Reforming Social Security: Lessons from Thirty Countries

Studies | Social Security

No. 277
Thursday, June 09, 2005
by Estelle James


The Basic Structure of Personal Accounts

Table I - Nature and Size of Private Funded Pillar

Most of the countries we examine in this study began with traditional pay-as-you-go defined benefit systems, similar to the United States. When these countries reformed their retirement systems, they shifted part of the responsibility for benefits to the private sector, usually to defined contribution plans, also known as personal accounts. But the proportion of benefits that was shifted varied widely, as did the management of funds. How much of these systems remain as government-paid, pay-as-you-go benefits? How large are the personal accounts? How are they managed? And what explains the differences across countries?

Worker-Based versus Employer-Based Plans. In the well-known case of Chile, the worker chooses the investment manager for the retirement funds, a pattern evident across Latin America and Eastern Europe. When these public systems were reformed, they were typically near insolvency, beset by evasion and inequities, and publicly discredited. Major change was needed.

“In Latin America and Eastern Europe, workers choose a private manager to invest their personal accounts.”

In Western European countries ( Switzerland, Denmark and the Netherlands), as well as Australia, the employer, sometimes together with a union, makes the investment choice [see Table I]. In these countries, employers are primarily responsible for private pensions, while the government continues to provide a separate public benefit, as it did before the reform. These are countries with long histories of employer-sponsored plans, traditionally defined benefit and often due to collective bargaining. During the 1980s and 1990s the governments of these countries realized that while employer-sponsored plans provided good pensions for half of the labor force, they did little or nothing for the other half. They also realized that, with aging populations, the bottom half of the income spectrum would become a growing fiscal burden unless private pensions were in place. Therefore, they mandated that virtually all employers provide retirement plans for virtually all their workers.1 

In effect, this was an add-on for employers who didn’t already provide such plans. The mandate was made explicit in Switzerland in 1985, and later on in Australia and Hong Kong. It was achieved in a less formal way in Denmark and the Netherlands, but with similar effects. In the United Kingdom, employers are not required to provide a pension plan, but they can opt out of the government plan by providing an equivalent private pension and they get a tax rebate if they do so. British workers can opt out of the government system or their employer’s plan into their own personal plans.

In most of these countries, employers who didn’t previously have pension plans have added defined contribution plans. And, many employers are transforming their preexisting defined benefit plans into defined contribution plans, just as has occurred in the United States. As this happens, control over investment choices for the personal accounts shifts toward workers.

Defined Benefit versus Defined Contribution Plans. Employers around the world have found that in globally competitive labor and product markets they are unable to credibly insure against longevity and investment risk, which is the goal of defined benefit plans. If investment returns are lower than expected, or if workers live longer than expected, employers (facing competition from other firms without these pension burdens) will be unable to come up with the extra money needed to keep their promises in the long run. And if employers try to avoid these risks by conservative funding policies, their costs will be higher than those of competitors who accept higher risk, in the short run. Regulations have placed increasing financial burdens on defined benefit plans to make their promises credible. Additionally, defined benefit pensions are difficult for workers to carry from one job to another. In contrast, defined contribution plans are typically more portable and help employers avoid longevity and investment risk. As a result, even though some employer-sponsored defined benefit plans remain, they are gradually being phased out, and in this paper we sometimes refer to all private plans that are part of social security as personal accounts.2

Although employers (sometimes together with unions) chose the trustees and the investment strategy under defined benefit plans, it is likely that workers will increasingly demand this power as the shift to defined contributions takes place — since they bear the risk and receive the return. In Australia, legislation has just given workers increased choice, and this will probably happen elsewhere as well.

“Contribution rates to personal accounts vary widely among countries.”

Contribution Rates to Personal Accounts. Table I depicts the contribution rates to personal accounts, which vary from 2.5 percent in Sweden to 10 percent or more in a number of other countries. Assuming a worker works for 40 years, has real wage growth of 1.5 percent per year, realizes an investment return net of administrative expenses of 4.5 percent per year, and retires with 20 years of expected lifetime, these varied contribution rates will provide pensions from the accounts that range from 14 percent to 56 percent of final salary. Except for Sweden, no country plans to keep its contribution rate to the accounts below 4 percent. In fact, it would not be efficient to have smaller accounts, because the fixed administrative expense per account would significantly reduce gross investment returns. (Sweden can do this only because its high average income results in fairly large accounts, even with a 2.5 percent contribution rate, and it has taken special measures to keep administrative costs low.)

Contribution rates to the employer-sponsored plans tend to be higher than average, perhaps because defined benefit plans require higher contribution rates, given the aging labor forces in these countries.

