Reforming Social Security: Lessons from Thirty Countries
Table of Contents
Reducing Administrative Expenses
“Account fees can be reduced by limiting investment choices.”
If administrative expenses consume 1 percent of assets annually, they reduce a 4 percent rate of return by 25 percent (to 3 percent) and final pensions by 20 percent for a full-career worker who contributes throughout his working life. It is obviously important to keep the costs and fees charged to worker-contributors under control, and this has been a source of considerable controversy and criticism in the overseas pension systems. Comparisons of costs and fees across countries are difficult because data are not always available. Moreover, fees are based on contributions in some cases and on assets in other cases, and converting contribution-based fees to equivalent asset-based fees depends heavily on how long workers keep their money in the system after the fee is charged.7 In most of this paper we compare systems in terms of their equivalent asset-based fees for full-career workers, because this immediately tells us how much the fees reduce gross returns and eventually the pension. The following generalizations emerge from a variety of studies [see Table II].
Retail versus Wholesale Securities Markets. Costs are much higher in worker-based systems that use the retail market than they are in employer-sponsored plans that use the institutional market. Latin Americans used the retail market because they had poorly developed financial systems. The institutional market was not available unless they sent their money abroad.In the retail market, fund managers must attract and sell to individual workers, one sale at a time, and they incur high marketing expenses to accomplish this — often more than 50 percent of total costs — which they pass on to workers in the form of higher fees. In contrast, the employer-sponsored plans described above use the wholesale or institutional market and get much lower costs. For example, costs are less than 0.1 percent of assets in the U.S. Thrift Saving Plan for federal employees and 0.3 percent to 0.7 percent of assets in large company or industry plans in the United States, Western Europe or Australia. But 2002 personal account administrative costs 1.2 percent in Chile, 2.5 percent in Mexico and 4.3 percent in Poland though now lower.8 We can structure our personal account system to reap the cost benefits of the institutional market — as several countries described below have begun to do.
Startup Costs versus Long Run Costs. Brand new personal account systems incur high startup costs. Pension funds managing the accounts must invest in information technology systems, staffing and marketing, often for two or three years before the contributions start flowing in. Furthermore, fees charged by pension fund companies do not cover their costs in the early years, although they hope to recoup them later on. It typically takes five to 10 years for pension fund companies in these countries to break even.9
- In El Salvador, fees were 29.8 percent of assets in 1999, the year after they started operating, but fell to 9.5 percent by 2002.
- Similarly, in Poland, costs were 21 percent of contributions in 2000, its second year of operation (half of those costs for marketing), but by 2002 had fallen to only 8 percent of contributions (less than one-quarter of this was for marketing).
- In Poland, fees covered only two-thirds of costs in 2000 but they reached 90 percent of costs in 2002.
“It is typically five to 10 years before private account managers make a profit.”
Economies of Scale. Incremental costs decline rapidly as the volume of assets rise. Systems with large asset bases and large accounts have lower costs, as a percentage of those assets. Economies of scale have led to mergers in the new systems, so the number of asset managers diminishes over time. Incremental costs of record-keeping also decline as the number of accounts increases, which is why many mutual funds in the United States outsource their record-keeping functions to a small number of companies that specialize in providing that service. The combination of startup costs and scale economies means that costs and fees will inevitably be high relative to assets in the early years of a new personal account system and will fall over time.
- In Chile, costs of pension funds and fees charged workers were 12 and 9 percent of assets, respectively, in the first year, 4 to 6 percent of assets in the next couple of years when average account size was around $1,000, but fell to 1.2 percent by 2002, when average account size exceeded $5,000 [see Figure II].
- Based on the current fee structure, they are estimated to be equivalent to 0.7 percent of assets per year for the full-career Chilean worker who contributes for 40 years.
“Administrative costs fall over time as a percentage of assets.”
Costs of Record-Keeping and Communications. Aside from marketing expenses, the biggest cost item in personal account plans is the cost of record-keeping and communications. These tend to be fixed per account — the same for a $200 account as for a $20,000 account. Thus, record-keeping costs as a percent of assets fall rapidly as average account size increases — which in turn means that the net return on investments grows. For example:10
- In the U.S. Thrift Saving Plan, the expense ratio fell from 0.7 percent in 1988, when average account size was $3,000, to 0.1 percent in 1998, when average account size reached $27,000. [See Figure III.]
- Most of these costs were for record-keeping and communications. The estimated annual dollar cost for record-keeping per account was roughly constant at about $20 in both cases.
