A growing number of countries have taken steps to avoid the crisis by allowing workers and employers to choose private alternatives to their public retirement systems:

• At least 20 countries have introduced forced savings programs, requiring workers to save for their own retirement.
• A broad number of countries either have partially privatized their systems or have a private option.
• Some countries require employers to provide pensions on top of the traditional social security program.

• Singapore's Central Provident Fund (CPF) requires employees and employers to contribute jointly to individual accounts, which may be used not only for retirement and for hospital expenses but also for such purposes as financing college tuition or purchasing a home.
• Chile, the first nation in the Western Hemisphere to adopt a social security system, became the first nation in the world to dismantle its public system, replacing it with the equivalent of Individual Retirement Accounts and affording workers both greater freedom of choice and higher retirement income.
• Britain allows employers and workers to opt out of the earnings-related tier of public social security by setting up private plans that promise benefits at least as generous as the public system.

While most countries in the world today have similar social security systems, a large and growing number of countries have retirement systems that differ from this traditional model. Many countries now allow workers and employers to choose private alternatives to their public systems. Some rely completely or partly on the private sector with no public system. Others operate fully funded rather than pay-as-you-go systems. Under these fully funded models, each worker's payments are saved and invested for his or her own future benefits, rather than immediately paid out to retirees.

"For the United States and other countries with a traditional model of social security, financial crisis is imminent."

This study reviews alternative social security programs around the world. After an overview, it presents case studies of some of the most interesting examples.

For the United States and other countries with a traditional model of social security, financial crisis is imminent. The alternatives point to a way of avoiding this crisis. After describing the problems traditional systems face, the study examines the alternative solutions.

Singapore is one of 20 countries that have provident funds or forced savings plans. Since 1955, Singaporeans have been required to save for their own retirement. Employees and their employers make monthly deposits to the Central Provident Fund. These deposits finance a wide range of programs and options, including the purchase of a home.

Detailed case studies of the Chilean, British and Singaporean systems are provided below. Virtually unknown, however, are the large number of countries that have at least partially privatized systems or a private option.

• In Switzerland, Denmark and Finland, the government provides everyone with a basic flat amount in retirement benefits that are means-tested to some degree. But the additional benefits related to income, analogous to the earnings-related tier in Britain, are provided by mandatory employer pensions.
• In Japan and Mauritius, the government pays a flat retirement benefit to everyone, plus additional benefits related to earnings during working years. But workers with private employer pensions or occupational plans providing at least equivalent benefits are allowed out of the public earnings-related system.
• In Greece, workers with approved employer or occupational plans providing at least equivalent benefits are allowed out of the entire public system.
• In Pakistan, employers provide survivors and disability benefits through private life and disability insurance.
• In Trinidad and Tobago and the Seychelles, the government requires participation only in a basic plan paying a flat amount in benefits to everyone. Payment into the earnings-related tier is voluntary, and workers can choose to pay into a private plan instead.

"A large array of countries have partially privatized systems or a private option."

Another 11 countries have no public social security system at all, leaving retirement benefits entirely in the private sector. These include Malawi, Burma (Myanmar), Georgia, Sierra Leone, Armenia, Azerbaijan, Bangladesh, Botswana, Somalia, Uzbekistan and Zimbabwe. In addition, in Ethiopia the system applies only to government employees or employees of government enterprises or associations, leaving all other workers to provide for their retirement privately.

Finally, several countries allow some portion of their workers to voluntarily opt in or out of social security:

• South Korea allows voluntary coverage for small businesses with fewer than five workers and for the self-employed including farmers and fishermen.
• Liberia allows voluntary coverage for small firms of under five workers, the self-employed, workers employed in their own family enterprise, intermittent workers and domestic employees.
• Besides South Korea and Liberia, the self-employed are free to choose whether to be in or out of social security in Germany, Thailand, Ireland, Belize, Palau, Panama, Costa Rica, Trinidad and Tobago, São Tomé and Principe, Ghana, St. Christopher and Nevis, Morocco, Burkina Faso and Iran.
• In Romania, farmers are free to choose whether to be in or out of social security. In Rwanda, this applies to all nonsalaried employees.
• In Jamaica, the Bahamas, Portugal, Togo, Cameroon and Guatemala, anyone in the country who is not covered by the public system can voluntarily join it.
• In Saudi Arabia, social security is voluntary for anyone employed by a small business with fewer than 10 employees. In Taiwan, social security is voluntary for small businesses with fewer than five employees.
• In Bahrain, Niger, the Philippines, Cyprus, Zaire and Guyana, those who leave social security-covered employment can voluntarily choose to continue coverage.

