Social Security Reform Around the World: Lessons from Other Countries

Policy Reports | International | Social Security

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

Administrative Costs

While prefunding, with private control over the funds, may be beneficial for the sustainability of the system and for economic growth, most analysts agree this should be done in a way that keeps administrative costs low, avoids undue financial and political risk and distributes its costs and benefits equitably.

Are Administrative Costs Too High? The biggest criticism of individual account systems concerns the high administrative cost and fees that have developed in some countries using the Latin American (retail market, worker choice) model. The advantage of private over public investment is the likelihood that it will produce a better allocation of capital, earn higher returns for the fund and spur higher economic growth for the economy. However, if decentralized systems charge high administrative fees, they reduce net returns and pensions. In Chile and most other Latin American countries, fees are front-loaded. This means that workers pay a one-time fee on new contributions rather than an annual fee based on assets. Specifically, this one-time fee is about 2 percent of wages, or 15 to 25 percent of new contributions, in virtually all cases. Ultimately, this makes the pensions 15 to 25 percent lower than they would have been in the absence of these costs. While expenses related to investments and record keeping are inevitable in any system of retirement savings, almost half of these total costs are due to marketing expenses that may be avoidable.

"Experiences in other countries show that personal accounts can be structured in a way that keeps administrative fees low."

To understand the impact of one-time fees on net returns, it is helpful to convert these one-time charges on contributions into their equivalents in terms of annual charges on assets, which is the way most mutual fund charges are assessed in the United States. Obviously, for accounts that have small accumulated assets (young workers with few years of contributions), this fee will be high relative to assets. However, for accounts that have built up substantial assets over the years, the fee will be small relative to assets. Simulations show that if the current fee schedule is maintained, the average Chilean worker who contributes for 40 years will pay the equivalent of less than 1 percent of assets per year.

To put these numbers into perspective, these charges are somewhat less than the fees and expenses found in the average U.S. mutual fund in which millions of individuals invest on a voluntary basis. So the perceived benefits far exceed the costs for many people. Moreover, they are not excessive in comparison to less expensive systems that produce much lower gross and net returns (e.g., publicly managed reserves in Singapore and the U.S. Social Security trust fund). Nevertheless, these costs and fees are a source of concern in mandatory systems where everyone is forced to participate and pay. And they are a particular problem in the early years of a system, when accounts are small.

Investing: The Retail Market, Worker-Choice Method. Most Latin American and Eastern European countries use the retail market, in which investment managers enter the industry and try to attract individual worker-savers. This is much like the mutual fund industry in the United States. Some analysts believe that administrative costs would be lower under a group plan with decisions made by an employer or union. Such group plans may be better positioned to benefit from economies of scale, greater financial expertise and lower marketing costs.10

"The average Chilean worker who contributes to a personal account over a 40 year period will pay less than 1 percent of assets per year in fees under the current fee structure."

Investing: The Group Plan Model. Most OECD countries use group plans - with an employer and/or union choosing the investment manager - and this often produces lower administrative costs. While these plans used to be defined benefit plans, under the new system employers have been shifting to defined contribution plans to avoid bearing the defined benefit risk. When employers or union representatives make the investment decisions while workers bear the risk, as in a defined contribution plan, such arrangements can open the door to financial abuse and principal-agent problems. For example, employers might choose investment managers or strategies that benefit them even if this results in lower returns for their workers. For this reason, we would expect to see greater worker choice - a shift toward the retail approach - in these OECD countries.

Investing: The Institutional Model. A third alternative draws on the experience of the institutional market, in which large investors (company defined benefit plans, foundations, endowments) face much lower rates. The reformed systems in Bolivia and Sweden represent attempts to use or mimic the institutional market to achieve lower fees in their mandatory systems by aggregating numerous small accounts into large money blocs and negotiating a group rate. This alternative may be especially desirable in (1) small countries whose markets cannot support many pension companies efficiently due to scale economies, (2) countries with undeveloped financial markets that want to attract investment expertise and minimize startup costs, and (3) countries with low contribution rates.

In Bolivia, an international competitive auction process was used to select two pension funds to run its mandatory private pillar. Although initially assigned, workers will soon be given the choice between them. This competitive bidding process has resulted in much lower costs than in other Latin American countries.

In Sweden, the pension authorities established a maximum fee schedule for managers of mandatory retirement accounts. Workers are permitted to choose among the large number of mutual funds, but the money is moved in large blocs, records are kept centrally, and funds do not even know the names of the individuals who invest with them - an attempt to avoid sales commissions. The allowable fees, again, are much lower than those charged in Latin America or Eastern Europe or by the mutual fund industry in Western Europe or the United States.11

Along similar lines, the voluntary Thrift Saving Plan for U.S. federal employees chooses its asset managers on the basis of competitive bidding. Workers have a choice of five (recently increased from three) portfolios, specializing in stocks, bonds and money market instruments, respectively. All these portfolios are benchmarked to broad market indexes and use passive investing, which is much cheaper than active management. Total cost is 11 basis points (0.11 percent of assets) per year.

The sidebar describes methods proposed by the President's Commission to Strengthen Social Security to keep administrative costs low in the United States.

Read Article as PDF