Social Security Reform Around the World: Lessons from Other Countries

Studies | International | Social Security

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


Introduction

Figure I - Relationship Between Percentage of the Population Over 60 Years Old and Public Pension Spending

1The presidential election of 2000, followed by the establishment of the President's Commission to Strengthen Social Security, put Social Security reform on the political agenda in the United States. In its final report, the Commission proposed reallocating part of the Social Security payroll tax to individual accounts that are invested in the financial markets - a recommendation that was welcomed by some and attacked by others. The debate is likely to accelerate over the coming year, and significant changes in our current system may be forthcoming.

"Over the past two decades, 20 countries have adopted private funded accounts to partially replace their pay-as-you-go systems."

The United States is not unique in its willingness to pay attention to this issue. Over the past decade, many countries around the world have instituted major structural reforms. This study places the U.S. debate in an international perspective. It explains the problems that have led countries to reform, outlines some of the commonalities and differences in those reforms, and considers their applicability to the United States. The most important commonality is the shift toward greater prefunding in accounts that are privately managed, as an important part of the mandatory Social Security system.

It may come as a surprise to many to learn that, compared with other developed countries that have not yet reformed, the U.S. Social Security system is relatively healthy. Yet it is clearly not sustainable at its current contribution and benefit rates, since cash outflows will exceed inflows in just a few years. The challenge we now face is how to cover this gap in a way that:

  • Is fiscally balanced and contains mechanisms to keep it sustainable in the long run;
  • Is good for economic growth, thereby increasing the welfare of both old and young;
  • Is administered in a cost-effective way;
    Avoids excessive risk - both political and financial market risk; and
  • Distributes its costs and benefits equitably.

The experience of other countries may help us find an answer to that challenge.

Cross-sectional analysis shows that public spending on formal pension plans increases exponentially as populations age. [ See Figure I.] In developing countries today, only 2 percent to 3 percent of gross domestic product (GDP) is spent on old age security. But in many industrialized countries this figure already exceeds 10 percent and will grow still higher in the years ahead. Because of its young demographics, U.S. expenditures on old age security are now only 6 percent of GDP, but this number will escalate when the baby boomers start to retire. Public spending on pensions and health (primarily Medicare) combined is already almost double that amount. Programs for the old are by far our largest civilian public programs, and they are destined to grow further.

"Ten more countries are considering the adoption of personal retirement accounts."

With such large sums involved, how this money is generated and spent can affect the entire economy. It influences the quantity and productivity of labor and capital and therefore the size of the GDP pie. For example, high payroll taxes for old age pensions may discourage employment or work effort among the young; and subsidized early retirement may reduce the supply of experienced labor, which will be especially harmful as populations age. In contrast, pension plans that accumulate retirement funds in advance can help to increase long-term national saving, productivity and growth. Also, with such large sums involved and so many people dependent on old age programs, it is important to structure the programs so that they remain fiscally sustainable, even as external conditions such as life expectancy change in unexpected ways.

Increasingly aware of these broad effects, countries have been reforming their systems to have beneficial effects on the economy as well as to provide a more secure old age income. They have done so by a structural reform that adds a funded privately managed defined contribution component to their existing mandatory Social Security systems. The establishment of individual accounts with part of the Social Security tax, which has been proposed in the United States, is a typical form that such a structural reform might take.


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