"Provident funds force workers to save for their own retirement."

A policy of mandatory provident fund participation is, in effect, a policy of forcing workers to save for their own retirement. Typically, governments insist that the funds pay a minimum rate of return, and upon reaching retirement workers usually receive their accumulation in the form of a lump sum payment. In some countries, workers have the option of taking an annuity in lieu of a lump sum amount and, in any event, workers can use their lump sum distributions to purchase private annuities.

At least 20 countries have such provident funds. The countries include Fiji, Malaysia, Gambia, Nepal, India, Nigeria, Indonesia, Papua New Guinea, Kenya, Singapore, Kiribati (Gilbert Island), the Solomon Islands, Sri Lanka, Swaziland, Tanzania, Uganda, Vanuatu, Western Samoa, Yemen and Zambia.

Although the primary purpose of provident funds is to provide savings for retirement (or benefits to survivors in the case of an early death), many of these funds also allow withdrawals for other purposes for which people voluntarily save.
"Many funds allow withdrawals for purposes other than retirement."
For example:

• Almost all provident funds allow members to withdraw their share of the fund in the case of permanent disability.
• In Kenya, withdrawals are allowed in the case of hospitalization; in India, withdrawals are allowed in order to pay for medical expenses; and part of the fund is designated for hospital expenses in Singapore.
• In Nigeria, Tanzania and Uganda, partial withdrawals are allowed in the case of unemployment.
• Withdrawals are also allowed to finance the marriage of a child in India; to purchase a home in Singapore, Malaysia, Papua New Guinea, Fiji and Zambia; for other types of personal savings in Zambia; and for investments in the capital market in Singapore.

• In India, Indonesia, Fiji, Kiribati, Nepal, Malaysia, Western Samoa, the Solomon Islands, Uganda and Zambia, provident funds make special death grants or funeral grants to the surviving family.
• Life insurance is automatically provided by provident funds in India.
• Maternity grants are provided in Zambia.
• Means-tested allowances are paid to the elderly and to widows in Fiji.

Other countries that mandate employer pensions as a supplement to traditional social security are France, Bolivia and the Ivory Coast. There seems to be no movement in these countries towards substituting the employer pensions for the traditional system, though the private benefits may help to keep the public system from growing larger.

• Jordan excludes employees of companies with fewer than five workers, agricultural workers, fisherman, seamen, the self-employed, family members working in family businesses and domestics.
• Saudi Arabia excludes businesses of fewer than 10 workers, agricultural workers, seamen, family workers and domestics.
• Pakistan excludes firms of under 10 workers, high-income earners, the self-employed and family workers.
• Sudan excludes businesses of under 10 workers, the self-employed, family workers, home workers (e.g., gardeners) and domestics.
• In Colombia, Venezuela and Iran, the social security system doesn't cover all regions of the country.
• In addition to the 16 countries that allow voluntary coverage for the self-employed, at least 24 other countries exclude them altogether from coverage.
• Besides Jordan and Saudi Arabia, El Salvador, Honduras, Iraq, Panama and Bahrain exclude some or all of their agricultural workers.
• Besides Jordan, Saudi Arabia, Pakistan and Sudan, small businesses are excluded from coverage in Thailand, Iraq, Pakistan and Bahrain.
• Family members working in family enterprises are excluded from coverage in Syria, the Dominican Republic, Ecuador, Ethiopia, Micronesia, Guyana, Jamaica, Ireland, Panama, the Philippines and Belize, in addition to Jordan, Saudi Arabia, Pakistan and Sudan, mentioned above.

"Only 61 percent of Latin American workers are participating in public social security programs."

Indeed, according to the official estimates of Latin American governments, only about 61 percent of all Latin American workers are participating in public social security programs.3 If Brazil is excluded, that figure drops to 43 percent. And this is probably an overestimate, because most Latin American governments underestimate the size of their informal, or underground, economies.

The clearest examples of this approach are Australia and South Africa. In these countries, there is no payroll tax on workers and employers for social insurance. Instead, the government finances means-tested benefits for low-income retirees out of general revenues. All other retirement and insurance benefits are provided through the private sector.

