Social Security Reform Around the World: Lessons from Other Countries

Policy Reports | International | Social Security

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

Financing the Transition

If a country with a pay-as-you-go pension system switches to a multipillar system that includes a funded component, some of the contribution usually is shifted to the funded pillar. For example, the proposals of the Social Security Commission would shift (or in the parlance of Washington, "carve out") amounts of 2 to 4 percentage points from the total payroll tax into the funded pillar, the individual accounts. This creates a temporary financing gap between the remaining pay-as-you-go revenues and the revenues needed to cover the current obligations of the old system. Some other revenue source must be found to cover this short-run financing gap, in addition to the long-run preexisting financing gap of the old system. This short-run gap due to the reallocation of the payroll tax to the accounts is known as the transition cost problem.

Countries that finance their funded pillar by adding an extra contribution rather than diverting money that was originally slated for the pay-as-you-go pillar (an "add-on" as opposed to a "carve-out") do not face this problem. For example, most OECD countries with multipillar systems started with modest pay-as-you-go pillars and financed their funded pillars by mandating additional contributions, thereby avoiding the transition financing gap. If the United States chose a small add-on instead of a carve-out, we too would avoid the transition financing problem. An add-on also has the advantage of helping to increase national saving. For these reasons, one of the Commission's plans included an add-on. The downside to this strategy is that workers who participate have to pay more.

"Transitions costs arise from the need to meet obligations that already exist."

All Latin American and Eastern European countries have used the carve-out approach and therefore have faced the transition cost problem. How did they finance the transition? Which of these methods would be most applicable to the United States? Because of the fungibility of money, it is difficult to answer these questions precisely. That is, if government debt and taxes both rise, it is difficult to know how much of the increased debt, versus taxes, was used to finance the pension transition. Knowing that would require knowing the counterfactual - exactly what would have happened otherwise - and unfortunately we do not. Compounding this problem is the fact that, even without a diversion of contributions to the funded pillar, all these systems were or would soon be in financial distress because their future obligations exceed their incoming revenues under the old system. The term "transition costs" properly applies only to the additional gap created by the carve-out.

While we cannot give precise numbers, we can describe more generally the five strategies that countries have used:

  • Making the carve-out relatively small and keeping some workers in the old system so that most of the contribution continues flowing into the pay-as-you-go pillar;
  • Downsizing the benefit obligations of the pay-as-you-go pillar, particularly for young workers, expecting the growth of the funded pillar to restore these benefits;
  • Applying state-owned assets or budgetary surpluses to offset the pension debt;
  • Borrowing temporarily to spread the burden of transition costs across generations; and
  • Using general revenues (higher taxes, lower government expenditures) to repay this loan over time.

Each of these methods and its applicability to the United States is discussed below. Each has different effects on income distribution and national saving which must be evaluated. The important thing to remember is that transition costs arise from the need to meet obligations that already exist. The transition costs diminish as these old obligations are paid off. In a viable program, in the long run the drop in new pay-as-you-go obligations exceeds the drop in revenues, so "transition costs" become "transition gains." Moreover, if the new system enhances economic growth by increasing long-term saving, labor supply and productivity, this will generate additional resources for the treasury that can be used to finance the transition.

"Over the long run, transition costs become transition gains."

Making the Carve-out Small. The transition financing gap will be reduced if some part of the new system remains pay-as-you-go, so contributions continue flowing into the pay-as-you-go pillar. This has been accomplished in several ways:

  1. Keeping a sizable public pillar and instituting a smaller private pillar. My research shows that countries with a large implicit pension debt, such as Sweden, Hungary and Uruguay, tended to keep a large public pillar, because they felt that otherwise they could not cover their transition costs. In contrast, such countries as Chile, Bolivia and Kazakhstan, which started with a relatively small pension debt, resorted to a small public pillar - a minimum pension guarantee, received only by lifetime low earners.17 The continued inflow of funds to a large pay-as-you-go pillar reduces the transition financing gap in the short run. But if benefits are too generous (actuarially unsound), the reform will not be sustainable in the long run.
  2. Excluding some workers. Exclusions from the new system may include such people as the military, the police or older workers (as in Chile) or may make the second pillar mandatory only for certain groups such as high earners (as in Uruguay).
  3. Making the switch voluntary for current workers. Most reforming countries have followed this approach, making the multipillar system mandatory for new workers but allowing current workers to stay in the old system if they wish. Usually workers over age 45 choose to stay in the old system while most younger workers switch. The former group continues contributing to the pay-as-you-go pillar, thereby reducing the financing gap, while the latter group partially withdraws with the expectation that the individual accounts will build up by the time they retire. One advantage of a voluntary switch is that it mitigates opposition to reform from groups most anxious to stay in the old system and permits a lower value to be placed on past service credits for those who switch. By choosing the minimum terms that are needed to convince the desired number of workers to switch, a government can substantially downsize its recognized debt and transition costs (as in Hungary). Obviously, the higher the expected rate of return on the individual accounts, the lower the compensation needed to induce workers to switch. In effect, the transition can be partially self-financed by building a strong second pillar.

