May 2005

The Global Experience of Pension Reform

The Global Experience of Pension Reform

Jose Pinera
Cato Institute

Chile established its personal retirement accounts twenty-four years ago. Since May 1, 1981, Chilean workers have had the option to create for themselves financial wealth because of ownership in their personal accounts. When given the option, 95 percent of Chilean workers decided to opt out of their payroll taxes in favor of their own private accounts, rather than to stay in the pay-as-you-go system, which depends on demographic changes, political decisions, length of lives, and many other variables. The end result is privatization, but it is the workers themselves who decided they wanted private personal accounts, not the government.

There are two reasons for the success of pension reform in Chile. The first one is the creation of a simple, transparent, and honest system that the workers understand and can voice their opinions about. The simple system offers workers a chance to opt out of the government system with a full payroll tax and put it in a personal retirement accounts. When they reach their retirement age of sixty-five, they can decide to buy annuities or keep the ownership of the money saved in their personal pension accounts. The money is inherited if they die early. The system in Chile has proven to be safe. There has never been a case of fraud in the twenty-four years since its creation.

The mistake of a pay-as-you-go system is that it is extremely difficult to try to define benefits for everyone in the system. Government can favor certain groups of people, such as the poor and the disabled groups. Promising the result without knowing the future of fertility rates, expectancy of life, and many other exogenous variables is equivalent to the creation of a time bomb.

The second reason for the success of pension reform is that it has been able to provide a good rate of return. The real rate of return above inflation has been 10 percent for twenty four years on average. This is, however, an extraordinary growth rate that is not expected to continue.

A cost of the private pension accounts is the commission. It has been about 0.65 to 1 percent of all assets managed today, and this cost has been diminishing.

The system is good because in Chile there was no capital market or long-term savings. Now the capital market is about 70 percent of GNP. The capital market allows people to buy houses financed by twenty-five-year, 6 percent interest-rate mortgages. There is also huge improvement in labor market unemployment. The end result in Chile has been able to the double the rate of growth for fifteen years. The system has survived through three governments and has been improved with experience and technology.

Estelle James

I will talk about the design features of an individual accounts system and the lessons learned from other countries.

If the pension fund is managed by private institutions, there will be a conflict since the government acts as the regulator and investor. It also opens the door for political lobbying for choices of investments.
 
Examples from other countries show that public funds get a lower rate of return than privately managed pension funds and are subjected to political manipulation and misallocation of capital.

Private management entails problems which includes high administrative costs and financial market risks. Workers may also spend their money too quickly during their payout stage. My main topic is how other countries solve these problems in their individual accounts system.

About thirty countries have adopted a pension fund system with a personal account component. They have a wide range of contributions and benefits, ranging from Chile where workers have to contribute 12.5 percent of their payroll tax to Sweden where workers only contribute 2.5 percent into their personal accounts.

A key to design a pension fund with personal accounts is to keep administrative costs low. If expense ratio is 1 percent of assets annually, it will decrease the final pension by 20 percent. Chile has cost of 0.7 percent of all assets managed, while the cost of the Thrift Savings Plans (TSP), in Holland, Australia, and Switzerland is only about 0.1 percent of assets. Low costs can be maintained by using the institutional markets and competitive bidding process.

Countries use portfolio restrictions to reduce risk. For instance, some require portfolio diversification and set limits in risky assets. On the other hand, from the experience of the United Kingdom, if workers are given too many choices, they sometimes make mistakes.

Every country that has an individual account system also has a safety net system. Some examples of the safety net system include minimum pension guarantee used in most Latin American countries, the flat benefit in western Europe, and the mean-tested benefit in Australia and the United Kingdom.

From the experiences of the countries that have an individual accounts component is the pension system, a mixture of pay-as-you-go publicly managed and privately funded individual accounts will create a system which is most diversified and sustainable. Ultimately, we will have to make a value judgment between reducing benefits and increasing revenues.

Phillip Swagel
AEI

Many critics point to the United Kingdom as the poster child for problems with pension systems with private accounts. However, the United Kingdom might also serve as a potential poster child for all that has been learned since the British experience. Some of the criticisms do raise valid concerns, particularly with regard to consumer protection and financial advice. In the plan discussed for the United States there would be an option to have a bond fund, just like in the TSP system, which would replicate the benefits of a guaranteed benefit. The calculation of the off-set rate, or the amount diverted from your guaranteed benefit, then becomes crucial. It is important to note however, that it is not the intention of the administration to fix the off-set rates to bias in favor of accounts, or the traditional system. 

If anything, the assumptions of personal account participation by the Social Security Administration (SSA) actuaries are too optimistic, with more participation than is likely, at least initially. This assumption has significant ramifications on the size of transition funding. As an ironic diversion, during the presidential campaign, the Kerry campaign set a $2 trillion transition cost which is derived from an assumption of 100-percent participation in accounts. This begs the question, if these accounts are so bad, why would everyone voluntarily opt-in?

There are several other criticisms of the system in place in the United Kingdom from which we can learn. One is with the issue of annualization and inheritability. This issue again points to the tradeoff between risk and security. Another concern is the issue of administrative costs. Though I suspect that administrative costs have gone down since 1996, they remain a concern for successful reform. 

It is likely that U.S. implementation of personal accounts will run into problems. But, they will probably be unforeseen ones, rather than mistakes made by other nations in the past.  Criticisms based on the failings of other countries, therefore, are not very persuasive, because none of those failings were necessarily unavoidable mistakes, or deep structural problems with accounts.

AEI intern Chris Cheung prepared this summary.