This is very close to the system in Chile, where a means-tested minimum benefit provides a floor of income for all retirees. It also follows the model advanced as most desirable by the World Bank, with the government providing for those in need and the private sector performing everything else. These countries have in effect already privatized their systems, with the government performing only the redistributive role that would remain in the public sector under any privatization proposal.

Hong Kong has a similar system. The government finances all benefits out of general revenues with no payroll tax. The benefits are means-tested, except for a modest flat monthly amount paid to everyone starting at age 70 (the means-tested benefits start at 65). In New Zealand, too, all benefits are financed out of general revenues with no payroll tax. But here a moderate, flat benefit is paid to everyone at retirement without a means test. All disability and survivors benefits are means-tested, however. The private sector then provides all retirement and insurance benefits above these amounts.

Other countries combine general revenue financing and means testing with a traditional social security system. In Canada, the government finances a universal pension benefit entirely out of general revenues. That universal pension pays a mostly means-tested flat amount, with about one-third of the total going to all retirees regardless of means. Employers and employees pay payroll taxes for an additional earnings-related pension benefit.

"In Australia and some other countries, government assists those in need and leaves retirement and insurance to the private sector."

Ireland has the same basic system except that employers pay part of the universal pension benefit through payroll taxes. In Italy and in Trinidad and Tobago, the government finances an entirely means-tested benefit out of general revenues, while employers and employees finance earnings-related pension benefits.

Other countries that include some general revenue financing and means testing include Belgium, the Bahamas, Norway, Kazakstan and Kyrgyzstan.

In 1955, Singapore introduced a compulsory savings program that currently covers about two-thirds of the total labor force in the country.5 While the accounts belong to the individual, monthly deposits are paid both by employees and their employers. Currently, the required contribution rate is 40 percent of wages, up to a salary ceiling of S$6,000 per month.6 All compulsory savings, both at the time of deposit and at the time of withdrawal, are tax-exempt.

In the early years, the CPF invested its funds entirely in government securities, and withdrawals were essentially limited to lump-sum retirement benefits or survivors benefits. Over the years, the program has become more flexible, giving workers more control over the investment of their funds and expanding the withdrawal options. Today, the funds finance a wide range of programs and options. The CPF permits people to purchase homes, invest in financial instruments and nonresidential property, pay for health care, purchase various types of insurance, finance a college education and save for retirement. [See Table I.]

Impact of the CPF.

"Singapore has the highest rate of home ownership and the highest savings rate in the world."

Singapore's CPF currently has about 2.4 million participants with accounts totaling $57 billion, or 72 percent of GDP, at the end of 1994. The high rates of contribution, along with rising wages, have meant that the CPF system has been an important contributor to the fact that Singapore has the highest savings rate in the world. [See Table II.]

• Depending on how CPF saving is defined, it equals between 16.3 percent and 30.4 percent of gross national saving.
• Gross national saving, in turn, equals about 48 percent of GDP.

Rate of Contributions.

Types of CPF Accounts.

• 30 percentage points go to the Ordinary account, which can be used for housing, approved investments, certain types of insurance, loans for college expenses and topping-up parents' retirement accounts.8
• 6 percentage points go to the Medisave account for hospitalization expenses.9
• 4 percentage points go to the Special account for old age and contingencies.

Medisave Accounts.

Currently, 6 percent to 8 percent (based on age) of an employee's salary is placed in a Medisave account, with a monthly maximum contribution of S$360, until the balance reaches S$17,000.11 Once that total is reached and maintained, additional contributions are automatically placed in an individual's Ordinary account. At age 55, a minimum balance of S$11,000 must be left in the account to pay medical bills during the years of retirement. Any excess may be withdrawn. Contributions above that figure are automatically transferred to the Ordinary account.

"The Singapore health care system relies in large part on individual self-insurance through Medisave accounts."

The Singapore health care system relies in large part on individual self-insurance rather than third-party insurance, and its hospital system accommodates people with different spending preferences. Thirteen of the country's 23 hospitals are run by the Ministry of Health. The other hospitals are private. Hospitals run by the government offer four levels of rooms, or "wards," which receive different levels of government subsidies.12

Over the years, as Medisave accounts have grown, so has the desire for the higher-class accommodations. According to one study, patients opting for the top level of accommodations grew from 2 percent in 1982 to 8 percent in 1992, while the number choosing a private hospital, where patients receive better accommodations, grew from 16 percent to 24 percent during the same time period.13

The Medishield Option.14

Singapore's health care system is a notable success. While the United States has been spending about 14 percent of its GDP on health care, Singapore spent only about 3.1 percent in 1992, yet its basic health statistics (average life expectancy, infant mortality rate, etc.) are equivalent to those of other developed countries in Asia. Moreover, Singapore achieved its health status with the lowest relative GDP investment of 58 developing economies.16

Nevertheless, Singaporeans have greater access to high-technology services than do individuals in Canada and many European countries - and at reasonable cost.17 Moreover, hospital utilization compares to that of American health maintenance organizations, which aggressively limit hospital stays.18 In Singapore, however, the length of hospital stay is a physician-patient decision, not a bureaucrat's or manager's decision.

