sum of the rate of wage growth and the rate of population growth, both of which raise the payroll tax base. With a stable population, a wage growth rate of 2 percent, for example, would yield a 2 percent rate of return on contributions. In contrast, the rate of return in a funded system is the return on investments, which historically has been over 5 percent in real terms.
This means that an individual would get a larger pension from his contribution in a funded system. In the current situation, it means that total benefits will not have to fall as far as they would under a PAYG structure--and may not have to fall at all. Moreover, if pre-funding increases national saving, this increase in rate of return also corresponds to an increase in real output, which eventually makes it possible for a relatively smaller working-age population to support a relatively larger older-age population.
While investment in the financial market involves risk, so does every other form of old age security. For example, the public pillar involves substantial political risk. The government has the right to change the benefit formula and has done so many times in every country.
The three pillars, taken together, reduce the totality of risk that old people face by diversifying across types of management (public and private), sources of finance (from labor and capital), and investment strategies (equities and bonds, domestic and international). Risk diversification is especially important given the long time periods and great uncertainty involved. Thus, even though each pillar poses its own kind of risk, a multi-pillar system is likely to reduce risk overall, and therefore to increase the risk-adjusted return.
--Estelle James is principal author of Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth (World Bank, 1994). She is a consultant to the World Bank and Director of its Flagship Course on Social Security Reform. She can be reached at firstname.lastname@example.org.
The European pension crisis is not "coming." It arrived long ago, is now maturing, and will culminate somewhere between the years 2010 and 2025. While the United States also has a social security problem, it pales in comparison with both the current situation and the expected demographic developments in Europe. By 2025, the numerically largest European age group will be those who are retired or about to retire, between the ages of 60 and 65, and the younger age groups (those of working age and their children) will be smaller in each decreasing age bracket.
When discussing European pension systems, we must differentiate among them: All major European countries have pay-as-you-go systems, but reliance on them varies.4 (See Chart 1.) In Germany, for example, 85 percent of pensions are provided by the pay-as-you-go system; in Great Britain, about 65 percent are; but in the Netherlands, only 50 percent are. In turn, about 5 percent of German pensions are funded by occupational schemes [employment-based plans], while in Great Britain, about 25 percent are; and in the Netherlands, occupational schemes make up about 40 percent of pensions. In each of these countries, individual provisions procure roughly 10 percent of pensions.
So there is some variation in the degree to which the European countries rely on pay-as-you-go systems and on occupational schemes. Those with strong reliance on the former--such as Germany, France, Italy, and Belgium--will be hardest hit by the looming demographic crisis, in which funding pensions for an expanding population of retirees will be forced on a decreasing and younger population of workers.
Among European countries, Switzerland probably comes closest to the United States with regard to the percentage of pension funds financed by a pay-as-you-go system. Approximately 42 percent of pension benefits in Switzerland come from that system, while the corresponding figure for the United States is, I believe, 45 percent.
But the similarity in pension funding stops there. In Switzerland, about 32 percent of pensions come from occupational schemes, while in the United States, the share is far less. In Switzerland, about one-fourth of pensions come from individual provi-sions, whereas in the United States, individual pensions amount to more than 40 percent of the total.
In Europe, a strong reliance on the pay-as-you-go system drives up the cost of labor and damages competitiveness. In Germany, the hourly wage in industry is roughly the same as in the United States. However, Germany's indirect labor costs in industry are more than twice those of a comparable U.S. worker; therefore, total labor costs in Germany are approximately 35 percent higher than in the United States. It is these indirect costs that drastically elevate labor costs in Europe, and they are the major cause of sluggish job growth.
In the United States, the indirect labor cost is about 40 percent of direct labor cost.5 (See Chart 2.) In Germany, indirect labor costs total 81 percent of direct labor costs; in France, 93 percent; and in Italy, 96 percent. In Europe, the total labor cost is nearly double the direct labor cost. This inflation in costs is the result of Europe's generous welfare schemes financed by payroll taxes.
In Germany, payroll taxes for health, unemployment, and pensions, plus old-age care, sum up to 41 percent. In 2001, Germany's social security payroll tax is 19.1 percent. (It would be 22 percent if the current government had not imposed an energy tax--under the euphemistic label of an ecology tax--and used the proceeds to subsidize the pension system.)
In addition to the social security tax, there are three other payroll taxes in Germany--13.5 percent for health, 6.5 percent for unemployment, and 1.7 percent for old-age care--bringing the total to 41 percent. Half of the health, unemployment, and pension payroll taxes are paid by the employer and half by the employee, which matters little when you talk about total labor cost and its consequences for competitiveness and employment.
