June 4, 1998

June 4, 1998 | Lecture on Social Security

Social Security Reform in Other Nations

This lecture was held at The Heritage Foundation on April 9, 1998.

Countries all around the world are reforming their social security systems. We see this happening throughout Latin America and in several OECD (Organization for Economic Cooperation and Development) countries, and now we have a wave of reforms beginning in Eastern Europe and the former Soviet Union. This shows that reform, although it is politically difficult at first, is indeed possible even in democracies. And the basic reasons for reform are similar throughout the world.

First, countries see that populations are aging, and they are going to encounter major fiscal problems if they don't change their systems.

But second, there is a more positive reason, which is that a change from the old traditional pay-as-you-go, defined-benefit type of social security system to a system that includes more funding, more individual accounts, and a closer link between benefits and contributions is good for the overall economy. It helps middle-income countries develop their financial markets. It helps all countries develop their long-term saving, which seems to be linked to capital formation and economic growth. And, beyond that, it is more equitable because despite the mythology that has surrounded old traditional systems--that they are equitable, that they are redistributive toward low-income groups--people are beginning to realize that the facts show otherwise and that systems are available that are both more efficient and more equitable at the same time.

The Structure of Reform

In the countries that are undergoing structural reforms, a multi-pillar structure is developing. This also happens to be the structure recommended by the World Bank, and we are glad that many countries are moving in that direction.

The new structure consists of two mandatory parts. One mandatory part--or pillar--handles people's retirement saving, the funded accounts that people are required to have. This pillar is a defined contribution instead of defined benefit, thereby linking benefits closely with contributions. Benefits are funded rather than pay-as-you-go, and the funds are privately managed. That is really the centerpiece of the structural reforms.

This pillar is always buttressed by another mandatory pillar, which is a publicly managed tax-financed arrangement designed to provide a social safety net to protect low wage earners.

That's the basic system we find in countries that are instituting structural reforms.

In addition, there is always a third, voluntary pillar for people who want more consumption and income in old age. But I am going to talk mainly about the mandatory part of the system. Despite the fact that this is the general model that reforming countries are following, they are following it in many different ways, and I will talk about the major variations that we see developing around the world.

Defined Contribution vs. Defined Benefit

Let me explain briefly the arguments for the characteristics of that middle pillar--that middle, mandatory saving pillar, the pillar that handles people's individual savings accounts.

It is defined contribution rather than defined benefit. The rationale is that this links benefits closely to contributions. Therefore, it should reduce the incentive for evasion. Evasion is a big problem in many countries. Evasion can run up to 50 percent of the labor force. But the smaller the tax element, and the closer the link between benefits and contributions, the smaller the incentive for evasion.

Perhaps more important, it discourages early retirement and makes the system less financially sensitive to early retirement decisions. Furthermore, it adjusts the retirement age upward, or the benefit rate downward, automatically as longevity increases.

This is really important, because a characteristic of defined-benefit programs in most countries is that people can retire early at rates that are not actuarially fair. So if you retire early, over your lifetime you collect a larger lifetime benefit than you do if you retire later. This is a bigger incentive for people to retire early. David Wise has done a study which shows that this incentive, in fact, is very closely linked to people's decisions to retire early. In some cases, this produces a very high implicit tax on continuing to work, and people respond to that high implicit tax. In some countries, the implicit tax is as high as 70 or 80 percent because people are foregoing a large benefit if they continue working.

This imposes a huge financial strain on the social security system. And it's bad for the economy because it reduces the experienced labor force.

When you retire, in a defined-contribution plan, you turn your capital accumulation into an annuity on actuarially fair terms. So if you retire early, you get a lower benefit. This has two advantages. It makes the system financially sustainable and, since you're not passing the cost on to others, you're discouraged from retiring early.

In addition, as longevity increases in a defined-benefit system, politicians face the very difficult task of raising the retirement age continually to keep up with the longevity increases. In a defined-contribution system, this process happens automatically without a difficult political decision. Either people voluntarily retire later, or they find themselves faced with lower annual benefits, which in turn leads them to postpone their retirement.

These are some of the reasons why we see this partial shift to defined contribution as desirable.

The Shift to Funding

We also see a shift to pre-funding, as compared with pay-as-you-go. This avoids unaffordable promises, which most developed countries have made by now. But the developing countries that we're dealing with haven't made them.