Home Ownership.

Insurance Options.

College Expenses.

Retirement Income.

"At age 55, CPF members can withdraw from their accounts all money above S$40,000."

At least S$4,000 of the S$40,000 minimum must be in cash, and the remaining amount may be a member's pledged property.22 However, if a member sells this property, he must ensure that the CPF board gets the required minimum amount in cash. A member may dispose of the minimum sum in one of three ways:

1. Obtain a fixed-term annuity from the CPF board. The board will pay a fixed monthly amount to the member beginning at age 60 and continuing until the account is exhausted.
2. Obtain an annuity from a private insurance company. The member can purchase a fixed-term annuity or any annuity that pays until death from CPF-approved companies.
3. Place the funds in banks as fixed deposits. Under this option the bank has instructions from the CPF to release only a certain amount on a regular basis, similar to the first option.

Investment Options.

Since January 1, 1995, members have been allowed to buy foreign stocks and bonds. Initially, they could invest only in foreign securities listed locally or on the stock markets of Hong Kong, Malaysia, South Korea, Thailand and Taiwan. Now, they may invest in regional markets through approved CPF managers. Approved CPF unit trusts will be permitted to invest in these markets beginning in 1997. Beginning in 1999, investments in the sre policymakers have shown considerable ingenuity in adapting the CPF system to serve not only social security but also other ends. This use of different accounts for different targeted purposes encourages members to spend money on some goods and services such as housing and health care rather than on others. In effect, Singapore has targeted certain "merit goods" - goods that are often provided by government in other countries - and devised a system that ensures that most people will be able to purchase them.

The most obvious defect in the Singapore system is that it relies on heavy government control of the accounts, although its investment policies have been liberalized significantly in recent years. Nevertheless, Singapore's CPF provides U.S. policymakers with a good example of how much can be accomplished when a social security system relies on individual work and responsibility rather than government benefits for retirement.

Singapore also has developed one of the world's most innovative ways of paying for health care - a vast system of individual self-insurance. Although it has provided a few safety net features for the very poor, the government of Singapore expects each individual to pay his or her own way and forces people to save for needs met by governments in most other countries.

"Chile, the first Western Hemisphere nation to adopt a social security system, was the first in the world to privatize."

The old system actually consisted of many separate social security systems: one for manual workers, one for salaried employees, one for government workers and about 50 additional programs for workers in different occupations and different locations. One unfortunate consequence of this diversity was that the groups with the greatest political influence had the most favorable programs. For example:

• Some workers paid lower payroll taxes than other workers for similar benefits.
• Some salaried workers received retirement benefits equal to 100 percent of average wages for their last five years of employment, while manual workers received only 75 percent.
• Some workers were allowed to collect benefits after only 35 years of employment, while the general system for manual workers had a retirement age of 65.
• Under the general system for salaried workers, pensions in payment were indexed for at least two years, whereas the general system for manual workers had no automatic inflation-indexing.

Widespread evasion of the payroll taxes added to the system's problems. Workers who knew they would not qualify for more than the minimum benefit (unrelated to contributions) often would collude with their employers to underreport wages so both could pay less in payroll taxes. Workers who expected more than the minimum benefit also would collude with their employers to underreport earnings prior to their last five years of work, because earnings in earlier years were not counted in calculating benefits.

"Many Chilean retirees saw the real value of their benefits decimated by inflation under the old system."

The social security funds that accumulated were poorly managed. Administrators of the funds were subject to political influence in making investment decisions, and they sometimes invested funds in projects managed by friends or business associates. As a result, the funds often earned a low rate of return and capital was not allocated to its most productive uses. Such practices made the Chilean economy less efficient and slowed its rate of economic growth.

Finally, since pensions in payment were either not indexed for inflation or had only limited indexing, many retirees saw the real value of their benefits decimated during the 1970s, when annual inflation rates under the Allende regime exceeded 1,000 percent.