Which of these methods would work in the United States? Since our nation has a relatively small implicit pension debt and financing gap (compared with other industrial countries), we could finance a largely funded privatized system if we chose to do so. That is, we could carve out half or more of the contribution (as in several recent proposals by Syl Scheiber, Martin Feldstein and Lawrence Kotlikoff) for the new funded pillar. In the Feldstein and Kotlikoff proposals, the individual account by itself is large enough to maintain currently scheduled replacement rates. In the Scheiber proposals, a 5 percent contribution to an individual account is accompanied by a smaller flat benefit in the pay-as-you-go pillar. Together, the two parts maintain currently scheduled replacement rates and progressivity. However, most proposals visualize keeping a substantial pay-as-you-go pillar, diverting only 2 or 3 percentage points, or 20 percent to 30 percent of the total contribution, to the funded pillar. In following this course we would gain the advantage of keeping the transition financing gap small.18

The Commission's proposal reduced this gap still further by making the switch voluntary. A voluntary switch is difficult to implement under the complex benefit formula in the U.S. system. Careful measures must be taken, or else high earners might be the largest group to opt out of the pay-as-you-go pillar, thereby withdrawing part of their contributions that were used to subsidize the benefits of low earners. Low earners would be left in the pay-as-you-go system, exacerbating its financing problem. The switching terms must be carefully devised to maintain fiscal balance and overall system progressivity. The Commission recommended that high earners should be more limited than low earners in the amounts of payroll tax they can reallocate, partially mitigating this problem. Also, each dollar reallocated by high earners would result in a larger percentage cut in defined benefits than for low earners. Workers over the age of 55 would continue making their full contribution to the old system and their future benefits would not be changed.

"Future Social Security or budget surpluses can be harnessed to cover part of the transition cost."

Downsizing Benefit Obligations. Before or in the course of making the transition, most countries have reformed their old systems by downsizing benefits, raising the retirement age, raising penalties for early retirement, tightening eligibility for disability benefits, and changing the indexation of initial benefits to price rather than wage indexation after retirement. Chile, Argentina, Uruguay, Hungary and Poland followed this strategy, which may be virtually indispensable to a good pension reform - especially in countries that start out with bloated benefits. (Of course, benefit cuts would be necessary in these countries whether or not they undertook structural reform.) These measures cut the transition cost problem, but only to a limited extent because they are generally phased in very gradually. Some, but not all, of these benefit cuts are typically made up through the growth of the funded pillar. That is, typically in Latin America and Eastern Europe, total benefits from the combination of both pillars in the new system were somewhat reduced, but benefits stemming from the pay-as-you-go pillar alone were cut much further. [See the sidebar for a discussion of U.S. Social Security Benefits under Reform.]

Using Existing Assets to Pay Off the Pension Debt and Cover Transition Costs. In some reforming countries, such as Peru and Poland, where public enterprises are being privatized, part of the proceeds have been used to pay off the pension debt - applying long-term assets against long-term liabilities. China is trying to sell off its shares of state-owned enterprises to generate resources that will finance its transition to a funded individual account system. This is not a potential revenue source in the United States. More relevant for our purposes is the use of treasury surpluses or temporary surpluses in the existing Social Security system.

While the Latin systems generally did not have a surplus in their old Social Security systems, the United States does, in the Social Security trust fund. The trust fund is not large, it will not last long and it consists exclusively of special non-tradeable government bonds. But until the trust fund is exhausted, redeeming these bonds is one of several methods that can be used to generate cash to pay off old obligations.

