Social Security Reform Around the World: Lessons from Other Countries

Studies | International | Social Security

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

How Countries Have Reformed and How They Manage the Funds

Figure IV - Number of Countries with Reformed Social Security Systems

To avoid these dangers in the future, 20 countries (from Latin America, Europe and the Asia-Pacific region) have reformed by incorporating prefunded, privately managed retirement accounts into their mandatory Social Security systems. [See Figures IV and V.] In most of these countries, somewhere between 6 percent and 12 percent of payroll is contributed to the funded plan. We can learn from the methods they have developed for managing the funds and handling the concomitant issues of risk, cost and equity.

The experience of the last 20 years shows us that structural pension reform is difficult but possible - even in democracies and welfare states. These structural Social Security reforms have certain commonalities, but also many differences - as a result of different initial conditions and political economies. The most important commonalities are:

  • A partial shift from pay-as-you-go to prefunding, with private management of the funds;
  • A partial shift from defined benefit plans to defined contribution plans;
  • Separate arrangements or "pillars" for the poverty-prevention part of the old age system (the public pillar) and the retirement savings part (the private pillar); and
  • Government regulation over the private pillar.

The term "privatization" has been applied to these Social Security reforms, but it would be more accurate to call them public-private partnerships, since each sector plays an important role - the public sector regulating and providing a social safety net, the private sector investing the funds.

Figure V - Number Covered by a Mandatory Private Plan%2C 1982-2000

The reforming countries also exhibit important differences, chief among them the nature and size of the public pillar and the question of who chooses the investment managers in the private pillar. This paper focuses on funding and how the funds have been managed.

Why Prefunding? Most analysts now agree that some prefunding is desirable for the sustainability of a pension system and for the broader economy. It is good for the finances of the system because a given contribution rate will support a higher expected benefit rate under prefunding than under pay-as-you-go.

  • The rate of return in a pay-as-you-go system is (approximately) the rate of wage growth plus the rate of population growth, both of which raise the payroll tax base that finances benefits. With a stable population and a wage growth rate of, say 2 percent, this yields a 2 percent rate of return to contributions.
  • In contrast, the rate of return in a funded system is the return on investments, which historically has been more than 5 percent in real terms for a mixed portfolio of stocks and bonds.5

"Funded systems give workers higher rates of return on contributions than pay-as-you-go systems."

This means the individual will get a larger pension from his contribution to a funded system. Thus if the support ratio is 2 and the target benefit rate is 40 percent of the average wage, a pay-as-you-go system requires a 20 percent contribution rate, but a funded system in which the funds earn a 5 percent real return requires only a 7 to 8 percent contribution rate. So a funded system shrinks the burden on younger workers and avoids the peak tax rates that would be required under a pay-as-you-go system as the population ages.

Figure VI - Returns to Publicly Managed Pension Funds

Prefunding is also good for the broader economy because it can help to build and mobilize long-term national saving. Saving, in turn, facilitates capital accumulation. Moreover, empirical analysis suggests that saving that is committed for the long term, as is the case for retirement savings, is especially productive.6 It increases the size of the GDP pie that will later be available for people to consume. If savings are suboptimal to begin with, due to public or private myopia or a tax wedge between social and private returns, the increase in future consumption is valued more than present consumption forgone by the savings. Everyone can then be made better off. Thus, mandatory Social Security saving can be an important ingredient of a long-run strategy for increasing productivity and output, enabling the standard of living to remain high when the ratio of retirees to workers increases. Long-term national saving can of course be increased in other ways, such as paying down the national debt, but retirement accounts is one of the most effective ways.

"Mandatory retirement saving can be used to increase a country's productivity and output."

However, prefunding mandatory retirement accounts will increase national saving only if it does not crowd out other private savings or increase public dissaving. Regarding the first point: if workers believe that a prefunded system is more credible than a pay-as-you-go 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. Regarding the second point: if the buildup of pension reserves relaxes fiscal discipline or if the government finances the transition solely through issuing additional bonds, this will mean that increased public deficits have absorbed the increased personal saving. The choice of debt finance versus other means of financing the transition will be discussed further below.

Why Defined Contribution? In a defined contribution plan, the worker contributes according to a fixed schedule (e.g., 3 percent of wages per year) and these contributions, together with the investment returns earned, eventually turn into retirement income. This creates a very close link between contributions and benefits. It is designed to discourage evasion and has few labor disincentives.

Most important is the impact on early retirement. Generally, defined contribution accounts are turned into annuities or other forms of gradual withdrawals when the worker leaves the labor market. For those who retire early, the annual annuity or withdrawal will be relatively small, because it must cover many years. For those who work longer, the annual benefit will automatically be larger, if it is adjusted on actuarially fair terms. Those who retire early bear the cost of their early retirement in the form of lower accumulations and benefits rather than passing the costs on to others and undermining the financial viability of the scheme, as occurs in most defined benefit plans. This provides an incentive for continued work, which increases the nation's labor force and productive capacity. The conversion of savings into annuities or other withdrawals on actuarially fair terms, which is characteristic of funded defined contribution plans, is thus good for the economy. It is also good for the sustainability of the Social Security system, particularly as longevity increases, since it provides an automatic mechanism for encouraging workers to raise their retirement age - but each individual makes his or her own choice. This avoids the need for a series of collective decisions about retirement age, which are difficult for politicians to make.