Examples of Cost Reduction Techniques. Several countries have taken special measures to keep costs low. For example, Bolivia entered the institutional market and used an international competitive bidding process to choose two asset managers to handle all the funds in the system; workers choose between them. The fee set by the bidding process leaves few resources or incentives to spend a lot on marketing. This accounts for the fact that Bolivia’s expense ratio is one of the lowest in Latin America, despite its small account size. Kosovo has also used a competitive bidding process to choose two asset managers, thereby avoiding marketing expenses; its fees are much lower than those of other countries in the region [see Table II].
“Investment and record-keeping costs have fallen to less than 0.1 percent in the U.S. Thrift Savings Plan.”
Sweden collects contributions centrally and allocates them among some 600 mutual funds according to the workers’ choices, but the funds do not get the names of the workers; they only get the aggregate amounts. The funds report back their investment earnings, which the central record-keeper records in the individual accounts. This blind allocation is designed to rule out sales commissions. However, Sweden does not have total confidence in this process, so the country also uses price controls. High-cost funds must pay a rebate to participants, which reduces their effective fee. The net result is an expense ratio of 0.7 percent of assets, which is expected to fall to 0.5 percent within 15 years as average account size grows [see Table II].
“Administrative costs can be reduced by competitive bidding and centralized collection and record-keeping.”
All Eastern and Central European countries (with the exception of Hungary) and about half the Latin American countries use centralized collection systems, which is usually the social security administrator or tax authority (although Croatia uses a private clearinghouse). In worker-based schemes, piggybacking on the tax system keeps marginal collection costs close to zero and builds in an automatic monitoring mechanism — providing it is a well-functioning tax-collection system. Centralized record-keeping exploits scale economies. One reason for the Swedish system’s low cost is that it has an efficient tax-collection system and uses centralized record-keeping. The employer-based plans in Western Europe, Australia and Hong Kong, in contrast, use a decentralized method, since each employing unit essentially applies its money to its own plan.
The U.S. Thrift Saving Plan for federal employees uses a competitive bidding process and passive investing, which is much cheaper than active investing. Passive investing means that the asset manager simply replicates the benchmark index and moves with the entire market, rather than attempting to pick individual stocks or sectors. Most studies have shown that in large efficient markets (as we have in the United States), index funds get a higher net return than the average actively managed fund — because they (1) save money on research operations, (2) have less product differentiation to market, and (3) active managers often guess incorrectly. Passive investment costs can be less than 0.01 percent of assets. The Thrift Saving Plan indexes to such benchmarks as the S&P 500 and Wilshire 4500, and most large company pension funds also index to a large extent.
Lessons for the United States. The United States will be starting from scratch and will have millions of small accounts. This environment will exist for many years, due to the large number of low-income earners and part-time workers. Therefore, strong measures must be taken to keep administrative expenses low, or they will consume much of the investment return. This suggests the United States should:
“Aggregating small accounts and using passive investing reduces costs.”
Use the institutional rather than the retail market. Aggregating assets and choosing a small number of asset managers will give the system “all or nothing” bargaining power. The asset manager will spend less on marketing. This should result in lower costs and fees. The Thrift Saving Plan sets a good example, since it chooses the asset managers for its portfolios in a competitive bidding process, with very low costs. Of course, there is always a trade-off. The trade-off in this case is that workers have less choice in the institutional market than they would in the retail market. As discussed in the previous section, restricted choice in a mandatory program may be desirable as well as cost-effective.
Use passive investing. Passive investing keeps costs low, reduces disparities across workers and also prevents inexperienced investors from making mistakes by trying to “beat the market.” Some analysts worry that this emphasis on passive investment will reduce the number of active investors, who are needed to keep the market efficient. However, the personal accounts will be a small part of total market capitalization in the United States for many years to come. Moreover, currently large company plans use passive investing much more than small investors do — one reason for their lower costs. Perhaps some of these large investors will switch to active investing if the personal account system focuses on passive investing — and they will be more effective at maintaining market efficiency.
Amortize startup costs over a long time period. Otherwise, older workers who only participate in the system for a few years prior to retirement during the start-up phase will pay a high price. Amortization requires a loan upfront, probably from the government, that is gradually paid off over the first 20 years or so of the new system.
Charge asset-based fees. Asset managers should base fees on a percentage of assets rather than a flat fee per account. Otherwise, low earners with small accounts will receive a lower net rate of return on investments, further deterring growth of their savings. (This does not decrease total costs but it involves a policy decision to cross-subsidize small accounts).
Estimated cost for a personal account system in the United States. Assuming that the new system will (1) keep annual record-keeping and communication costs per account at $20 (the estimated cost in the Thrift Saving Plan and low-cost mutual funds), (2) use index funds and (3) choose asset managers in a competitive bidding process — the expense ratio for the new personal account system will be 30 basis points (0.30 percent) or lower, after eight to 12 years. This is a lower administrative fee than workers with small accounts could get for themselves in the mutual fund market today.