At the World Bank, we are urging them not to make those unaffordable promises. That avoids the large payroll tax increases that you get as populations age in a pay-as-you-go system. It avoids the intergenerational transfers that automatically take place--income transfers to the early cohorts that retire away from their children and grandchildren. And it helps to build long-term saving.

Many countries, including the United States, feel that they have a shortage of long-term saving. It is true that we have global capital markets and to some extent we can import capital, but it is also true that domestic investment seems closely tied to the rate of domestic saving, and this in turn is a source of economic growth. So funding can be an important source of long-term national investment and growth if it is part of a set of policies designed to increase public and private saving.

Higher Rates of Return Through Private Management

Why should the middle pillar of mandatory saving be privately and competitively managed? The important point here is that this maximizes the probability that investment decisions will be based on economic rather than political considerations. It therefore maximizes the real rate of return to society and the monetary rate of return to the pension fund.

At the World Bank, we have assembled data on rates of return to publicly and privately managed pension funds, and we show that publicly managed pension reserves around the world have fared poorly. In most countries, in fact, they have earned negative real rates of return.

The reason is that the investments have been politically dictated. Often they have to be invested exclusively in government bonds--we see that in the Social Security Trust Fund. But sometimes they are invested in special-issue government bonds that yield negative real rates of return. In addition, sometimes they have to be loaned to failing state enterprises that are going bankrupt. The pension funds are used to bail them out.

In any event, for a variety of reasons, if the funds are publicly managed, it is very difficult to avoid political objectives creeping in. And these can conflict with the economic objective of maximizing the economic rate of return. Decentralized competitive management is most likely to get you an efficient allocation of capital.

In addition, for the middle-income countries that the World Bank deals with, funded, privately managed pension plans can be a very important way of developing financial markets, and in fact this has been shown to have played a very important role. Econometric studies of Chile's rapid rate of economic growth during the past 15 years, for instance, indicate that the funded pension plans played a major role, in particular in developing financial markets. The development of financial markets is given credit for an increase in total factor productivity of about 1 percent per year.

The Latin American Model

These pension reforms are taking somewhat different forms in different parts of the world. In particular, I want to talk about three types of reforms.

The Latin American model more or less follows the model set by Chile in 1980. Chile was, as you know, a pioneer in social security reform. But that system has spread now throughout Latin America to Argentina, Mexico, Peru, Bolivia, and Uruguay. It is going to sweep South America and is moving to Central America.

Interestingly, it has just been adopted by Hungary and by Kazakhstan. I would expect that, in one form or another, in the next three to five years this kind of reform is going to be sweeping throughout Eastern and Central Europe and the former Soviet Union, always with variations dictated by country conditions.

The key features of the Latin American model are:

  1. Workers choose the investment manager.
  2. Workers have individual accounts and can move their individual accounts from one pension fund to another.
  3. The pension funds are very much like mutual funds, but they operate subject to regulations that are set up by the countries.

Another key feature of the Latin American model is that there are transition costs. Pre-reform, a large contribution was being made to a pay-as-you-go system. When some of that contribution is diverted to the individual account, you still have the obligations remaining from the old pay-as-you-go system. Somehow, you have to cover those transition costs.

This is a big problem, and it has stymied a lot of countries. It really slowed down the reform process in Eastern and Central Europe. But, in fact, it turns out that the transition cost problem can be solved, and I will talk for a minute or two at the end about how it has been solved in these countries.

A major criticism of the Latin American model that has been raised--and I mention it because it is sure to surface in the United States as an important factor--is the issue of administrative cost. Chile has been criticized for having high administrative costs, stemming in large part from high marketing costs. I just want to say three things about that.

First, I think the administrative costs in Chile have been overstated, because there were heavy start-up costs. There always are when you're instituting a new system.

Second, in Chile all the fees are front-loaded. That is, you pay when you make your contribution, but you don't pay annual expenses based on your accumulated assets. Naturally, in the first few years of the plan, when contributions are high relative to assets, this looks like a big subtraction from your rate of return. But as time moves on and your assets grow relative to your annual contributions, it will be a much smaller subtraction from net return. These costs have been coming down over time as a percentage of assets. Simulations show that for a worker who contributes for 40 years, the fee structure in Chile will amount to less than 1 percent of assets annually, which is more or less comparable to what mutual funds in the U.S. charge. So this is in part a red herring.