Europe's demographic structure is far more problematic than that of the United States. By 2025, the situation will have worsened in both Europe and the United States, but the problems anticipated for the United States are relatively benign when compared with those of Europe. (See Chart 3.)
For the United States, the distribution of population aged 40 and over still has roughly a pyramidal shape. Below age 40, the size of the age groups is fairly constant, give or take a few dents. This is a harbinger of trouble, since the base of young people paying into a pension system is not expanding. Projecting these trends forward indicates that, by 2025, all age groups in the United States from 0 to 70 will be of similar strength.6
Projections, however, are much worse for Europe. In contrast with the United States, the groups in Europe below age 40 are not of equal size, and are getting smaller for each younger group. Consequently, Europe will face a huge problem in 2025 when the numerically largest age group will be that between 60 and 65 (those who are retired or about to retire) and the younger age groups (those who are of working age and their children) are smaller in each decreasing age bracket--somewhat like the pyramid standing on its head.7 The European population is bound to decline over the next 50 years, whereas in the United States, which is unique among industrial countries, the population will increase, albeit at a reduced rate. (See Chart 4.)
The sustainability of Europe's pay-as-you-go-financed social systems rests on the hope that there are enough working-age people to support those of old age. During Bismarck's time in the late 19th century and even after World War II, the number of old people who relied on the support of those working was relatively small, and many people were entering the labor force. Today, the support ratio (i.e., the quotient of the number of people between ages 15 and 64 divided by those 65 and older) tells a different story. (See Chart 4.) In Europe, this quotient has fallen from 7.0 in 1950 to 4.1 in 2000. By 2025, it will be 2.7; and by 2050, it will be less than 2.0. If 60 percent of those aged 15 to 65 are working at that time, the burden of supporting four retirees will rest on as few as five workers.
A pay-as-you-go-system would be inconceivable in such a situation, since the payroll taxes would be enormous, and the implied labor costs would mean there would be few jobs. This impending crisis is no secret, but few politicians dare to address its consequences.
A discussion of the problems facing European pension systems would be incomplete without a discussion of the possible solutions: which would be suitable and which would not significantly help the situation. The major problem in Europe, of course, is not a lack of awareness of the demographic trends, but rather an unwillingness to point out their consequences.
Immigration is often suggested as a remedy for Europe's demographic dilemma, but it clearly is not the solution to the problem. Western Europe has experienced an influx of immigrants throughout the 1990s, and it is likely to experience further immigration in the coming decades--mostly from Central and Eastern Europe--as a result of the enlargement of the European Union (EU). The immigration of people who are willing to join the European labor force is most welcome for a variety of reasons. However, this will contribute only marginally, at best, to the alleviation of Europe's pension problem.
To maintain the European support ratio in the year 2025 at the level of 1995 (4.3), as many as 240 million immigrants would have to be allowed. Given that the population of the EU in 1995 was 371 million, this would mean adding two-thirds more people through immigration, which is clearly inconceivable. (Incidentally, Japan would need to allow immigration of about 120 percent of its current population level in order to keep its support ratio at the 1995 level.) Even very generous but realistic immigration thus would only marginally alleviate Europe's demographic problem, and by no means solve it.
Increasing Labor Force Participation
Another remedy that is often suggested is to increase labor force participation, especially of women. Though this could help somewhat in countries with a low labor force participation rate, it will not solve the problem.
In Italy, labor force participation is slightly less than 60 percent; in Germany, it is over 71 percent. Even raising Germany's level of work force participation to that of the United States (77 percent) would help only marginally. If the U.S. level is reached in Italy, it would make a comparatively larger difference. But, in either case, it would not solve a problem of the magnitude we are facing.
Systemic Change Toward a Fully Funded System
The hard truth is that substantial changes must be made in the current pension systems. This change can take the form of a radical switch from a pay-as-you-go to a fully funded system, with all its attendant consequences from severe transition costs, or it can take the form of a partial switch with lower transition costs combined with a reduction in pay-as-you-go pension benefits. A reduction in pay-as-you-go benefits would mean lowering the absolute level of pensions or an increase in the retirement age, which of course corresponds to a reduction in the benefit level. Any such reduction will be hard to achieve as an increasing number of voters is retired.
In Western democracies, a switch from a pay-as-you-go system to a fully funded system will not happen overnight. Though their comparatively wealthy societies would be able to shoulder the transition costs, no Western democracy currently has a majority in favor of such a radical switch. At best, we can only hope to achieve a political consensus for a very gradual transition over a long period of time; realistically, the most that can be currently achieved is a funded supplement as a partial substitute for a minor portion of the pay-as-you-go system.