Private Sector versus Public Sector Benefits. All countries have retained some kind of public benefit, in addition to the new private benefit. Table I and Figure I depict the share of total benefits an average worker can expect from his account. The private share of benefits is much larger than the private share of contributions, since the expected rate of return on the accounts is usually greater than what pay-as-you-go systems can credibly promise. For example, in Sweden, which has the smallest private pillar in relative terms, about 14 percent of total contributions go into the accounts; but 30 percent of total benefits are projected to come from the accounts.

Figure I - Share of Benefit from Funded Accounts Across Countries

“The percentage of benefits paid from personal accounts also varies.”

In some cases the public benefit is partly or wholly financed out of general revenues, rather than by an earmarked contribution [see Table III]. Often the public benefit is progressive, so it provides a higher proportion of total pension income to low earners than to high earners. For example, in Chile, which has the largest private pillar in relative terms, 100 percent of contributions go into the accounts and, for the average worker, the personal account pays 100 percent of benefits. [See Figure I.] But the minimum pension guarantee, which is Chile’s public benefit, is financed from general revenues and will provide about 20 percent of the total benefit for low earners.

Table I and Figure I show that countries are basically divided into three groups: those where the personal accounts have almost the full responsibility (high) for supplying retirement benefits, those where personal accounts have supplementary responsibility (low), and those where the responsibility is shared roughly equally between the public and private benefits (medium).

  • Most Latin American countries depend primarily on the personal accounts, following the Chilean example, where workers may divert (carve out) their full payroll tax to the accounts while the government simply provides a minimum pension guarantee.
  • In contrast, some Eastern and Central European countries, as well as Sweden, depend primarily on the traditional benefit, with the personal account playing only a modest supplementary role (in some cases, this role is projected to increase over time).
  • In between are the industrialized countries of Western Europe and Australia, where responsibility is shared almost 50-50 between the public and add-on private benefits.

“Many countries have funded personal accounts by diverting payroll taxes from the old system.”

How can we account for these differences in relative size of the private benefit and the use of add-on versus carve-out? Countries of Eastern and Central Europe typically have large implicit pension debts due to aging populations and generous benefits owed to workers and retirees in the traditional systems. These countries were more likely to start relatively small private plans, because they could not afford the high transition costs they would face with a larger shift of contributions. Nor could they afford an add-on in view of their already high payroll tax rates, which often exceeded 25 percent.

The opposite is true for countries with younger populations and smaller pension debts, such as those in Central America. Workers could and did divert most of their contributions to the accounts. Finally, countries like Switzerland, the Netherlands and Australia were able to move toward a 50-50 division with an add-on approach. They had relatively small contribution rates or financed their public benefits from general revenue, and they added mandates for substantial employer pensions that will provide about half of most workers’ total pension.3

“Given the choice, most workers have switched to the new system.”

Voluntary versus Mandatory Personal Accounts. Practically every country that has established worker-based accounts used a payroll tax carve-out — diverting part of the contribution from the traditional system.4 Switching to personal accounts was usually voluntary for existing workers but mandatory for new entrants to the labor force. Once a person switched, this choice was usually irrevocable.5 Allowing individual choice over changing from public to private plans reduces political opposition and transition costs, since some workers may choose not to switch. However, the past 25 years have shown that, given the opportunity, the vast majority of workers have switched; almost all younger workers have switched; and in total, many more workers switched than was projected — demonstrating their lack of confidence in their old systems. Therefore, transition costs have been higher than expected.

Making the new system mandatory for new entrants to the labor force ensures that the old system will eventually phase out of existence. Colombia and Argentina have not included this mandate and have kept the two systems existing side by side. The old system has few participants, but imposes duplicate administrative costs on everyone.

In contrast, countries that used employer-based plans as the basis for privately funded social security benefits effectively imposed an add-on for employers who did not already offer such plans, and participation was mandated for virtually everyone. (If an add-on is voluntary, it is no longer part of the mandatory social security system.) While employers were required to add a benefit, the cost of that mandate was undoubtedly passed back to workers in the form of lower wage growth over time. For example, in Australia the new pension contribution by employers was an explicit trade-off for wage growth in an inflationary environment.

How Much Choice among Investment Portfolios? When the Latin American and Eastern European countries initiated their personal account systems, their financial markets were undeveloped, with limited financial instruments. And, few workers had any investment experience. As a result, investment choices were tightly circumscribed, with strict limits placed on equities, derivatives and foreign investments. Bank deposits and government bonds were the main investments. Diversification was limited because financial instruments were limited and international investment, which would have permitted much greater diversification, was restricted. Moreover, relative rate of return guarantees (described below) led most asset managers to offer similar portfolios — giving workers little choice. [See the sidebar, “Personal Account Investments in Chile.”] The basic ethos at the beginning was to be cautious, prevent disasters and wide disparities across individuals, and liberalize later as workers developed financial experience.

