[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]
THE FUTURE OF SOCIAL SECURITY FOR THIS GENERATION AND THE NEXT:
EXPERIENCES OF OTHER COUNTRIES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SOCIAL SECURITY
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 18, 1997
__________
Serial 105-41
__________
Printed for the use of the Committee on Ways and Means
----------
U.S. GOVERNMENT PRINTING OFFICE
51-503 cc WASHINGTON : 1999
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Social Security
JIM BUNNING, Kentucky, Chairman
SAM JOHNSON, Texas BARBARA B. KENNELLY, Connecticut
MAC COLLINS, Georgia RICHARD E. NEAL, Massachusetts
ROB PORTMAN, Ohio SANDER M. LEVIN, Michigan
JON CHRISTENSEN, Nebraska JOHN S. TANNER, Tennessee
J.D. HAYWORTH, Arizona XAVIER BECERRA, California
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
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C O N T E N T S
__________
Page
Advisory of September 8, 1997, announcing the hearing............ 2
WITNESSES
Australia, Commonwealth of, Department of Social Security,
Anthony Blunn, as presented by Paul O'Sullivan, Australian
Embassy........................................................ 43
Cato Institute, Jose Pinera...................................... 30
Conservative Party of Britain's Policy Development and Briefing
Unit, London, England, Daniel Finkelstein...................... 16
Enoff Associates, Ltd., Hon. Louis D. Enoff...................... 51
Ghilarducci, Teresa, University of Notre Dame.................... 22
International Center for Pension Reform, Santiago, Chile, Jose
Pinera......................................................... 30
International Social Security Association, Bromma, Sweden, Karl
Gustaf Scherman................................................ 5
Kay, Stephen, University of California at Los Angeles............ 36
O'Sullivan, Paul, Australian Embassy............................. 43
THE FUTURE OF SOCIAL SECURITY FOR THIS GENERATION AND THE NEXT
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THURSDAY, SEPTEMBER 18, 1997
House of Representatives,
Committee on Ways and Means,
Subcommittee on Social Security,
Washington, DC.
The Subcommittee met, pursuant to call, at 11:10 a.m., in
room 1100, Rayburn House Office Building, Hon. Jim Bunning
(Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SOCIAL SECURITY
CONTACT: (202) 225-9263
FOR IMMEDIATE RELEASE
September 8, 1997
No. SS-10
Bunning Announces Sixth Hearing in Series
on ``The Future of Social Security
for this Generation and the Next''
Congressman Jim Bunning (R-KY), Chairman, Subcommittee on Social
Security of the Committee on Ways and Means, today announced that the
Subcommittee will hold the sixth in a series of hearings on ``The
Future of Social Security for this Generation and the Next.'' At this
hearing, the Subcommittee will examine the views of experts on the
Social Security reform experiences of other countries. The hearing will
take place on Thursday, September 18, 1997, in the main Committee
hearing room, 1100 Longworth House Office Building, beginning at 11:00
a.m.
In view of the limited time available to hear witnesses, oral
testimony will be from invited witnesses only. However, any individual
or organization may submit a written statement for consideration by the
Committee and for inclusion in the printed record of the hearing.
BACKGROUND:
The Subcommittee's first five hearings in the series have focused
on the recommendations of the Advisory Council on Social Security, the
fundamental issues to consider when evaluating options for Social
Security reform, the findings of the 1997 Social Security Board of
Trustees, and the views of policy experts, organizations with different
generational perspectives, business and labor representatives, and
Members of Congress on Social Security reform.
Forecasts of future insolvency of the Social Security program are
largely due to the aging of the population, particularly the coming
retirement of the post World War II baby boom. Most industrialized
countries are experiencing problems similar to the United States. The
effects on each country's retirement system, however, differ, depending
on each country's stage of economic development, societal behavior, and
cultural attitudes. Many of these countries have implemented reforms of
their Social Security systems.
Social Security systems in other countries can be broadly
categorized by distinguishing the method of financing between pay-as-
you-go, financed mostly from current revenue and run by the government,
and those that are funded in advance, which may be run by the
government or the private sector. Other variations include degrees of
income redistribution, government and private-sector responsibilities,
benefits payable based on need or as a matter of right, and choice of
alternative plans.
Remedies being enacted by other countries include raising the
retirement age, making certain benefit reductions, mandating
participation of workers who have remained outside the system, raising
contribution rates, and establishing compulsory contributions paid to
individual accounts in a national account managed by a public agency.
In 1981, Chile fully replaced its public pay-as-you-go plan with
privately and competitively managed mandatory personal savings plans.