Retirement Pensions.

The government has authorized 21 private investment companies, known as Adminstradoras de Fondas de Pensiones (AFPs), to administer and invest the individual account funds. The companies were specially created for this purpose and are not allowed to engage in other business or financial activities.25 Several American investment firms are now involved in owning and operating AFPs. New York-based Bankers Trust has a 42 percent ownership share of the largest AFP, Provida, which holds 25 percent of the private system's assets. Aetna Life and Casualty of Hartford owns 51 percent of the second-largest AFP, Santa Maria.

Workers are required to place their account with one of the 21 investment companies, although they can switch their accounts among the companies on short notice. The companies can invest in government and corporate bonds, mortgages, stocks, bank certificates of deposit and other financial instruments, but they are required to hold a diversified portfolio with limited risk.26 At the end of 1990, the AFPs had invested 44.1 percent of their funds in government bonds, 17.4 percent in bank time deposits, 16.1 percent in mortgage bonds, 11.3 percent in common stocks and 11.1 percent in corporate bonds. Until now, investment in foreign stocks has been prohibited, but reforms expected to be adopted soon will allow some foreign investment. Each company is required to provide a minimum rate of return on pension account funds, set as an average of the percentage of the average return earned by all 21 companies. The government guarantees this minimum return, which in effect means that the government is the insurer of last resort.

"Workers in Chile are required to place their accounts with one of 21 investment companies, although they can switch their accounts as often as once a month."

At retirement, workers can use the funds accumulated in their accounts to finance their retirement benefits in one of three ways:

• They can use all of their funds to buy an annuity from an insurance company that pays a specified annual income for life plus survivors benefits for their dependents, backed by a government guarantee.
• They can keep their account with the investment company and make periodic withdrawals, leaving the remaining funds in their estate to be passed on to their children or other heirs.27
• If they have more than enough funds in their accounts to pay normal expected benefits, they can withdraw the excess as they choose.

The general retirement age under the private system is 65 for men and 60 for women. Workers may retire earlier if they have accumulated sufficient assets to pay at least 50 percent of their average earnings over the previous 10 years and 100 percent of the minimum wage. Workers also may choose to retire later, with their funds continuing to accumulate and ultimately paying commensurably higher benefits.

The government guarantees a minimum pension benefit to all workers under the new system, supplementing the worker's private benefits to the extent necessary to achieve the minimum. The amount of this minimum benefit is 85 percent of the minimum wage, increased to 90 percent for retirees age 70 and over. Chile's minimum wage is about half of its average wage. Consequently, the minimum pension benefit guarantee under the new system is equal to about 40 percent of average wages, which is about what the U.S. Social Security system pays to average income workers.

"The government guarantees a minimum pension benefit to all workers."

Survivors and Disability Insurance.

The private insurance policies replace the benefits paid by the old system for disability or death occurring during the worker's preretirement years. The disability policy, along with funds accumulated in the worker's retirement account, pays a monthly benefit for the rest of the worker's life equal to 70 percent of average earned wages during the 12 months prior to disability. The life insurance policy, along with the worker's retirement funds, pays the same benefit (as a percentage of income) to a surviving spouse, dependent parents and dependent children as is paid to the survivors of retirees (described above). The disability benefits under the new system amount to at least twice as much as under the old system, and the new system's survivors benefits are at least 50 percent more. In addition, the government guarantees the same minimum benefit for disability as for retirement, and it guarantees minimum survivors benefits as well.

Total Contributions.

Inflation Indexing.

The new system is entirely denominated in terms of a separate currency (la Unidad de Fomento or UF), whose value is adjusted for inflation each month by the government so that each unit of the currency maintains a constant value in real terms. All benefit amounts, individual investment account totals and investment returns under the new system are expressed in this currency so that real values adjusted for inflation can be easily determined.

"Employers were required to pay workers an 18 percent wage increase at the time the new system was adopted."

As stated before, workers who were participating in the old system at the time of the reform could opt to remain in the public system or switch to the new private system. For those who made the switch, the government issued special nontransferable bonds - called recognition bonds - to compensate them for their past contributions to the old government system. The bonds represented a sum roughly equal to the proportion of benefits already earned under the old system by past contributions. The sum is indexed to increase with inflation and earns interest until the worker retires. At that time, the accumulated sum is added to the funds in the worker's individual retirement account and is used to finance the worker's retirement benefits. Workers who switched to the private system also are eligible for the government-guaranteed minimum benefit. Between these minimum benefits and the recognition bonds, all workers who switched to the private system are assured of receiving benefits at least as high as promised under the old system, and probably higher.