Nevertheless, my third point is that even 1 percent is pretty high for a mandatory system. It is something we have to think about seriously, and we have to develop ways to bring it down.

The OECD Model

The second main model that we find developing is what I call the OECD model. Australia is a key example of this model. You also find it in Switzerland, Denmark, and the United Kingdom.

A key feature of the OECD model is that rather than having individual accounts with individual choice, you have group choice. That is, the employer and/or the union trustees choose the investment manager for the company or the occupational group as a whole.

This course was taken in these countries for historical reasons. They had a large number of collectively bargained plans; and when they added their mandatory savings tier, it was easier and more politically acceptable to build on these plans and simply say "We are going to have group choice."

The advantage of group choice is the possibility of economies of scale and expertise, which may keep costs down. But the possible disadvantage is the principal agent problem. The investment manager your employer chooses for you may not be the investment manager you would have chosen for yourself. This manager may not use the investment strategy that you want. You may not think it's the best investment manager for you.

As a result, we see in these countries some choice for workers beginning to emerge--as we in the U.S. have in 401(k) plans, for example. The employer may say, "You can choose any fund you want from among this family of funds." Furthermore, we see in the United Kingdom, and also to a smaller extent in Australia, policies that allow people to opt out of the employer's plan into their own personal account.

So I think that pure group choice is not really a viable political equilibrium. Pressures develop to give people some individual choice. But these OECD countries started with group choice, and still are predominantly group choice.

The other really important feature of the OECD countries is that these countries typically had very modest first pillars. Australia just had a means and asset-tested publicly financed safety net, and Switzerland had a modest pay-as-you-go system. So when they decided they needed a second funded tier, they just added it on. They said, "Well, we had this small tax-financed public pillar. It's clearly not going to be enough as the population ages, so we're going to add on a mandatory saving component." Since they did not divert contributions, there was no transition costs problem in these countries.

The Swedish Model

The third model--which I give to you with a question mark--is the Swedish notional account system. It has been adopted also in Italy and Latvia. To some extent, it is on the verge of being adopted in Poland. China would like to have a funded individual account system, but they can't figure out how to finance the transition; so far, they have a notional individual account system.

The basic idea of the notional individual account system is that, ostensibly, it is defined-contribution instead of defined-benefit but it remains pay-as-you-go. People have individual accounts. They have bankbooks that show their accumulations and the interest that they are earning on the accumulations. But there is actually no money in those accounts. There are no assets. It's virtual; it's notional.

The theory behind this is that you get the advantage of defined contribution and the closer link between benefits and contributions. Yet the system basically remains pay-as-you-go.

On the one hand, this means the countries don't face transition cost problems. In fact, the countries that have adopted this system have done so precisely to avoid facing the transition cost problem. The money keeps flowing into the pay-as-you-go system.

However, it also means that the countries don't get the benefits from funding. They don't get the buildup of long-term national saving or financial market development. They don't avoid payroll tax increases in the future, or intergenerational transfers.

From my way of looking at it, the minuses outweigh the pluses, but these countries have decided that is the way they want to go. Typically, they will have a small funded component, such as 2 or 2.5 percent. In Sweden, collection and record-keeping for the funded component will be centralized, workers will choose the investment manager from among a long list of mutual funds, and the money will be moved in large blocs. Poland is planning to have a larger funded component as well as the notional account.

Basically, the notional account is another way of setting up a large first pillar, the public pillar, and most of these countries are going for a small funded, privately managed second pillar.

Covering Transition Costs

These are the major variations that you see around the world. Let me now explain the ways the Latin American countries, and now Hungary and Poland, are going to cover their transition costs. There are four main methods.

  1. Downsizing
    The most universal is to downsize the old system. Usually, the old system is too generous to begin with. It is unsustainable, and it has to be downsized. You cut the benefit rate; raise the retirement rate; change the indexation method, often from wage indexation to price indexation; and eliminate the abuse of disability.

This is almost universal. We find this in practically every country that has reformed. And I would say that it's essential.

