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Social Security: Reform, Refund or Opt-Out? (Part 3)

Posted: May 18, 2009 | Author: | Filed under: U.S. Economy | Tags: , , , , , , , |Comments Off on Social Security: Reform, Refund or Opt-Out? (Part 3)

Lessons from the World

One of the most interesting things about the large number of countries Osaka Asahi Shinbunreforming their public pension programs is how dissimilar many are to the United States.  A large number are in Latin America or are Asia countries that are not experiencing the demographic challenges faced by the United States.  Instead, they reform their systems because the old systems have lost their store of value function.  Privatization is required because the trust between recipients and their governments has broken down.  Chile (1981), Columbia (1993), Peru (1993), Mexico (1997), Bolivia (1997), El Salvador (1998) and Kazakhstan (1998)  have the least future demographic problems, are not developed countries, and have had the largest reforms.[1]  The expected retirement benefits in these countries are now derived from the income produced by an asset portfolio in individual accounts.

The most moderate reforms have happened in countries with high per capita incomes and severe demographic problems.  These countries include Switzerland (1985), the United Kingdom (1986), Denmark (1990), Australia (1992), Argentina (1994), China (1995), Uruguay (1996), Hungary (1998), Sweden (1998) and Poland (1999).  These developed countries have adopted systems that blend defined contribution accounts with a defined benefit.  Germany and Japan have serious demographic problems.  They are also highly developed countries.  They—like the United States—have passed minor reforms.  These countries have less suspicion that their government will not provide secure retirement resources somehow.  Traditional PAYG systems require a “social contract.”  Trust between workers of different generations is higher developed countries than in developing countries.  Trust between households and government is also higher.

England under the Thatcher realm was one of the first developed countries to privatize the public pension system for the sake of cost savings and ideology. The Conservative party argued that the state should revert to providing a ‘floor’ pension rather than a plan supporting comprehensive earnings replacements.  The Thatcher government introduced three major reforms.[2]  First, they cut back indexing the basic flat rate pension from earnings to price indexation.  Second, they cut benefits by more than half under the State Earnings-Related Scheme (SERPS) that was introduced in the mid 1970s. This program was generous and aimed at income redistribution to eliminate the poverty potential of poorer pensioners.  Third, they allowed opting out into personal pensions.  The reforms made during the Thatcher years and later reforms made by the labor party eliminated SERPS.  They also reformed the Minimum Income Guarantee (MIG) (which is now called the Pension Credit Guarantee).  This left the U.K. system in a financially sustainable position but they now are experiencing a resurgence of poverty among the elderly.[3]

Chile replaced its PAYG system with pre-funded personal retirement accounts as a result of a crisis in 1980.  Chile is a developing country with incipient capital markets.  Under the new system, personal accounts have helped to modernize the economy and solve many of the problems it had with its capital markets. However, the new system has not proven to be a panacea to workers seeking better and secure retirement benefits. 

The traditional system provided benefits for at least two thirds of the workers. In 2003, the number of active participants was estimated to be about 62 percent of the labor force or 68 percent of those employed.  This is in stark contrast to the U.S. Security system that covers 96 percent of the workforce.  The sporadic numbers for active participation in Chile means that many workers may not reach the 20 full years of contributions threshold required to receive the minimum pension guarantee.  The rate of participation also brings into question concerns the number of workers that will be projected to depend on the minimal pension guarantee or the assistance pension.  This raises serious questions concerning the fiscal consequences of the system.

It has estimated that commissions and fees ate up more than 25 percent of the worker’s accumulated benefit in the program’s early years.[4] Some regulation has improved this, but fees and commissions remain higher currently than those of publicly run pension plans.  Studies of the Chilean reform have shown that the systems is successful for those in the top of the income distribution but that low-income workers will find that their personal retirement accounts will not provide enough funds to keep them out of poverty.

Japan also has a blended program that is reviewed every 5 years.  Japan is clearly focused on long-term financial sustainability of the program as it stands.  It is a two-tiered public pensions system with a privatized component in the second, earnings-related tier.   General tax revenues supplement employer and employee contributions. 

 They have also experienced issues since allowing opting-out with funding of the Employees’ Pension Insurance (the second tier called the EPI).  They law allows some of the EPI benefit to be contracted out.  This has been in place since 1966 so there is over three decades of experience with partial privatization in Japan.   A number of contracted-out plans have been paying smaller pension payments than promised to new beneficiaries.  It is estimated the three-quarters of the contracted-out private plans were in deficit in 1999. Many have plans have been terminated.[5]  The Ministry of Finance set up a Pension Fund Management fund to oversee reserve fund management and supervision of the contracted-out private plans.  Japan has also been debating privatizing the existing social insurance program and conversion of financing from PAYG to prefunded or fully funded defined contribution programs.   Experience with the contracted-out plans has left the Japanese public less-than-enthusiastic for further privatization.

Coming up in Part 4:  My take and conclusions

[1] Smetters, Kent, Prospects for Social Security Reform in the United States, NBER Website, Friday, April 07, 2006.

[2] Disney & Emmerson 2004

[3] Diamond (2000)

[4] Soto (2005)

[5] Liu (1999)

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