Germany is a case in point: The current Social Democratic-Green government has added a funded tier to the mandatory, payroll-tax-financed pillar of the pension system. Workers are asked to contribute an additional 4 percent of payroll into a funded scheme on top of their current payroll tax approaching 20 percent. Given the dimension of the problem in Germany, a funded scheme based on 4 percent of payroll would seem inadequate to relieve a 20 percent payroll tax scheme. Furthermore, the 4 percent private savings level would only be reached in 2008, starting with 1 percent in 2002.
Yet the seeds of greater change may be contained within this program, in spite of its initial low level and slow start. Just as good food whets the appetite, over the course of 10 years, the returns on even a minimal 4 percent set-aside for private retirement savings could encourage people to demand more, asking for set-asides as high as 8 percent, 10 percent, or 12 percent in the future. This dynamic took place in the United Kingdom where, over the course of just a few years, the possibility of opting out of the state earnings-related pension system has engendered wide public acceptance of privately managed pension funds.
However, if reform takes place gradually, like putting one toe timidly in the water at a time, the temperature better be inviting. The initial experience with innovative reform should be given room to generate recognizable benefits. The German pension reform unfortunately imposes onerous conditions on a nascent funded scheme. My fear is that, under these conditions, the bird won't fly. In the end, the whole idea of individually funded pensions will not be embraced, because it will get a bad rap and send people running back into the claws of the welfare state.
While in principle allowing privately managed funds, Social Democrats and Greens in Germany are suffocating them with a myriad of unnecessary regulations. Based on their paternalistic and machine-age attitude that government should "protect" people, they go overboard in micromanaging the system. For example, the government will only allow funds that will guarantee that no money will be lost over a 10-year period. Consequently, the 4 percent private savings cannot be invested in typical pension funds with a combination of equities and bonds, but in essence will be invested in insurance-type instruments.
To encourage people to save and invest and reduce reliance on a pay-as-you-go system, pension reform also must go hand-in-hand with tax reform--specifically, a switch to the deferred taxation of retirement savings. The Social Democrats have missed that boat because of their ideological hang-ups.
Furthermore, labor markets must be deregulated in order to facilitate employment growth and thus generate both payroll tax revenue and retirement savings. But in countries such as France and Germany, labor markets are being reregulated, with negative consequences for growth and employment already visible in spring 2001. Europe is far away from solving its pension crisis and keeps missing one opportunity after the other for reform. As time goes by, solutions will come with higher adjustment costs.
Above all, we need a supply-side policy mix to spur increased productivity. An increase in productivity will, on the one hand, help us to finance the standard of living for the recipients of the current pay-as-you-go system and, on the other hand, allow us to increase retirement savings.
If, as I suspect, Europeans are not yet willing to discard their comfortable welfare state cushion but at least begin to realize that it is suffocating them, then the only remedy is that they save, invest, and grow their way out of the welfare state. This will require a productivity and investment boom similar to that in the United States, which has been facilitated by a policy mix of tax reform, deregulation of the labor market, and privatization.
Europe is slowly beginning to make headway in tax reform and is taking important strides in privatization. The remaining frontier for reform is the labor market, and progress on this front will be crucial for Europe's prospects for pension reform in the future.
As I once told an acquaintance from Atlanta, I am from the deep, deep South--Australia, that is--where pension reform has been aggressively pursued and implemented since 1993. It is clear to me that, given the situation the United States is confronting, social security reform can, and must, be achieved.
The United Kingdom, Switzerland, and Sweden provide good examples of what can be done. Each of these countries has faced similar demographic imperatives that led to the sweeping pension reforms now underway.
There is pressure across Europe to develop solutions for the problems posed by a rapidly aging population of some 370 million people. In countries where pension reform has become a reality, it is noteworthy that political support from and consultations with trade union groups played an important role.
Typically, the people in "Generation X" in these countries have registered a high level of skepticism regarding the benefits provided by the pay-as-you-go first pillar of pension systems. Pressure is mounting for reform that reminds me of the words of a famed Beatles' ballad; they wonder: "Will you still need me, will you still feed me, when I'm 64?" Certainly in the United Kingdom, and increasingly in other countries, the government will likely play less and less of a role in the future of individuals who reach retirement age.
As Chart 1 shows, throughout Europe there will soon be a rapid decline in the ratio of young people to elderly. Whereas in 1950 less than 10 percent of the population was over the age of 65, by 2025 that age group will comprise more than 20 percent of the population. Conversely, while in 1950 over 25 percent of the population was ages 0 to 14, by 2025 only about 17 percent will be. Many countries, including Italy, Germany, and France, are well aware of this trend. Part of the reason for this phenomenon is the rise in life expectancy.