The government finances the recognition bonds, minimum benefits and benefits currently being paid under the old system out of general revenues. The reform also abolished an additional payroll tax of more than 10 percent, which financed unemployment insurance, workmen's compensation and family assistance benefits. These benefits are now paid out of general revenues, and a value-added tax was adopted to help finance them.

Moving to a Fully Funded System.

Freedom of Choice for Employees.

• Workers are free to choose which investment company will handle their funds, so they can pick the institution that offers the investment strategy they prefer.
• The private retirement investment accounts are completely portable, following the worker from job to job, so the system does not restrain choice in employment.
• Workers can contribute additional funds to their accounts, up to double the required 10 percent of wage income. With the additional contributions, workers can retire early or receive higher benefits at the normal retirement age.
• Workers can delay their retirement without penalty, increasing the benefits they will receive at a later retirement age.
• At retirement, workers can purchase an annuity that provides a fixed monthly income, or they can make periodic withdrawals from their accounts and leave the remainder for their heirs.

The Performance of Private Funds.

"The new system increases workers' freedom of choice and gives them control over their own resources."

The investment companies are strictly regulated to avoid political influence or personal favoritism in making investment decisions - a common practice under the old system. Furthermore, unbiased investment decisions are in each company's self-interest. To remain competitive, each investment company must make investment decisions based on economic considerations alone. As a result, the new system tends to produce high returns on investments and to allocate funds to Chile's most productive uses, as indicated by the private capital market. The more efficient allocation of capital in turn means higher productivity, output, income and economic growth.

The investment returns on funds in the private retirement accounts have been quite high. The latest available data show that the funds have earned an average real rate of return of 13 percent since the new system was adopted. This performance has greatly exceeded expectations and would result in substantially higher-than-projected benefits, even if returns should fall substantially in future years. As a result of the heavy participation in the new system and the high returns earned on retirement investments, the retirement funds have grown quite rapidly:

• By the end of 1990, the total assets of the AFPs equaled about 25 percent of the total assets of the entire banking system.
• By the end of 1992, AFP assets were equal to about 40 percent of Chile's entire GDP.
• The savings rate in Chile is reportedly more than 25 percent, which the government attributes primarily to the social security reform.

Higher Benefits, Lower Payment.

• Retirement benefits under the new system are estimated to be at least 70 percent higher than under the old system.
• Disability benefits under the new system are at least twice as high.
• The new system's survivors benefits are at least 50 percent higher.
• Yet payments into the new system are about 40 percent less than taxes under the old system.

"Retirement benefits are estimated to be at least 70 percent higher, yet payments into the system are about 40 percent less."

Equity and Fairness.

Effects on Employment.

Pinera suggests that the private contributions are perceived less as a tax and more as personal savings that enhance the workers' personal wealth and are part of their employment compensation. To the extent this is so, the depressing effect of the old system's heavy payroll tax burden has been reduced even further, and the new system will result in still more jobs and increased employment.

"Workers are developing substantial direct ownership in Chile's private business sector."

Trade Union Reforms.

Other Privatization.

Eduardo Aquilera, a top union leader in Chile and an original opponent of the reform, now evaluates the new system this way:30 I have always believed in the saying 'the money where my eyes can see it' ["la plata donde mis ojos te vean"] and in the AFP system my money goes to my individual account and is mine, and the government cannot use it as they see fit. After 14 years, I am now enthusiastic about [the reform]. I have U.S. $100,000 in my pension account [on an annual income of U.S. $18,000] and that is the best guarantee of my future pension. The bottom line is that the private system has been an enormous advancement for the Chilean workers.

"The Chilean reform probably involves the single most massive dismantling of public sector social insurance in modern history."

Similarly, Robert Myers, Chief Actuary of the U.S. Social Security Administration from 1947 to 1970 and an opponent of a private option for social security in the United States, evaluated the new private system in Chile this way:31 "In summary, the new system - both as to its design and as to its performance - is excellent."

The Basic Benefit.

• For those with below-average incomes, this benefit replaces more than 18 percent of preretirement earnings.
• If a worker's preretirement income is exactly 18 percent of the national average, then the basic benefit replaces exactly 100 percent of preretirement income.
• For those with above average income, the basic benefit amounts to less than 18 percent of preretirement earnings.