Recently, other Latin American countries have begun replacing or
supplementing their public pension schemes with mandatory or voluntary
competitive private savings plans.
In announcing the hearing, Chairman Bunning stated: ``The United
States is not alone in facing the challenges of an aging population. We
can learn a great deal from the experiences of other countries who have
tackled needed changes in their Social Security systems.''
FOCUS OF THE HEARING:
The Subcommittee will receive the views of experts on the Social
Security reform experiences of other countries. Specifically, Members
of the Subcommittee would like to hear the views of each individual
regarding: (1) prevailing factors contributing to Social Security
reform, (2) national budget and macro-economic effects of the reforms,
(3) problems faced during the transition to the new Social Security
system, including transition costs and how such costs were paid for,
(4) the degree of individual risk and reward assumed, (5) the degree to
which protections against inflation are contained in the new Social
Security system, and (6) the degree to which features of the Social
Security system are applicable to the United States situation.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement
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Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of
Representatives, 1102 Longworth House Office Building, Washington, D.C.
20515. If those filing written statements wish to have their statements
distributed to the press and interested public at the hearing, they may
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noted above.
Chairman Bunning. The Subcommittee will come to order,
please.
Today marks our sixth hearing in a series on the future of
Social Security for this generation and the next. During this
hearing, we will focus on Social Security reform experiences of
other countries.
Forecasts of future insolvency of the U.S. Social Security
Program are largely due to demographics, including aging baby
boomers, declining birth rates and increased life expectancies.
The United States is not alone in facing the challenges of an
aging population. With few exceptions, life expectancies are
increasing throughout the world.
The World Bank estimates the number of people age 60 and
over around the world will triple between the year 1990 and the
year 2030. However, the strain this places on the retirement
systems differs depending on each country's economy, society,
and culture. Most industrialized countries are experiencing
similar solvency problems with their Social Security Programs.
Today, we will hear about the experiences of four foreign
countries who have reformed their Social Security Programs.
Each of these countries has implemented or is about to
implement, varying degrees of privately managed personal
savings accounts.
In 1981, Chile fully replaced its public pay-as-you-go plan
with mandatory private accounts. The United Kingdom has allowed
workers to partially opt out of the State plan in favor of
private accounts. We will hear testimony from representatives
of Chile and the United Kingdom today, along with
representatives from Australia and Sweden. We can learn a great
deal from the experiences of these countries who have tackled
needed changes in their Social Security systems.
Each of these countries instituted change during economic
and political environments that are not identical to the United
States. However, we should listen carefully to their reasons
for change, and closely consider the aspects of their reforms
that could shed light on possible reforms of our own Social
Security Program.
In addition to the representatives from the foreign
countries, we will also hear from Social Security experts who
will provide their own observations on what we can learn from
these and other countries.
In the interest of time, it is our practice to dispense
with opening statements, except from the Ranking Democrat
Member. All Members are welcomed to submit statements for the
record.
I yield to Congresswoman Kennelly for any statement she
wishes to make.
Mrs. Kennelly. Thank you, Mr. Chairman. Today, we review
the Social Security reform experiences of several countries.
Some of those countries face demographic and economic
situations much like the United States. Others, like Chile, are
developing social insurance systems along with new economic
systems.
There are some important lessons to be learned from each of
these countries. Those lessons are both positive and
cautionary. Some of the countries we will hear from today have
experienced significant economic growth and project long term
increased national saving from their revised systems. But those
same countries also provide cautionary lessons about the
effects of privatizing some or all of our national retirement
system.
Most countries that have adopted this approach have
experienced excessively high administrative costs. Moreover,
one country, Great Britain, has experienced significant
consumer fraud and investor unhappiness with investment
outcomes. No system has survived without revisions. We must
review these lessons carefully and exercise care in
implementing changes in our own retirement system.
I want to thank today's witnesses for appearing before us,
and I look forward to hearing what they have to say. Thank you
for coming.
Chairman Bunning. We have a very distinguished panel of
witnesses and I am going to introduce them, or try to. Some of
the pronunciations might suffer a little bit, but I will try.
Karl Scherman is president of the International Social Security
Association in Sweden; Daniel Finkelstein is director of the
Conservative Research Department for the Conservative Party of
Britain's Policy Development and Briefing Unit in London; Dr.