The first pillar of old-age pensions for most European countries was designed at a time when people were not living as long as they are today. In recent decades, there has been a rapid increase in life expectancies, and geneticists are expected to continue to push the frontier of longevity even further.
Meanwhile, falling fertility rates have contributed to a decrease in the ratio between the younger and older populations. While the United Kingdom has not experienced the baby boom that the United States, Canada, Australia, and New Zealand did, a significant portion of its population will be elderly by 2030. Sweden, likewise, faces a problem regarding the portion of its population that will begin to draw retirement benefits by 2030. And, based on trends within its population pyramid, Switzerland's projections suggest that a large segment of its population will be elderly by 2030.
The elderly in the United Kingdom in 2000 received a basic old-age pension of £66.75 (US$95)8 per week, which is not much when one considers that a train ticket from London to Edinburgh costs £182 (US$260). The pension is basically a flat benefit with some minimum income guarantee and rent and utility subsidies. This low expenditure equals about 4.7 percent of GDP.
There is also a second-tier benefit. In 1975, the government introduced a new program that included the pay-as-you-go need-based (Basic) pension plan (a flat benefit plus a minimum income guarantee) and the State Earnings Related Pension Scheme (SERPS). It is now under revision, and plans are underway for reforms that would convert it to more of a flat-rate benefit (known as S2P).
It is important to note that in the United Kingdom, members of both the Conservative and the Labour parties are committed to developing a plan in which individuals would save more for their own retirement needs and strategies for meeting their health care needs as well. Since 1998, it has not been compulsory for workers to be members of the employer's occupational pension scheme, and individuals have been allowed to develop more of their own retirement plans. The occupational pension schemes in place have a value of £800 billion (US$1 trillion), and an increasing transfer into personal pensions is now underway.
The third pillar in the United Kingdom are personal pensions and long-term retirement vehicles. The newest vehicle for social security reform, hot off the production line in April 2001, is the Stakeholder Pension, which is really a compulsory minimum standard--a simplified generic plan of defined contributions. Its governing structure is similar to existing personal pension plans that involve a trustee arrangement. It breaks down the connection of pension funds to the employer (the employment nexus). Children can have their own individual defined-contribution retirement accounts, in their own names, whether they are seven years of age or six months. This is an interesting step away from existing pension structures in the United Kingdom.
With Stakeholder Pension plans, the government is targeting full-time workers who earn less than £30,000 (US$43,000) annually. The question that must be asked is, are people who are struggling to survive going to put large amounts into these individual accounts, especially if there is a requirement to report these transactions annually to the government? If the answer is "not likely," then this new program may fail to attract its targeted audience of low-income workers and instead attract adults in higher-income households who are not in the workforce but who will use the investments as a tax shelter. People can contribute up to £3,600 ($US 5,000) into these retirement vehicles.
There is no doubt that a wholesale change in the system is underway toward a high-volume, low-margin, simplified defined-contributions plan. The worry for financial service providers is that the maximum (and, effectively, the only) charge that can be assessed on these products is 100 basis points (1 percent). At the same time, these products must be able to accept minimum contributions of £20 ($US29) on an irregular basis.
Such factors assure they will be passively managed funds. The problem: It is not economical to distribute these funds through traditional channels, through agents and intermediaries. We are already seeing the effects--within the last three months, more than 6,900 agents and intermediaries have lost their jobs in the United Kingdom.
While approximately 5 million to 8 million people stand to benefit from these products, at issue is whether participation should be compulsory. Although the Blair government has said that compulsion is not necessary at this stage, some in the industry have said that it will be key to making these products efficient.
Behind the scenes, recent political changes have actively pushed the reform process forward, and the 401(k) pension model as well as Australia's example are being closely examined by the government. The pension mis-selling crisis that took place in the United Kingdom points out a valuable lesson: Haste makes waste. More than 2.5 million people were hurt when they were persuaded to adopt pension schemes that were not in their best interests. It will take another four to five years to resolve the problems that resulted from this scam.
In sum, we can expect the United Kingdom to continue to show strong growth in individually designed defined-contribution products, and in the development of a pension "supermarket" using the Internet and other forms of electronic distribution. These changes will make the system much more efficient.
Now let's look at Switzerland's system. The first pillar of its pension system provides a flat benefit with an earnings-related component. The pension benefit increases in value according to the earnings index.