The Latin countries (aside from Chile) also did not have surpluses in their general treasuries. Chile is said to have built up a surplus in its public treasury in preparation for financing its pension reform. In contrast, the U.S. budget surplus has disappeared; but it may reappear in the future, still in time to help. If a surplus exists that otherwise would be used to increase government spending or cut taxes, then its use to allow the buildup of retirement accounts enhances national saving and labor productivity.

Issuing General Treasury Debt to Cover the Remaining Cash Gap in the Short Run. Because of the fungibility of money, we do not know to what extent the transition in other countries has been financed from benefit cuts plus asset reallocations, but 30 percent might be a good estimate in many cases. The remainder is usually financed by government debt, with the intent to gradually repay this out of taxes and system savings that continue after the old obligations have passed. The relevant proportion for the U.S. could only be determined by crunching the numbers for many alternatives.

"Government borrowing to find the transition debt is merely an exchange of implicit public debt for explicit public debt."

Government borrowing has increased in the early years of the reform in almost every Latin American and Eastern European country. Indeed, some use of temporary debt finance is almost inevitable so that a heavy double burden is not imposed on the transition generation of workers. Temporary borrowing with gradual repayment allows policy makers to determine how the burden of the debt should be distributed among cohorts. Since young and future workers will benefit most from the reform, by receiving larger pensions or paying lower contributions than they would have otherwise, it is appropriate that they should also pay part of the cost. This is accomplished by borrowing to cover part of the transition cost and repaying the loan later on.

It is crucial to realize that total public debt is not increased by this financing arrangement. The pension debt exists right now, in every pay-as-you-go system. Rather, borrowing temporarily as part of a transition to a funded system is simply an exchange of hidden implicit debt for more observable explicit debt. In fact, in the course of the reform the total pension obligation of the government has been reduced in almost every country. This also holds for the plans recommended by the Commission in the United States. The fact that the remaining debt becomes more explicit increases the likelihood that pressures will be brought to bear to pay it off. Using special issue transition bonds with scheduled retirement dates could enhance such pressures. In countries that have already reformed, some of the new bonds were sold to the pension funds in the new second pillar. Government debt and bank deposits have been the largest initial investments of practically all new pension funds in Latin America and Eastern Europe, although they are gradually moving toward much more diversified portfolios.

Paying Off the Debt in the Long Run. However, if one object of the reform is to increase national saving, then the painful fact is that someone's consumption must be cut, at least temporarily, relative to what it would have been otherwise; and pure debt finance will not accomplish that. Eventually, taxes must be raised or benefits and other government expenditures cut enough to pay off the debt. The slower the payoff, the lower the required tax rate per year and the more politically acceptable may be the reforms, but this also delays the timing of increased national saving for productive investment. Indeed, if the transition is largely debt-financed and if the debt is not paid off in a timely way, the benefits of "pension reform" are substantially mitigated.

"If part of the U.S. Social Security system were converted to a private system, as recommended by the Commission, the transition cost could be financed with a small temporary increase in the payroll tax rate or base."

Each financing method has its downside. Cuts in expected defined benefits hurt workers as they retire, although this is largely compensated by their purchase of private annuities from the personal accounts. Reducing other government expenditures may be difficult to achieve, and some government services that enhance labor skills and capital, hence productivity and economic growth, might be lost. If taxes are increased during the transitional period, we must decide which taxes. The choice is between increasing payroll tax rates, increasing the payroll tax base or turning to general revenues. A broader tax base would allow a lower payroll tax rate to achieve any given target revenue. It would be less distortionary to labor markets and more growth-enhancing. It would be more progressive, which many people would interpret as more equitable. But it also might be the most difficult to implement politically. Argentina has imposed a new tax explicitly for this purpose, but this action is rare.

It has been estimated that if half the current pay-as-you-go system were converted to a funded direct contribution system, the financing gap could be paid off by a payroll tax rate of about 1.5 percent or a consumption tax of 1 percent for about 70 years in the U.S.19 A smaller carve-out, as proposed by the Commission, could be paid off with a smaller tax, in fewer years. If the new pension system increases economic growth, the growth premium would allow the transition costs to be paid off faster, while still leaving a consumable surplus for workers and retirees in the long run.

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