Figure VII - Returns to Publicly Managed Pension Funds

"Returns to privately managed funds outpace returns to centrally controlled accounts."

Why Private Management of the Funds? While many analysts now agree on the benefits of funding, a big issue in the United States concerns how these funds will be managed. Who should choose the investment managers and how much should we constrain worker choice? Practically all countries that have adopted structural reforms in recent years have chosen private control over the funds - believing that this maximizes the likelihood that economic rather than political considerations will determine the investment strategy and will produce the best allocation of capital and the highest return on savings. In some Organization for Economic Cooperation and Development (OECD) countries (e.g., Switzerland, Australia, Denmark and the Netherlands), for historical reasons, employer and/or union representatives choose the investment managers for employees of an entire company or for all the members of an occupational group. In Latin America and Eastern Europe (e.g., Argentina, Chile, Mexico, Hungary and Poland), workers choose the investment managers for their own individual accounts in the retail market. And more recently an "institutional market" approach has been adopted in countries such as Bolivia and Sweden. Under this approach, fees are negotiated centrally in order to gain for numerous small accounts the low fees that large institutional investors usually pay. In all these cases, the investment managers are private companies, ultimately chosen by private rather than public sector agents.7

"Private control means economic, rather than political, factors will control investment decisions."

These countries have all been influenced by empirical data that show publicly managed pension reserves around the world earn low returns, far below the rate of return on bank deposits or the growth of per capita income, and frequently lose their principal as well. [See Figures VI and VII.] This is largely because public managers have been required to invest in low-interest government securities, make loans to failing state enterprises or invest in other politically motivated investments. Moreover, with publicly managed funds politicians are subject to pressures to raise benefit payments rather than to invest (for example, this happened in the early years of the U.S. Social Security system). The hidden and exclusive access to these funds also makes it easier for governments to run larger deficits or to spend more wastefully than they could if they had to rely on a more accountable source of funds. Some economists believe this happened in the United States beginning in the 1980s, as the Social Security trust fund built up and was used to finance the growing public deficit in a nontransparent way.8

"Government-owned, centrally controlled pension funds make it easier for governments to run larger deficits or spend more wastefully."

In contrast, as can be seen in Figure VIII, 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. They reap the benefits of investment diversification, including international diversification, which enables them to increase their yield and reduce their risk. They build constituencies that help them resist political manipulation. They spur financial market development by creating a demand for new financial instruments and institutions, especially important in middle-income countries. In Chile, the systemic reform implemented 20 years ago has made financial markets more liquid as the number of traded shares on the stock market and their turnover increased; has created demand for the equities of newly privatized state enterprises; has encouraged the emergence of information disclosure and credit-rating institutions; has expanded the variety of financial instruments including indexed annuities, mortgage and corporate bonds; and has improved asset pricing. These developments have played a particularly important role in explaining Chile's rapid growth rate since it started its new Social Security system.9

Figure VIII - Returns to Privately Managed Pension Funds

"Privately managed pension funds earn a higher rate-of-return than public funds without incurring additional risk because their holdings are more diversified."

Some critics of private management have argued that the United States is different from the African and Latin American countries that misallocated and dissipated their publicly managed pension funds. They argue that we should prefund, and the funds should be invested in securities markets, but that the government should manage the funds and choose the investment strategy, in order to benefit from scale economies and financial expertise. Canada and Ireland are now experimenting with a centrally managed trust fund that will be invested in a diversified portfolio, hoping that they have built in legal safeguards that will protect them from political manipulation and will make them the exception to the rule. It is too soon to tell whether they will succeed.

The United States does indeed have governance procedures and trustee laws that would prevent gross abuses of a publicly held trust fund. However, we also have pressure groups, intensive lobbying and campaign contributions that influence policy formation. If funds were publicly managed, we could imagine these pressures being brought to bear on issues such as: Which companies, industries and indexes should be the focal points for investment? Which products (e.g., tobacco, abortion pills) should be prohibited for investment? Should the funds be used to prop up the stock market when it is falling or to temper it when it is soaring? Should antitrust actions be started and profit-reducing regulations be imposed on companies in which the public fund has major investments? Should the government as regulator provide insider warning to the government as investment manager, before starting regulatory actions that might hurt stock prices?

"If public funds are invested in the private markets, it is reasonable to expect that political considerations will interfere with prudent investment choices."

Such pressures on fund allocations will not maximize the financial returns to the system or the productivity of capital in the economy. They could also lead to wasteful spending of resources to influence these allocations. Public control of Social Security funds would concentrate a lot of market power in one large investor and could lead the government to play a large and largely unhealthy role in the governance of corporations in which it has invested. Moreover, it would be extremely tempting for the government to use these funds as a hidden source of deficit finance, enabling it to spend more and tax less in the short run. But this means that, in the long run, the funds would not be saved - the payment of pensions would remain an increasing liability of future taxpayers. For all these reasons, private decentralized management of the funds seems to be in the best interest of the pension system, the broader economy and the general polity. In the U.S. context, this would imply individual accounts.

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