Social Security Reform Around the World: Lessons from Other Countries

Policy Reports | International | Social Security

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


Twenty countries in Latin America, Europe and the Asia-Pacific region have structurally reformed their Social Security systems over the past 20 years to make the systems more sustainable, equitable and growth-enhancing. At least another 10 countries are considering such reforms. They have tried to achieve these beneficial effects by increased prefunding, with the investment managers chosen on a competitive basis by workers, unions and/or employers. They have tried to insulate the system from political pressures that might emphasize short-run gains over long-run stability. The funded private arrangement has been accompanied by a publicly managed social safety net, for risk diversification and mitigation as well as redistribution. While the reformed systems in most of these countries are still too new to evaluate, Chile's 20-year-old pension reform appears to have made a major contribution to that nation's high economic growth rate.

What does all of this imply for the forthcoming Social Security debate in the United States? Despite the very real problems in our system, it is healthier than those in many other countries that have not yet reformed their systems. Our benefit rate is modest, our retirement age realistic and rising, and actuarial penalties discourage early retirement. Yet we will have to do something to maintain the solvency of the system. We can cut benefits and raise contribution rates, or we can change the basic structure. Since we have to change the system in some way, we should give a lot of thought as to what is the best way. We should choose a fix that lasts, instead of one that will prove insufficient after 10 years. And we should think about how the various proposals will affect the aggregate economy. For example:

  • Keeping the payroll tax low can help preserve incentives for employees to work and employers to hire labor;
  • Penalties for early retirement and rewards for continued employment can increase the supply of older workers;
  • The shift toward individual savings accounts can generate a stock of investable resources; and
  • Private management of these funds can help ensure that investment decisions are based on economic rather than political considerations.

"The longer we wait, the more difficult and expensive it will be to enact reforms."

Most analysts on all sides of the political spectrum now believe that some prefunding is desirable - to make the financial balance of Social Security less sensitive to demographic change, to reduce the pension debt we bequeath to our children and grandchildren, and to build national savings for the long term. But once we agree to prefund, the question immediately arises: Who should manage the funds? And here there is greater disagreement. Some argue that a single centrally managed fund backing the current defined benefit formula would be cheaper and better than a shift to individual accounts. However, the experience of many countries suggests that it is difficult to insulate publicly managed funds from political manipulation and this manipulation leads to low rates of return for the economy and the pension funds. Moreover, a Social Security surplus that is under the government's control may increase government's deficit spending rather than saving. This is the basic rationale for private competitive management. Despite much controversy about the administrative costs and fees in such a scheme, analyses of retirement savings plans in the U.S. and abroad suggest that it is possible to carefully design the system to keep these low.

As discussed above, most of the financing for these accounts can come from a carve-out of the existing contribution rate - so long as policy makers are willing to cut benefits from the pay-as-you-go pillar that would remain, below the level that is currently scheduled. Based on the experience of other countries, this cut would be gradual and would not affect current pensioners. The reduced defined benefit would be largely or fully recouped through annuities purchased by the assets in the personal accounts of contributing workers. The fact that the individual accounts are likely to earn a rate of return higher than the return in a pay-as-you-go scheme helps to restore these benefits without the large increase in contribution rate that would otherwise be necessary. Moreover, if the higher rate of return corresponds to increased saving, labor supply and productivity, this enhances real output and enables the real income of both retirees and workers to increase.

This paper has surveyed some of the key implementation issues, including how to contain administrative costs and risk, how to achieve an equitable distribution of benefits and how to cover transition costs. These issues are difficult, but they are not unsolvable. Other countries have solved them. The report of the Commission to Strengthen Social Security demonstrates that we can solve them, too. The longer we wait, the fewer our degrees of freedom and the more benefits will have to be cut or contribution rates raised. The sooner we reform, the larger the accounts baby boomers will build up before they retire, hence the less painful the transition will be. Policy makers will be doing the country a service, as well as acting on behalf of our children and grandchildren, if they reform Social Security now.

NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.

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