The second pillar is oriented around occupational defined-benefits schemes offered through "foundations," which are separate from the employer, with a goal at retirement of replacing approximately 60 percent to 70 percent of final pay after 40 years. It is important to note that Switzerland's model, like those of Australia and Chile, has a mandatory second pillar whose benefits generally gravitate around a cash-balance or defined-contribution plan. The problem with this system is that the products offered come with very high compliance costs.
A minimum return of 4 percent is guaranteed in the second pillar. Apparently, a large portion of the investment of these funds is in bonds and fixed-interest deposits. This makes the 4 percent guarantee a difficult challenge, and reserves may have to be tapped to bring every investment's return up to the required amount.
Pension assets in Switzerland are 117 percent of GDP and rapidly increasing. Generally, the conversion rate is approximately 7.2 percent, and it is planned to go down to about 6.5 percent. A reduction in the conversion rate of annuity products will definitely raise concerns. Essentially, people would see their pensions reduced. Competitive effects will be dramatic, certainly in Switzerland, and the generous tax treatment for contributions is quite significant.
Sweden's pension system originally had a generous first pillar with a pay-as-you-go social security structure. The second pillar, an earnings-related supplementary system, also was based on a pay-as-you-go model. Finally, there was a third pillar with investments in the small private annuity market and life insurance companies.
The system was based on the concept that the government would play a central role in the retirement security and health care of its citizens. However, by the late 1980s and early 1990s, demographic trends made it clear that the system, as designed, would collapse. After a parliamentary inquiry in 1994, it became clear that significant reforms would have to be implemented. By 1998, some reforms had been put in place, and they were implemented beginning in the autumn of 2000.
Today, Sweden's first pillar is a Guaranteed Pension similar to its previous basic pension. The second pillar is rapidly changing and may provide a lesson for the United States. While 16 percent of an individual's salary goes to finance the pay-as-you-go pension to support those who are currently in retirement, 2.5 percent also goes into a Pension Premium Account (PPA). It is an income-based pension. To date, as much as US$5 billion has been rushed into these individual accounts managed by fund managers.
The third pillar of Sweden's pension system is comprised of life insurance company products. Today, for the new PPAs, more than 500 funds are offered by more than 120 fund managers--a radical shift away from the pay-as-you-go model. There is no doubt that there is a large bias in this system toward investments, and growth is expected in overseas equities.
There is currently debate within the Swedish government regarding cost containment through pooling individual PPAs. Certainly, if the investments of a substantial number of individuals can be pooled, costs can be contained. This mechanism can provide a valuable lesson for those who are considering reforms in other countries. There is cost containment through the pooling of individual PPAs.
The maturing of the first pillar system may reduce the overall soundness of the retirement system because of a smaller labor supply in the future and the negative perceptions of the contributions being a high tax to fund payments to current retirees. In 2000, total (employer and employee) social insurance contributions equaled 38.07 percent of earnings. That is a large amount in any country.
There is no doubt that a significant shift is underway. Yet Pension Premium Accounts may be just the tip of the iceberg. Already high contribution levels may have to be increased to deal with the aging population. As the system moves toward defined contributions with PPAs, public education will be necessary to enable consumers to make more informed choices regarding their investment decisions.
It should be noted that the Swedish model is highly complex in terms of the interface between the individual funds manager and a quite detailed and complex computerized system. It is taking some time to work through the problems that emerged during the initial "teething" stage of this reform.
There is a strong link between demographic shifts, economic prosperity, and pension reform. Like Australia, the United Kingdom, Switzerland, and Sweden have seized the opportunity for reform and moved rapidly away from the bankrupt pay-as-you-go model.
In 1969, the United States successfully landed people on the moon--a pretty sizeable challenge. I think the United States will find that social security reform, also a significant challenge, can be no more insurmountable than landing on the moon.
David O. Harris is a Research Associate and Consultant at Watson Wyatt Worldwide in the United Kingdom.
As former director of the Office for Pension Reform in Poland in 1996 and 1997, I have firsthand experience with pension reform. My presentation could be titled "Bringing Hope Back to the People of Central and Eastern Europe," since many of the reforms being made today should assure them that they will "still be needed and fed when they are 64." This is an important motive for reform in Eastern Europe.
Today I would like to discuss four aspects of pension reform in Central and Eastern Europe: the progress of pension reforms in transition economies; the design features of the pension reforms in those economies; the similarities and differences between the situations in Central and Eastern Europe and other countries; and, finally, the lessons that we can learn from these pension reform experiences.
What do I mean by "reform" when it comes to Central and Eastern European pension systems? Essentially, I mean moving from a monopolistic, mandatory pay-as-you-go system of defined benefits (which I will call the first pillar of a pension system) to include a fully funded pillar that has mandatory participation (the second pillar) and, ultimately, an option for voluntarily funded participation (the third pillar).