  1. Other sources of revenue
    You can use other revenue sources to help pay the existing pensioners--such as a surplus in the treasury or the social security system. Chile had that. We in the U.S. happen to be in the fortunate position that we may have a budgetary surplus that we can use for this purpose.

Some countries have just privatized or will privatize state enterprises, and they are allocating some of those revenues for pension reform. Kazakhstan, for example, has oil revenues. So you can look for special revenue sources or other assets that you can use to offset these pension liabilities that you're paying off.

  1. Partial pay-as-you-go
    You can keep part of the new system pay-as-you-go. No country has made a total switch from pay-as-you-go. Some people say Chile made a total switch, but I consider that a misnomer because workers did have a choice. Some workers, particularly older workers, stayed in the old system. Furthermore, Chile does provide the social safety net, the minimum pension guarantee, that is financed out of current taxes.

So the typical way is to keep older workers in the old system but let younger workers choose. Some countries even allow new workers to choose, which I think is a big mistake. It is not a sustainable way to go.

When you keep part of your system pay-as-you-go, this means you keep some revenues flowing into the pay-as-you-go system. That helps to pay your current obligations. That is the plus. The minus is that, at the same time, you are building future obligations to the people who are making those contributions.

So you have this trade-off between meeting your immediate cash flow needs and, on the other hand, worrying about your longer-term obligations. I think it is a danger to go too far in this direction, but it is a method that all countries have used to one extent or another.

  1. Debt finance
    Finally, if all these other methods still leave a financing gap, you can use a combination of debt finance and a temporary tax that is used to retire that debt. If you make a large transition, I think that some debt finance is inevitable. It spreads the transition costs over many cohorts rather than just making the first few cohorts bear the entire burden.

You often hear people say, "Oh, you can't make a transition because this one cohort will be paying for their own retirement and for the retirees' retirement at the same time, and it's too heavy a burden." Debt finance is a way of spreading it out.

On the other hand, if you just have a small transition to individual accounts, there is less argument for debt finance. In any event, you would want to pay off that debt pretty quickly to get the advantages of long-term saving.

When considering debt finance to finance the transition, you might say, "This is bad; the financial markets won't react well to this." Indeed, the IMF used to discourage pension reforms on the grounds that it would be increasing the explicit debt. But the IMF has changed its position on this because they now recognize that temporary debt finance is just a way of transforming an implicit debt into an explicit debt. It is really not increasing the debt. In fact, if it is part of a pension reform program, it is decreasing the debt in the long term. Hungary even got an increase in its credit rating from Moody's when it did its pension reform partly financed by debt, because Moody's saw this as a signal of long-term fiscal control.

Relevance for the United States

Let me comment on the relevance of this for the United States. Which of these models is more appropriate? Basically, the U.S. could really go either way--that is, with the Latin American model and some transition costs or the OECD add-on model and no transition costs--because we have a relatively modest pay-as-you-go system by international standards.

I think we do face some important trade-offs, however. I hear, from talking to people and from reading the newspapers, a lot of interest in having individual accounts, but the numbers that people are talking about are very small numbers such as a 2 percentage point carve-out or a 2 percentage point add-on to payroll taxes that would go into an individual account.

If we don't have an add-on, because people equate this with a tax increase, and if we are reluctant to have a large carve-out because of the transition cost problem, then we are stuck with very small individual accounts. A 2 percentage point individual account means, for the average worker, about $500 a year going into the individual accounts. Even for high-income workers, it means only $1,300 a year.

This is a small amount, and we know that there are economies of scale in this business. So if we have a very small account, we may not benefit from economies of scale, and we will have to think very carefully about how to run these accounts on a cost-effective basis. Probably we will have very limited choice for workers in order to reap some of those economies of scale.

On the other hand, if you have a larger account, which would probably require an add-on, that gives us the possibility of great choice for workers in their investment options while still reaping the economies of scale and permitting more generous benefits as well.

I think we're going to end up with some individual accounts, but important issues will be what should the size be, what kind of safety net should we retain, what will the impact be on administrative costs, and how much choice can be allowed consistent with keeping administrative costs low? All of the countries outside of the notional account countries have individual accounts with contributions varying from 7 to 10 percentage points, but they also have total contribution rates (for the first and second pillars combined) that are much higher than ours.

We need to do a lot of thinking about that, and looking at the experience of other countries can help us.

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