Teresa Ghilarducci, professor of economics at the University of
Notre Dame; Dr. Jose Pinera, president of the International
Center for Pension Reform in Santiago, Chile, and cochairman of
the CATO Institute Project on Social Security Privatization;
Stephen Kay, a doctoral candidate at UCLA; Paul O'Sullivan,
Deputy Chief of Mission at the Australian Embassy, who will
present the testimony of Anthony Blunn, Secretary of the
Australian Commonwealth Department of Social Security; and Lou
Enoff, an old friend, of Enoff Associates Limited, former
Acting Commissioner of Social Security.
Mr. Scherman, if you would begin, please.
STATEMENT OF KARL GUSTAF SCHERMAN, PRESIDENT, INTERNATIONAL
SOCIAL SECURITY ASSOCIATION, BROMMA, SWEDEN; AND FORMER
DIRECTOR GENERAL, NATIONAL SOCIAL INSURANCE BOARD
Mr. Scherman. Mr. Chairman, I am grateful for having been
given the opportunity to address the Social Security
Subcommittee of the Ways and Means Committee. This is the first
time a president of the International Social Security
Association has been invited to testify before this
Subcommittee. This fact makes this event especially significant
for me.
Sweden is at present considering a major public pension
reform. Like today's system, the new one will be a compulsory
national scheme. In addition to an earnings-related part, there
will be a fairly high guarantee level for those who have not
earned enough pension credits.
The earnings-related part of the scheme will contain a
fully funded supplement. Two percentage points, out of a total
contribution of 18.5 percent, will be set aside for this
purpose.
To summarize, the reform will be designed to reduce the
increase in pension spending; to more closely link
contributions and benefits; to make pension spending as a
percentage of GDP, gross domestic product, less sensitive to
the rate of growth of the economy; and to make it possible to
have a stable contribution rate in the future.
The reduction of the pension spending will be obtained
primarily by three measures: The first one is a new benefit
formula that will take all lifetime earnings into account. This
will mean that everyone who does not work full time all his
adult life, will get a lower pension than in the current
system. For many persons, this will mean a fairly substantial
reduction.
The second measure is a new indexation method, according to
which the pensioners will be fully compensated for inflation
only if the growth in the economy exceeds a certain level.
Thus, the pensioners will be made to share with the active
population the problems following a weak economic growth.
The third cost containment measure is that the amount of
the old-age pension will depend on life expectancy. Thus, when
life expectancy increases, there will be a built-in incentive
to work longer, or to save more prior to retirement, or both,
or to accept a lower yearly pension.
Another feature of the reform that will contribute to a
stable contribution rate in the future is the use of a reserve
fund in the pay-as-you-go system as a buffer for demographic
fluctuations. These will be dealt with by letting the size of
the fund fluctuate, instead of changing the contribution rate
from time to time. There is presently a reserve in the current
pay-as-you-go system that corresponds to 5\1/2\ years of
pension payments. This reserve will slowly fall to about 1 year
of payments around the year 2040, and then increase again.
In the new system, the fall in the current reserve fund
will be compensated by accumulation of reserves in the premium
reserve supplement to the earnings-related pension. There is
today a heated debate in Sweden about this part of the new
pension system.
Mr. Chairman, by way of concluding, I venture to share with
you a few thoughts about our reform that I think might be of
interest to you in your own reform process.
First, we might say that we face similar problems. Sweden
is a mature postindustrial State with important social
commitments, and we have realized that we have major problems.
Our social insurance programs are neither financially stable
nor adapted for encouraging continued work force participation
for older workers.
Second, I want to say that an economically sound pension
reform can be brought about without a total switch to a fully
funded system by changing the benefit formula, indexing
pensions to wages instead of prices, introducing demographic
reserve funds, and adapting benefits to average life
expectancy.
Last, although not absolutely necessary, it might also be
worthwhile to switch a share of the earnings-related pension
system into a fully funded scheme, thereby spreading the risks
as much as possible.
Mr. Chairman, distinguished Members of the Subcommittee, I
appreciate very much to have had this opportunity to share with
you some thoughts about the Social Security reform efforts in
my home country. Thank you for listening. I am prepared to
answer any questions that you want to put to me.
[The prepared statement follows:]
Statement of Karl Gustaf Scherman, President, International Social
Security Association, Bromma, Sweden; and Former Director General,
National Social Insurance Board
I am grateful for having been given the opportunity to
address the Social Security Subcommittee of the distinguished
Ways and Means Committee. This is the first time a President of
the International Social Security Association has been invited
to testify before this important Subcommittee. This fact makes
this event especially significant for me.