Earnings-Related Benefit.

"In addition to a basic flat-rate pension for all workers, Britain has a second, earnings-related tier of benefits."

Counting both the basic and SERPS benefits, the average income earner would retire with benefits equal to about 38 percent of preretirement income. If the worker had a dependent, nonworking spouse, the total benefit would be equal to about 49 percent of preretirement earnings. This is about 10 percent less than the benefits paid to the average wage earner under the U.S. Social Security system.

Financing.

Retirement Age.

Pension Benefits for Workers Who Are Contracted Out.

The Success of Contracting Out.

• About 50 percent of British employees are covered by an employer pension plan.
• About 90 percent of workers covered by employer pension plans currently are contracted out of SERPS.
• Thus almost half (about 45 percent) of all British workers are contracted out of SERPS.

Personal Pension Accounts.

Management of Personal Pension Accounts.

"Individuals can also contract out of the second tier by setting up personal pension accounts."

Drawing Retirement Benefits.

• At the retirement age, individuals must purchase a compulsory annuity to provide an annual income for the remainder of their lives.
• The annuity must provide for a 50 percent continuing payment to a surviving spouse.
• The annuity must be increased each year by the increase in the consumer price index or by 3.0 percent - whichever is lower.

Housing Purchases.

Built-In Protection.

"Private pension benefits are indexed for inflation by contract and protected against a sudden downturn in portfolio value immediately prior to retirement."

Others argue that the private sector cannot offer inflation-indexed benefits. But in Britain, as in Chile, the private pension benefits are indexed for inflation by contract. This is feasible because private investments regularly earn real returns well in excess of inflation. Moreover, in Britain the government now issues inflation-indexed securities. As a result, investors can purchase securities that promise a government-guaranteed real rate of return, with automatic adjustments for inflation.38

Success of the Personal Pension Accounts.

Defined-Contribution Employer Plans.

"More than 70 percent of British workers have chosen to opt out of the public system."

Through all of the private options, more than 70 percent of British workers have now opted out of the public SERPS program, which is about half of the nation's social security system. Many of the remainder are workers who do not have employer-provided pensions and are too old to exercise the personal pension account option. Like Chileans, Britons have shown a massive preference for the private sector over the public system.

Peru

Workers exercising the private option now contribute 10 percent of wages to their investment accounts to finance retirement benefits. These funds are invested tax free through an AFP of the worker's choice. Workers may contribute an additional 10 percent of wages to their accounts. All contributions are tax deductible, and the investment returns are tax-free. The retirement age is 65 for men and 60 for women, but earlier or later retirement is allowed on the same terms as in Chile.

Workers contribute an additional 3 percent to 4 percent to the private system to finance private life and disability insurance to cover the survivors and disability benefits provided by the old system. Those who choose the private option receive a 5 percent pay increase from their employers, who are relieved of payroll taxes under the reforms.

"Peru, Argentina and Colombia have privatization efforts under way."

Those already in the workforce who choose the private option are given recognition bonds for their past contributions into the old system. As in Chile, the bonds accumulate with interest until retirement, when they can be cashed in over time to help finance retirement benefits. Also as in Chile, the government continues to finance minimum benefits for those whose assets are inadequate. And the AFPs guarantee a minimum investment return. Peru's new system has not been in effect long enough to report results. But it holds great promise of replicating Chile's success.

Argentina

In addition, the new system includes an entirely private earnings-related component applying to workers under 45, with no option to stay in a public system for these benefits. Under this component, workers pay 10 percent of wages up to a maximum of US$36,000 in wage income per year into individual investment accounts, to be managed by AFP institutions. The government actually collects the payments itself and then distributes the funds to the chosen AFPs. At least 20 organizations have applied to be AFPs, and each must guarantee a minimum return on its investments. Regulations limit AFP investments to no more than 50 percent in stocks, 50 percent in corporate bonds and 30 percent in mortgages, among other restrictions.

While still too young to report definitive results, this new system should produce an overwhelming economic success, similar to Chile's.

Colombia

As indicated above, under pay-as-you-go financing, the funds paid by workers and their employers today are not saved and invested to finance the future benefits of those workers. Rather, these funds are mostly paid out immediately to finance the benefits of current retirees. The benefits to be paid in the future to today's workers in retirement must be funded by collecting taxes from future workers.

"Pay-as-you-go financing leaves a system vulnerable to adverse demographic and economic developments."

