Unemployment Insurance in a Free Society

Policy Reports | Welfare

No. 274
Tuesday, March 29, 2005
by William B. Conerly, Ph.D.

Reforming the Unemployment Insurance System with Individual Unemployment Accounts

Like Social Security, unemployment insurance is funded by payroll taxes. People who are working pay the benefits of people who are not. Like Social Security, there is a federal trust fund. In this case, the fund reimburses state governments for administration costs, while benefits are paid from state trust funds. Like the current proposals to reform Social Security with personal accounts, so that workers’ savings will fund part of their retirement benefits, a second personal account could be established that sets aside a portion of payroll taxes to pay unemployment benefits. During periods of unemployment, workers could draw on their unemployment funds, together with investment returns. If they do not use the funds during periods of unemployment, they could access it when they retire.

Figure V - Unemployment Benefits Funding in Chile

“Chile leads the world in the creation of individual accounts for unemployment insurance.”

Chile , which led the world in establishing individual social security accounts for retirees, has also led in the creation of individual accounts for unemployment insurance. 10 Economist Martin Feldstein first proposed the idea in 1975; Chile began implementing a system in 2002, building on its success with individually-owned retirement accounts. It works like this:

  • Workers pay 0.6 percent of their wages into individual accounts, while employers pay a 2.4 percent payroll tax divided between individual accounts and a “joint account” that pays benefits to new or low-wage workers when their accounts are exhausted.
  • The accounts are administered by the same private pension funds that manage Chilean workers’ retirement accounts and are invested conservatively in a variety of securities.
  • The individual account is held in the worker’s name and is paid out when the worker becomes unemployed or retires. [See Figure V.]
  • After a worker’s account is sufficiently funded to support five months of benefits, taxes are paid directly to the employee, not the unemployment account.
  • Unemployed individuals with fully funded accounts will be able to draw 30 percent to 50 percent of their previous wages for up to five months at a time.

America’s system of personal accounts need not duplicate the Chilean system. However, there are some elements in the Chilean system that we believe are critical for the success of an American program:

  • Each worker in the personal account system has his or her own account, funded like the current system, by employer taxes.
  • A backup system, also funded by employer taxes, covers those who have not built up a large enough individual account balance to cover their unemployment benefits.
  • Another option would be to allow loans from the joint account to the individual accounts of unemployed workers whose balances are too small to meet their living expenses, to be paid back out of the workers’ future earnings. 11
  • Unused balances in individual accounts could be withdrawn in cash or rolled into a personal retirement account when the worker retires.

Employment Benefits of Individual Accounts. The biggest problem with the current unemployment insurance system: It discourages rapid reemployment. Individual accounts solve this problem. Workers with individual accounts will feel urgency about their reemployment, because finding new work rapidly allows them to add to their retirement income. In Chile, the UI administrator trains the worker to understand the connection between unused unemployment funds and retirement income by mailing the employee’s annual unemployment insurance account statement in the same envelope as one of his quarterly individual social security account statements. 12

“Chileans can draw upon their funds even if they quit or are fired.”

Unlike the U.S. unemployment system, Chileans can draw upon their funds even if they quit or are fired from their last jobs. This allows workers more flexibility in changing employment, thus reducing the need for costly adjudication of claims.


“Individuals can draw from their accounts when they become unemployed or retire.”

Implementation Issues. A personal account system in the United States would be easy for states to administer. Current state-run systems raise issues when people move from one state to another. If people are nervous about changing to a new system, it need not be mandatory. States could offer traditional unemployment insurance in exchange for employer contributions. With good experience rating of employer taxes, the system could pay for itself. However, workers should not be allowed to change back and forth between the two systems, as this could make both systems financially unstable.

“An American individual account system could be funded by existing employment taxes.”

How can we finance a system of personal accounts? Over time, the system would be self-funded through existing employment taxes. Existing trust funds would pay for the transition (the federal trust fund for administration and the state trust funds for benefits) and the balances of both funds could be applied toward financing individual accounts.

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