“Chile allowed more investment choices as financial markets developed.”

In some cases, most notably Chile, financial markets have developed considerably over the past 20 years, in part due to their pension reforms. Consequently, countries are now gradually liberalizing these restrictions, with Chile taking the strongest steps in 2002, when it opened the door to multiple portfolios, including some with considerable equity and international exposure.

Employer-sponsored plans, in contrast, were mandated in countries with well-developed financial markets and employers who had years of experience operating in those markets. So a much wider range of investment choice and diversification was permitted from the start.

In worker-based defined contribution plans it is desirable for individuals to have some discretion over investment portfolios, allowing workers with different degrees of tolerance for risk to make different risk-return trade-offs. However, the British experience, where workers could choose between their own account, their employer’s plan and the state plan, illustrates that unconstrained choice is not necessarily better. Many inexperienced workers chose poorly. Choices need to be carefully structured to enable inexperienced investors to use it well. [See the sidebar, “The British System.”]

Lessons for the United States. Compared with other industrialized countries, the United States currently has a trust fund surplus and a relatively small pension debt stemming from our younger population — which makes it easier to divert some of the current payroll tax into personal accounts. On the other hand, we have a relatively low contribution rate, which makes an add-on easier. Our public benefit rate is relatively low, which limits the degree to which it should be cut. Viewed from this comparative perspective, the United States should be able to move toward personal accounts that have a contribution rate of around 4 percent (which could be phased in), on the basis of a mixed add-on plus carve-out. This would cover about half of the total expected benefit for the average worker.6

We could move directly toward a new system of personal accounts that workers manage themselves, or we could build on existing employer-sponsored plans. First some comments on the latter option.

The most common employer-sponsored plans are 401(k) plans, under which contributions are deducted from employees’ wages before taxes and are deposited in mutual funds, often with a matching contribution from the employer. These plans appear to be working well for much of the labor force. But some participants make poor investment choices or face high administrative costs, and therefore experience low net rates of return. Some concentrate their investments in the company where they work, thereby increasing their risk because of the lack of diversification. Some young and low-income workers do not participate, or withdraw their savings before retirement, and many small employers do not offer any retirement plan for their workers. If we wanted to make employer-sponsored 401(k) plans part of our Social Security system, we would have to regulate them more tightly and make participation mandatory. Small employers who do not currently have such a plan (and larger employers who want to avoid the administrative burden) could be required to “add-on” contributions to low-cost pooled index funds, patterned after the Thrift Saving Plan (the retirement plan for federal civil servants). This approach would eventually achieve lower administrative costs than existing 401(k)s and could gradually replace many existing employer plans.

“A 4 percent contribution to personal accounts would fund about half the scheduled retirement benefits of U.S. workers.”

In contrast, if we choose to develop a new system of worker-based accounts, this could be done through an add-on or a carve-out or a mixture of the two. If a carve-out is used, switching could be voluntary, to defuse opposition from workers who do not want to face financial market risk. If they did stay in the old system, transition costs (discussed later in this study) would be reduced — but in making projections we should anticipate that most workers under the age of 50 are likely to switch. The choice to participate in these accounts should be irrevocable and mandatory for new labor market entrants or for all workers under a designated age, such as 35.

If we finance the accounts partly through an add-on, participation for all workers under some age such as 35 would have to be mandatory from the start (otherwise it would simply be part of voluntary retirement saving, which we have now, and is unlikely to expand coverage). In either case, some degree of mandate would be involved and low risk investment options, such as inflation-indexed treasury bonds would have to be offered for those who preferred to avoid financial market risk.

The United States has the most sophisticated financial markets in the world. But many workers, especially low-income workers, have had little investment experience. Therefore we would be wise, especially at the beginning, to give workers very limited choices, to prevent big mistakes and disparate outcomes. Unlike Latin America, all the permitted portfolios in the United States should be broadly diversified among industries and sectors — the best recipe for reducing risk — and indexed to well-known benchmarks. The Thrift Saving Plan for U.S. federal employees is a good model. It started with only three portfolios — money market, large cap stocks and bonds — which individuals could mix in varying proportions. It has just added two additional portfolios — a foreign fund and a small cap fund — and is on the verge of adding a life cycle fund that combines the underlying funds in different proportions automatically as the individual ages. Other risk-reducing techniques using modern financial tools should also be considered (see section on guarantees).


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