This pay-as-you-go financing leaves the system vulnerable to adverse demographic and economic developments. One of the most important is a decline in fertility, in the average number of lifetime births per woman. As fertility declines, there are fewer workers to pay promised social security benefits, leading to financial crisis.

Another critical factor is life expectancy. As people live longer, retirement benefit obligations race ahead of payroll taxes paid by current workers in the pay-as-you-go system, again leading to financial crisis.

Both of these developments have been arising for some time, particularly in the Western developed countries. As Table V shows, fertility rates around the world have declined sharply since the early 1950s and are expected to decline further by 2020-2025.

• In the United States, fertility has declined from 3.45 in the early 1950s to 1.92 in the late 1980s, a decline of almost half.
• Over that same time period, fertility in France declined from 2.73 to 1.82, in Italy from 2.32 to 1.33, in Germany from 2.16 to 1.44 and in Spain from 2.57 to 1.46.
• Elsewhere around the world over that period, fertility declined in Japan from 2.75 to 1.68, in South Korea from 5.18 to 1.73, in Australia from 3.18 to 1.86, in Mexico from 6.75 to 3.60 and in Brazil from 6.15 to 3.20.

Table VI shows that life expectancy also is increasing around the world and is expected to continue to do so.

• In the United States and United Kingdom, life expectancy has increased by about six years from the early 1950s to the late 1980s.
• Over the same period, life expectancy has increased by about 10 years in France, Italy and Greece, 13 years in Spain, eight years in Switzerland and seven years in Germany.
• Elsewhere over that period, life expectancy has climbed 14 years in Japan, 22 years in South Korea, 19 years in India, 18 years in Mexico and six years in Australia.

"The fertility rate in developed countries needs to be about 2.1 to maintain a stable population - and only Ireland is at that level or projected to be there."

The impact of these two trends is shown in Table VII, which indicates the percent of population over 65.

• In the U.S., this percentage has increased from 5.3 percent in 1960 to 12.6 percent in 1990 and is projected at 16.3 percent in 2020.
• In Italy, elderly residents have increased from 9.3 percent of the population in 1960 to 14.1 percent in 1990, with projected growth to 20.9 percent in 2020.
• In Japan, the percentage of elderly has climbed from 8.9 percent in 1960 to 11.7 percent in 1990, and is projected to grow to 24.2 percent in 2020.

When a pay-as-you-go system begins, it offers a good deal to the first generation of retirees. That is because they pay taxes for only a few years before retirement and can receive full benefits because workers' current taxes are not saved for their future benefits.

"As a pay-as-you-go system matures, it becomes a bad deal for workers."

But over time, the return paid by the pay-as-you-go system falls as people retire who have paid full taxes for more of their working years. Eventually, the system reaches a mature stage when people retire having paid full taxes into the system for their entire lives. At that time, even under the best circumstances, the system pays a below-market return, since the funds paid in as taxes are not invested in assets and do not earn market returns. As a result, the system can only pay a positive return to the extent that payroll taxes grow faster than benefit obligations. This can occur only when the growth in real wages is high and the ratio of workers to retirees is also high.

But, over the long run, real wages can be expected to grow at 2 percent at most. Over the last 25 years in the United States, real wages have grown at around 0.5 percent. Moreover, relative population growth can be expected to hold to no more than 2 percent over the long run. By contrast, the capital market investment returns that would be earned by a fully funded invested system are much higher. The full real rate of return to capital before tax (which measures the full productive output of capital investments) is 10 percent or more.40

This means that in the mature stage of a pay-as-you-go system, workers receive much lower returns than if they had been allowed to invest in a private fully funded system like that of Chile and similar countries.41

This problem is worsened by declining fertility and rising longevity, which reduce relative population growth for workers vs. retirees. The result is that reduced returns in the pay-as-you-go system, discussed above, make those returns even worse when compared to capital investment returns. One study of the United States indicates that middle-income couples are now losing about $1 million in real terms over their lifetimes because of the low social security returns compared to capital market returns.42

The countries whose nontraditional social security systems are discussed in this study show the way to solve these problems. The privatized systems of Chile and other countries shift from a public pay-as-you-go system to a private fully funded system. In the process, they end and even reverse the accumulations of unfunded liabilities. They avert the long-term financial crisis of pay-as-you-go systems by shifting to fully funded systems. And they allow workers to receive higher returns and better benefits.

Countries around the world should look to these nontraditional social security systems as models for reform.

NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.