Table 1 offers a side-by-side comparison of the current systems in nine countries in this region: Bulgaria, Croatia, Estonia, Hungary, Kazakhstan, Latvia, Macedonia, Poland, and Romania. Table 2 discusses the reforms in other countries in this region.
Please note that the second pillar is clearly a funded pillar and, therefore, is similar to the third pillar that is voluntarily funded, but--especially in Central and Eastern Europe--also squarely a part of the social security system, with mandatory funding and some special guarantees and regulations. In this respect, it is like the first pillar.
As Table 1 shows, Hungary, Poland, and Latvia have already introduced a multi-pillar system with a sizeable second pillar and an existing third pillar of voluntary participation, while Kazakhstan legislated its mandatory second pillar in 1998. Latvia's reform process was an uncharacteristically long one. The other Eastern and Central European countries in the table are all very advanced in the process of moving from pay-as-you-go (PAYG) monopoly systems to a multi-pillar system.
Latvia substantially reformed its pension system's pay-as-you-go pillar five years ago and introduced a multi-pillar system only this year. Several other countries, such as Macedonia, are in the process of reform, which has been either fully or partially legislated this year. Other states will begin reforms in 2002 (Croatia, Bulgaria, and Estonia) and 2003 (Romania).
In the fourth column of Table 1, the size of the second-pillar contributions is shown as a share of payroll. On average, between 5 percent and 8 percent of payroll goes to a mandatory-funded pillar financed by social security contributions. There are some exceptions to this, of course. Kazakhstan, for example, strictly follows a Chilean approach by mandating that 10 percent of payroll goes into the second pillar.
On the other end of the spectrum, countries such as Latvia and Bulgaria--fearing transition costs and the challenge of filling the gap for pay-as-you-go pensions--have decided to start with a very small (2 percent) second pillar, gradually increasing it to 5 percent and 9 percent of payroll, respectively. This arrangement could in some sense be considered dangerous, given the possibility of political reversals in the government.
The fifth column shows the countries' projected pension fund assets in 2020. While projections for pension assets are less than the 117 percent of GDP anticipated in Switzerland, for example, they are still sizable--averaging close to one-third of GDP. So the reforms are serious, and the portion of the workforce affected by the funded pillar, typically ranging from around 50 percent to 70 percent, is also significant.
The strategies in the different countries may vary regarding who is affected by the reform and in what way. In most countries, reform involves a mandatory switch to the funded pillar for all new entrants and, in some countries, for those below age 30. Typically, the systems will allow some participants a choice regarding the funded pillar. For instance, in Poland those between 30 and 50 years old had such a choice.
It is important to keep in mind that in Hungary there is a possibility of some reversal of reform. Essentially, the current government is contemplating making the second pillar voluntary for new entrants, and there is debate regarding what that would mean for the future of pension reform. I do not believe that it will mean much unless the government at the same time makes the pay-as-you-go pillar more attractive than it is now. It is unclear whether the government is even considering it.
Hungary constitutes a good example of some of the political dangers of reform. The share of payroll designated for the second pillar was intended to be as low as 6 percent only for the first year of reform, and it was intended to grow to 7 percent and then 8 percent. However, due to transition costs and other increased expenditures by the government on other areas, that increase was not realized.
Reforms that are taking place in Latin America provide a benchmark point of reference for Central and Eastern Europe. Those systems are compulsory and universal and allow opportunity for choice. An individual can choose a pension fund from options that include privately managed pension funds, usually joint stock companies. There is also a firewall between the pension industry and other industries which, compared with Western Europe or the United States, are relatively undeveloped.
In Latin America, pensions are managed by specialized firms, rather than by existing investment funds or insurance companies, and there is a strict separation between the assets of the asset manager and those of participants. There is a rule of one fund per company and one fund per worker. The system also includes other investment limitations, such as a rate-of-return guarantee. However, there has been an attempt to make those provisions less restrictive, such as basing the rate-of-return guarantee on 24 months rather than 12 months of activity.
Albania: Some elements of parametric reform in 1993- A two-tier benefit formula, with a base benefit and a wage-related increment; early retirement provisions mostly removed; and indexation according to prices.
Armenia: Some parametric reform-Pensions are almost flat (the formula consists of a base pension and a very limited differentiation portion based on years of service); retirement age increasing by half a year per year until it reaches 63 (for women in 2004) and 65 (for men in 2011); removal of some early retirement privileges; and discretionary indexation (subject to availability of resources). Currently, individual accounts are being introduced, plans for NDC are being developed, and legislation to eliminate remaining early retirement privileges is being developed. No second pillar is envisaged. Medium-term reform plan envisages introduction of the third tier.
