Social Security Reform Around the World: Lessons from Other Countries

Studies | International | Social Security

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


Risk and Guarantees

Risk and uncertainty are inevitable in all old age security plans, given the long time horizons that they cover. One of the concerns most frequently voiced concerning individual accounts deals with financial market risk - the possibility that investments will have a poor outcome for some workers. However, it should be borne in mind that there are risks of a different kind associated with public pay-as-you-go defined benefit plans.

In a pay-as-you-go system, as conditions change in unexpected ways, a collective decision is made about how to adapt to those changes. For example, suppose the old live longer and the dependency rate rises. Who bears the resulting costs for the system? We don't know the answer until the situation arises. If, on the one hand, retirees are politically strong, as they are in the United States today, they will be able to retain their benefits for many years, while workers pay more. If, on the other hand, workers are politically strong, benefits will be cut in order to keep payroll taxes stable. It is also possible, in the case of a major political upheaval (as in the former Soviet Union, the former Yugoslavia or China), that the rules on which workers counted will change altogether. In all these instances, workers and retirees face the risk of changing conditions that will greatly affect their current or future well-being. But the risk is political risk.

"Stock market risk can be mitigated over the long-term by diversification."

In contrast, in a private funded system, workers and retirees face financial market risk - the market may not perform as well as we hope or believe it will. Generally, the investment contract spells out how benefits will be affected, so the locus of risk is better defined before conditions change than in a public defined benefit scheme. A variety of risk-sharing options are available. They range from arrangements where the entire loss is borne by the worker investors (as in stock market mutual funds) to arrangements where the entire loss is borne by a guaranteeing institution (as when insurance companies guarantee a fixed rate annuity) and to complex risk-sharing contracts that afford workers some downside protection if they agree to forgo some potential upside gain (as in "collars" or variable annuities with floors). In general, the more risk the worker- or retiree-investor bears, the greater the return he can expect and the greater the loss he can incur.

Risk cannot be avoided, but it can be reduced and the rules for sharing it can change. What are some reasonable principles that might be considered for mitigating risk and sharing it efficiently?

Reducing Risk through Diversification. As a starting point, given the great uncertainty faced by old age security programs stemming from their long time horizons, the best protection against risk is broad diversification of income sources. This is achieved by a system that has publicly and privately managed components: financing based both on wages and returns to capital, on both mandatory taxes and voluntary savings, and investments both in stocks and bonds. In this sense, adding a private investment component to a system that is exclusively public and pay-as-you-go probably reduces risk overall by diversifying the sources of total retirement income. If the public source fails due to political risk, the private source may remain, and vice versa.

Within the funded pillar, financial risk can be further reduced:

  • By regulations that require benchmarking to a broad market index rather than concentrating on a narrow sector;
  • By making periodic contributions rather than one lump sum (dollar-cost averaging);
  • By holding for long time-horizons and withdrawing gradually, rather than trying to time the market; and
  • By investing in a broad range of securities, both in domestic and international markets, to minimize country-specific risk.

"Most reforming countries have restricted the portfolio choices to reduce risk."

History tells us that attempts to avoid market risk through fixed income securities imply a low nominal return and therefore introduce the risk that pensions will not meet replacement rate targets. Investing gradually, holding stocks for the long term and withdrawing gradually protects the equity premium against short-term volatility by diversifying through time. While the future may differ from the past, holding a diversified stock portfolio for 20 years or more has always resulted in a net gain that exceeds the return from a pure bond portfolio.12 Diversifying across sources of retirement income, types and locations of financial instruments, and dates of investment and withdrawal seems to be the most effective way to reduce risk in a very uncertain situation. [ See sidebar ]

Risk Control Strategies in Reforming Countries: Diversification and Guarantees. What have reforming countries actually done? Frequently they have restricted the portfolios in which pension funds may invest in order to rule out highly volatile and concentrated portfolios. Latin American and most continental European countries include explicit portfolio limits, while the Anglo-Saxon countries typically rely on the more discretionary "prudent man rule."13 The latter approach seems to perform better than the former, but it may be difficult to implement in countries without well-developed rules of law and prudent man precedents.

"Most reform plans in the United States would allow workers to choose from a limited number of broadly-diversified portfolios."

To shift part of the remaining risk away from the worker, many countries require guarantees of absolute or relative rates of return by the pension funds and/or include a minimum pension guarantee by the government. Switzerland requires a minimum return of 4 percent nominal over the workers' tenure with a given employer. This constraint may, however, lead to overly conservative investments, as rates of inflation and nominal interest rates fall. Chile penalizes funds that earn a return that is 50 percent lower or 2 percentage points lower than the industry average, whichever comes first. (The averaging period, initially one year, was increased to three years, and further easing is now under consideration.14) This rule has been accused of leading to investment herding among pension funds, as each fund tries to look very much like the others. Rather than having a choice of different points on the risk-return frontier, stemming from differing asset allocations - as would be the case in a well-functioning financial market - workers have the much less meaningful choice among companies that provide the same asset allocation and risk-return mix.

"In many Latin American countries, the government provides a minimum pension guarantee, designed to keep retirees out of poverty."

In many Latin American countries, the government provides a minimum pension guarantee that retirees will not fall into poverty. In Mexico, current workers are permitted to return to the old pay-as-you-go system upon retirement if this yields a better pension. One might anticipate that this would lead to a moral hazard problem - workers buying overly risky portfolios, knowing they will benefit from the prospect of gains but are protected from downside loss. The Mexican authorities have avoided this moral hazard problem by greatly limiting the funds' choice of investment strategies: At least 65 percent of all assets must be invested in government bonds (as of 2000, the funds were still 99 percent in bonds), and international investments are proscribed. Since workers have no real choice of portfolios, moral hazard is avoided, but the flow of funds through the pension funds to the financial market and the private sector is also avoided. Thus, guarantees reduce risk for the worker but they also introduce new costs, potential moral hazard problems and investment restrictions.


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