Social Security Reform Around the World: Lessons from Other Countries

Policy Reports | International | Social Security

No. 253
Friday, August 30, 2002
by Estelle James

Executive Summary

Social Security reform is one of the most prominent domestic policy issues in the United States. The U.S. is not alone in facing the daunting challenges posed by its retirement security program. The gross implicit unfunded debts of retirement security programs in developed countries (that is, the amounts they owe current pensioners and workers) far surpass the official explicit federal debt. The same is true of the net implicit liabilities, adjusted for projected future rights and contributions.

  • The United States' gross public pension debt is more than 100 percent of Gross Domestic Policy (GDP).
  • Public pension debts in Italy and Japan are more than double their official federal debts and the two combined exceed 240 percent of GDP.
  • France and Germany shoulder public pension debts four times the size of their official federal debts.

Paying this debt will put a huge strain on public treasuries and on these economies more broadly. Under traditional systems, either benefits will have to be cut below scheduled levels, or contributions will have to rise substantially.

Recognizing the problem, 20 countries have made funded private retirement accounts (PRAs) for 80 million workers part of their mandatory retirement security programs. Many other countries are about to do the same. The reformed systems in these countries have many differences, but share certain characteristics:

  • The private retirement accounts represent a partial shift from a pay-as-you-go system to a prefunded system.
  • They represent a partial shift from defined benefit (DB) plans to defined contribution (DC) plans under which retirement income is determined by contributions plus investment earnings.
  • The account balances, and their contribution to national saving and economic growth, increase through time.
  • Contributions to the private accounts are compulsory for new workers and sometimes for current workers as well; the investments are regulated; and the private accounts are integrated with the remaining public program.
  • Future benefits to retirees under the new social security system come from two places the public DB and the annuity from the individual's own account. Part of the pension is financed by assets in the accounts, rather than by contributions coming from young workers.

Reformers in the United States can take several lessons from the experiences of other countries around the world. In constructing their systems of funded private accounts, these countries have grappled with problems that we will face, as we decide how to shape our system. Their solutions are not necessarily right for us, but they do show us that solutions exist and they provide us with a menu of tested options.

Lesson 1: Private sector control over personal retirement accounts is more profitable than a centrally controlled pension reserve. The average privately managed pension fund around the world earned a large positive rate of return, that far exceeded inflation and wage growth, during the last 30 years. By contrast, the average publicly managed pension fund lost much of its capital during the same time period. This occurs for two reasons

  • Public managers are often required to invest in low-interest government securities, as is the case with the U.S. Social Security system, or are pressured to make politically motivated investments.
  • Hidden and exclusive access to centralized pension reserves makes it easier for governments to run larger deficits or spend more wastefully than they could if they had to rely on a more accountable source of funds.

Competitively managed private pension plans are more likely to invest in diversified portfolios and to resist political manipulation.

Lesson 2: Individual accounts can be created in a way that minimizes administrative fees.

  • In Chile, administrative costs relative to assets have fallen substantially as assets have grown, and now amount to less than 1 percent of assets per year for an average worker who contributes for 40 years. This is lower than the fee paid by the average mutual fund investor in the US.
  • Most Organization for Economic Cooperation and Development (OECD) countries, like Switzerland, Australia, Denmark and the Netherlands, use group plans with an employer and/or union choosing the investment manager, which often produces administrative costs that are far lower than those in Chile.
  • Bolivia used a competitive bidding process to choose two investment managers, thereby cutting out most marketing costs.
  • In Sweden, pension authorities established a maximum fee schedule for fund managers and mandated central collections and record keeping. Administrative costs are projected to be less than 0.5 percent of assets per year in the long run.

Lesson 3: Personal retirement accounts, if structured properly, do not involve undue risk. Reforming countries typically reduce risk by 1) encouraging diversification of pension fund investments; 2) guaranteeing absolute or relative returns; and /or 3) instituting a pension floor or other benefit from tax-financed sources that supplements the personal account.

  • Chile and other Latin American countries started with a list of quantitative regulations over permissible fund investments but they have gradually liberalized.
  • Switzerland requires a nominal return of at least 4 percent of assets, over the worker's lifetime with an employer.
  • Several Latin American countries provide a minimum pension guarantee; Argentina provides a flat (uniform) public pension to all eligible workers; Australia sets a floor through a means and asset-tested old age pension.

Lesson 4: Reformed systems can continue the redistribution of income. In some cases, the reformed systems redistribute income from high earners to low-income earners better than traditional pay-as-you-go programs, which are biased against people with shorter life expectancies.

  • Argentina's flat pension (about 25 percent of the average wage to all workers with at least 30 years of contributions), disproportionately benefits low-income workers. Chile's minimum pension guarantee goes mainly to low earning women.
  • Australia's means and asset-tested public old age benefit goes to the bottom 2/3ths of workers in the income distribution.
  • In Switzerland, a public benefit that is almost flat, financed by a payroll tax that has no ceiling, accompanies the personal accounts, so the net result is a very redistributive old age pension that also reduces risk.

Lesson 5: Reform involves transition costs. Borrowing temporarily to transition to a funded system does not increase the size of a country's total public debt. Instead, it transforms a hidden implicit debt into a transparent explicit debt. Because this pension debt stops growing when personal accounts are created, eventually it can be paid off.

All Latin American and Eastern European countries have funded their personal account systems by moving some portion of the workers' contributions from the public system to the private, in what is known as the carve-out approach. This creates a transition cost. But in the course of reform, the total pension obligation of the government has actually been reduced in almost every country. By contrast, most OECD countries have avoided the transition cost by mandating additional contributions. They can use this approach because they started with a modest public benefit and contribution rate.

Currently, some 80 million workers in 20 countries have access to personal retirement accounts. These countries include Chile, the United Kingdom, Switzerland, Denmark, the Netherlands, Argentina, Colombia, Peru, Bolivia, Mexico, Uruguay, Australia, Hungary, Kazakhstan, Poland, Latvia, Sweden, Hong Kong, El Salvador and Croatia (roughly in the order in which they adopted the plans).

Macedonia, the Dominican Republic, Kosovo and even China have passed reform laws, which they are now in the process of implementing. Other countries are moving in that direction. Interestingly, the United States is not yet on this list.

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