Azerbaijan: Main reforms limited to a two-year increase in the minimum retirement age to 62 (for men) and 57 (for women) and a rationalization of occupations benefiting from early retirement provisions. No second or third pillars. Benefits curtailed through arbitrary ceiling on the reference wage and discretionary indexation according to resource availability.
Georgia: PAYG reformed (close to flat rate); retirement age increased to 65 for both men and women; most sector privileges eliminated; no second pillar; third pillar legislation passed but not used.
Kyrgyz Republic: PAYG reformed, NDC basis; retirement age undergoing increase to 63 (for men) and 58 (for women); no second pillar; third pillar legislation drafted under the Asian Development Bank (ADB) program but inadequate and never passed by parliament; many privileges eliminated under reform; disability criteria stricter; some institutional reforms such as coordination with Tax Inspectorate and strengthened accounting; overall reform has led to much lower deficits as well as lower arrears.
Lithuania: Started with the usual retirement age of 60 (for men) and 55 (for women). In 1995, the law increased those ages at the rate of four months per year for women and two months per year for men until a uniform age of 65 was reached. Later, the retirement age was reduced to 62.5 (for men) and 60 (for women). Sector privileges were significantly reduced.
Moldova: PAYG reform; retirement age being increased to 65 (for men) and 60 (for women); length of service requirement tightened; most privileges eliminated; pensions linked to lifetime contribution but in reality very flat. No second pillar; third pillar legislation passed but not used.
Russia: The reform package has been approved by the government. It includes an NDC first pillar and introduces funded early retirement schemes (as the only major reform of the PAYG system), and establishes a second pillar in 2002 with 2% contribution that will increase over time. Financing, design, and institutional issues remain a challenge for implementation of this scheme. A third pillar exists but faces major portfolio risks and has weak enforcement.
Slovakia: The retirement age has not been increased- now 60 for men and between the ages of 53 and 57 for women, depending on number of dependent children. There are still privileges for early retirement, but compared to other countries, the numbers of persons retiring early is relatively limited. Early retirement for persons within two years of regular retirement age who were laid off was abolished in 1999. There is a special system for the armed forces. Until recently, the Slovak system was not projected to go into deficit until 2012. Due to increases in pension payments, however, it is now projected to go into deficit within a few years.
Slovenia: Parametric reform, including moving the retirement age from 63 to 58 for men and from 63 to 61 for women. The third pillar has been legislated. It is serviced by the existing or new specially licensed financial institutions.
Tajikistan: PAYG being reformed gradually (with some reduction in range of pensions given); retirement age is still at 60 for men and 55 for women but will be increased in steps every year starting from July 1, 2001, until 2003 when it will be 63 for men and 58 for women; employees now contribute 1% of salaries, and employers 25% of salaries, to the Social Protection Fund; some sector privileges eliminated; no second or third pillar yet in place; recently passed legislation for individual records to be used (with pilot in Dushanbe).
Ukraine: Drafted legislation on the second and third pillar, which has been approved by the parliament. The second pillar will go into effect in 2003 (or when macroeconomic conditions permit) at 2% of payroll, increasing to 7% of payroll within four years. Voluntary pension funds are operating but are not regulated or supervised.
Uzbekistan: Centralized collection responsibilities in the government's tax committee; pension fund merged into the Ministry of Social Maintenance (with the function of managing pension fund expenditures imposed on the Ministry); enhancing actuarial capacity; contemplating reforms of the PAYG system (currently unreformed), including phasing out early retirement privileges; introducing lifetime assessment (but not increasing retirement ages); and preparing third pillar legislation.
Yugoslavia, Federal Republic of (Serbia and Montenegro): No reforms so far. The public pension system is characterized by low retirement age, generous accrual rates resulting in extremely high replacement rates that are over 120% for old-age benefits, generous early retirement provisions, lax disability certification, and extremely high payroll tax. The system is unaffordable and unsustainable.
While Table 1 and Table 2 provide a general overview of the way pension reform is taking place in different Eastern and Central European countries, Table 3 indicates which elements of pension reform are new and which are not. The new features indicate that:
Pre-reform pension systems in Central and Eastern Europe are unlike those of Western European countries in that incomes are four to five times lower; but they are similar with respect to high coverage and increasing debt. In that respect, also, they are unlike the Latin American systems.
Overall system design differs with Western Europe also with respect to the role of the first pillar, which remains the dominant pillar. In some cases, rather than significantly reform this pillar, it often begins to mimic the second (funded) pillar.
