Criteria for Social Security Reforms--an International Perspective by Estelle James

> 20 countries have social security systems with funded privately managed accounts Diffusion of structural reform around the world, Cumulative number of reforming countries

Number Contributors to Mandatory Multi-pillar Systems,

Typical size plan 6-12% contribution rate to funded pillar This usually includes some disability and survivors’ insurance, administrative costs Therefore, larger than usually mentioned in US--but wage base is larger here Sweden has new 2.5% IA, complex system to keep administrative costs low

Criteria used for choosing and evaluating system Sustainable Good for economic growth Avoids undue financial risk, political risk Cost-effective Distributes costs and benefits equitably

Sustainability and growth Most analysts now agree that pure pay-as- you go (PAYG) system is not sustainable-- very sensitive to demography Our current system is PAYG: unsustainable Suppose benefit ratio (benefit/wage) = 38% –when support ratio (workers/pensioners) = 3, required contribution rate = 12.7%, –when SR = 2, CR = 19% or benefit falls to 25% –we are heading there as population ages: either benefits will go down or contribution rate up

Agreement that some pre-funding is good for sustainability, growth If support ratio=2 & replacement rate=38% –under PAYG contribution rate = 19%; –under pre-funding CR = 6% (if r = 5%) – =15% (if r = 2%) So partial pre-funding can help sustain current benefits and avoid peak tax rates Good for workers and economy--increases long term saving, productivity, output Broad agreement pre-funding is desirable Disagreement: public v. private management

Public v. private management of funds In theory, public funds--scale economies But many countries have earned low, even negative rates of return on publicly managed pension funds--bad for systems and poor allocation of capital for economy Reasons--government bonds or politically motivated investments for public funds May encourage deficit finance

-1.8% -12%-10%-8%-6%-4%-2%0%2%4% Japan Korea Philippines Sweden US Malaysia India Costa Rica Morocco Singapore Canada Jamaica Kenya Guatemala Sri Lanka Ecuador Egypt Venezuela Zambia Uganda Average gross returns minus bank deposit rate RETURNS TO PUBLICLY MANAGED FUNDS

-8.4% -50%-40%-30%-20%-10%0%10% Philippines Morocco US Sweden Malaysia Canada India Japan Korea Jamaica Sri Lanka Singapore Kenya Guatemala Costa Rica Ecuador Tanzania Egypt Venezuela Zambia Uganda Peru Average gross returns minus income per capita growth RETURNS TO PUBLICLY MANAGED FUNDS

-10%-8%-6%-4%-2%0%2%4%6%8%10% United Kingdom (84-96) Sweden (84-93) United States (84-96) Belgium (84-96) Chile (81-96) Ireland (84-96) Netherlands (84-96) Spain (84-93) United Kingdom (70-90) Australia (87-94) Denmark (84-96) Switzerland (84-96) Japan (84-93) Netherlands (70-90) Hong Kong (83-96) Denmark (70-88) Canada (75-89) United States (70-90) Japan (70-87) Switzerland (70-90) Average public schemes Average private schemes Gross returns minus income per capita growth RETURNS TO PRIVATELY MANAGED FUNDS

Is political manipulation of public funds likely in the US? We have good governance, trustee laws But we also have pressure groups, lobbying, campaign contributions –Which companies, industries, indexes? –Which products to prohibit? –Market timing--prop up market? –Conflicts between anti-trust cases & regulations v. maximizing returns. –Will deficit spending be encouraged? –Will investment power be too concentrated? –Public investors & corporate governance

This is main rational for IA’s Pre-funding desirable, private management of funds best for economy and government Secondary rationale--giving people some control over their own retirement savings is beneficial socially and psychologically

But has to be done right How to minimize political risk, financial market risk How to be keep costs low How to distribute costs and benefits equitably How to cover transition costs

Risk Risk and uncertainty inevitable in all old age security plans, given long time horizon Political risk--governments change, benefits cut, accumulated funds dissipated Financial market risk--price volatility Best protection against risk--diversification: public & private, stocks & bonds, domestic & international, broad market benchmarks, long time horizon (historically, no loss with 20-years of diversified investment)

Costs Funding keeps tax costs lower than PAYG But IA’s may incur administrative costs, especially at start-up and for small accounts Methods used by low-cost funds and countries: scale economies, competitive bidding, passive investment, holding for long term, minimize marketing costs

Distribution Current system supposedly redistributes from rich to poor families, but studies in many countries have shown otherwise (recent NBER studies in US): –rich live longer –members of middle class families who work few years often gain –major gainers have been first cohorts

Essential to protect low-earners, who are most dependent on social security They will benefit from higher rate of return They will benefit from low payroll taxes (young families with children are poorest) Public tax-financed (PAYG) part should be more progressive than currently--my view Important to model welfare of lowest earners to make sure they gain from reform

Transition costs Transition costs arise because benefits must continue to be paid to current pensioners while part of contribution is diverted to IA’s Other countries have financed transition by: –cutting benefits, keeping some workers in PAYG system, using budget surplus, proceeds from state enterprise sales, tax hike, borrowing –difficult to figure out counterfactual

Key points: Transition costs arise from pension debt of current system, not created by shift to IA’s Current system will run increasing deficit, that will continue in long run if not changed Transition to IA’s makes deficit come sooner, but it is temporary

Do transition costs use up gains? Transition costs can be covered and workers still come out ahead if new system enhances economic growth and removes distortions: –increases long term saving –avoids labor market impact of peak payroll taxes –more labor and capital and higher productivity Way has to be found to capture some of these gains to finance transition

Conclusions Basic rationale for IA system-- sustainability and growth Many difficult implementation issues--risk, costs, distribution, transition But these issues are not insoluble--other countries have solved them and hopefully we can do it better Best to get started sooner rather than later, so change can be more gradual, less painful