Notional (or Non-Financial) Defined Contributions
In a system of notional, or non-financial, defined contributions (NDCs), each person has an account, and the amount of each worker's contributions to that account can be clearly seen. Though NDCs are unheard of in Latin America, they are becoming quite popular in Europe and in Central Europe.
The Latvian and Polish systems include NDCs in the first pillar, as does the Swedish system. However, that system remains pay-as-you-go, with the pensions of today's elderly being paid by the contributions of the current workforce. Nevertheless, the lifetime sum of contributions at the age of retirement is divided up by the average life expectancy at the age of retirement, so the system tries to mimic funding and tries to create the same microeconomic incentives. Contributions paid when you are young count for the purpose of pensions, unlike typical PAYG DB schemes.
Increases and decreases of pensions, depending upon when you retire, are actuarial, so we often look at those systems and the NDC systems as having several microeconomic advantages of funding without having macroeconomic advantages.
Minimum Pension Guarantees
Solid minimum pension guarantees are another feature of the system in Eastern and Central Europe. Because the first pillar is maintained, there is no need for recognition bonds such as those that were used in Latin America to phase out the first pillar.
Privatization proceeds are important, especially in Poland, where they have been a source of funds to finance transition costs. They are good economically because this is a one-time source of revenue; therefore, financing the one-time expenditure sounds appropriate. It also has much support because privatization revenues help those who are the oldest--that is, those who contributed more to national wealth.
Models for Reform
A number of mechanisms have been adopted to improve on the Latin American design, one of which is calculating the return rate on 24 months rather than 12. Others include making switching of members more difficult and putting restrictions on agents.
Essentially, the reforms provide individuals with ample opportunities for choice. A second generation of reforms in Central and Eastern Europe may include limitations on options for investments and an increasing use of group contracting to lower the costs.
The Central and Eastern European reforms are not strictly replicas of existing models. They draw on the Latin American example, but they also have changed that model significantly, given different initial conditions. This new model of reform could serve as an example for some European Union countries.
In a March 2001 "Learning from the Partners" conference in Vienna, countries seeking accession to the EU were paired with current EU countries. The panelists were asked to talk, not about their own countries, but their partners'. It became clear that the EU accession countries have a better pension system than many of the EU countries. Granted, they have lower pensions because their incomes are lower, but the system is better in terms of sustainability, the role of the private sector, and the expectations of future pensions.
In addition, the systems were less segmented and more transparent. The contrasts between several partners at the conference--for example, Croatia and Spain, Bulgaria and Greece, Austria and Hungary, and Germany and Poland--made this point quite obvious. Of course, each government defended its own system in response. It was an important conference because it made it clear that EU accession countries should be invited to the table not only to learn, but also to offer advice.
There is obviously a great difference between the situation of Eastern Europe and that of Western Europe and the United States. Despite those differences, I firmly believe that there are aspects of pension reform in Central and Eastern Europe that could and should be looked at carefully by the United States and Western Europe. These aspects involve not only how the architecture of the overall system is designed, but also how to manage the flow of contributions as the transition is made to a second or third funded pillar, and how to improve incentives to contribute to the system.
However, because the situations in the West and in Central and Eastern Europe are different, not every aspect of the latter region's reforms will be applicable. For example, the West would not need a firewall between the pension industries and other industries given the development of the financial market.
Without a doubt, some agenda for pension reform is critical for all countries. But it is remarkable to consider how much has already changed in Central and Eastern Europe within the last three or four years, how much is changing in Western Europe today, and the changes that are on the horizon for 2004 and 2005--changes no one would have foreseen in the early 1990s.
Michal Rutkowski is Social Protection Sector Manager for the Europe and Central Asia Region at the World Bank.
1. This Heritage Lecture is based on the proceedings of a conference on "What Americans Can Learn from the Coming European Health Care and Pension Crisis," held at The Heritage Foundation on April 26, 2001. The conference was sponsored by The Heritage Foundation and the Centre for the New Europe. The remarks included here are based on the speakers’ presentations and have been updated and revised by the speakers.
2. For an account of the commission’s recommendations, see David C. John, "Social Security Commission Report Shows Value and Feasibility of Individual Accounts," Heritage Foundation Backgrounder No. 1512, January 11, 2002.
3. For more information on the Centre for the New Europe, Avenue Louise 326, B6,1050 Brussels, Belgium, see www.cne.be.
8. Conversion rates are cited from http://www.x-rates.com as of November 16, 2001, using data from the Federal Reserve Bank of New York and the International Monetary Fund.