1. Introduction
Sweden is at present considering a major social security
pension reform designed to: curtail rising pension spending;
adjust pension benefits automatically for lengthening life
expectancy;
1. more closely link contributions and benefits;
2. make pension spending as a percentage of GDP less
sensitive to the rate of growth of the economy.
Pension reform is a major political challenge. The Swedish
experience is that a condition for a successful reform is that
it be designed in a non-political setting in a process in which
all major political parties are participants and in which both
practical politicians and technical experts can work together.
The reform process takes a long time and should be started
without delay, once the need for reform is observed. Also,
simply coming up with a new set of principles for handling
retirement benefits is not likely to be sufficient. One needs
also to have worked out how to make complementary changes in
survivor and disability benefits before one can expect reform
of retirement benefits to be finally adopted.
I am pleased to be able to share with you, distinguished
Committee members, the Swedish experience from an arduous and
complex reform process.
2. Prevailing factors contributing to Social Insurance reform in Sweden
2.1 An overview of the current system
All persons residing in Sweden are covered for certain
benefits, the most important of which are: medical care, basic
pension, child-allowance and parental benefit at a flat rate
level. These are available on the sole basis of residing in
Sweden and do not depend on the payment of any contributions.
Persons with income from gainful employment (whether as
employed or self-employed) are also covered for sickness cash
benefit, supplementary pension, work injury and unemployment
benefits and parental benefit at an income-related level. All
schemes, apart from the medical care and child allowance, are
in principle contributory.
To summarize, basic features are that the Swedish system is
statutory, universal and based on residence, and that it is
generally not means-tested but income-related.
Administration
The Social Insurance system in Sweden is administered by a
Government agency, the National Social Insurance Board, through
its regional and local agencies. The Ministry of Health and
Social Affairs is responsible for legislative questions and
policy questions at the political level. Unemployment benefits
are under the Ministry of Labor administered by the Labor
Market Board and Unemployment Insurance Funds. Medical care in
general is a responsibility for the regional County Councils,
while medical care for the elderly is provided by the local
municipalities.
Costs and financing
The scope of the Swedish social insurance system as well as
the insurance costs have increased markedly during the last
three decades. The main reasons behind this development have
been the implementation of new schemes, improvement of the
benefits, and the maturing of the pension system that was
introduced in 1960. An increasing unemployment has lately added
to the rise in costs.
The total social insurance outlays (exclusive of
unemployment benefits and administrative costs and expressed as
a percentage of GDP) increased from about 7% of GDP in 1965 to
a maximum of more than 20% in 1993. Since then the costs have
decreased, and are expected to amount to around 18% of GDP in
1997. In addition to this public health care costs are
estimated to correspond to about 8% of GDP.
Social insurance is financed mainly through employers'
contributions and to some extent also through contributions
from the insured persons themselves. Other sources of finance
are allocations from the state budget and yields from
accumulated capital in a reserve fund linked to the
supplementary pension system. Public health care is financed
mainly by local income taxes, levied by the County Councils and
the municipalities. For 1997 the total employer's contribution
to the social security is around 30% of the wage bill, and the
employee's contribution is close to 6% of the wage up to a
ceiling.
Costs for old-age, disability and survivors' benefits
amount to about 28% of the wages. Contributions cover about
18.85 percentage points of this.
2.2 Problems in the economy
During the last few years the social insurance systems have
been under debate in most parts of the world. A stagnating
economy, high unemployment and a recent monetary crisis are
phenomena that Sweden has in common with numerous
industrialized countries. In the case of Sweden, the country
entered a deep crisis in the beginning of the 1990's, both in
the economy and in the society as a whole.
In this situation the social insurance system has come into
focus. The size of the National Swedish Social Insurance
System--around 20 per cent of the GDP--means that it is of
greatest significance not only to the well-being of the
individuals, but also to the economy as a whole.
Major changes and adaptations of some of the most important
social insurance schemes have already been implemented and
other changes are under consideration, the most essential one
being a reform of the pension system after a decision in the
parliament in 1994.
The Swedish economy now seems to recover, but still the
fight against the effects of the crisis dominates the
Government's policy.
2.3 Structural problems
The main structural problem with social insurance in Sweden
is that there are no direct links between the state of the
economy and the paying of benefits from the various schemes.
The ability to pay is dependent upon the growth in the economy.
With a low growth in the GDP, as Sweden has experienced lately,
the burden on the working population gets heavier than if
growth is high.
The pension system is the biggest part of social insurance
and, there, the problems resulting from the lack of
correspondence between growth in the economy and expenditures
of the system are the most conspicuous. The current pension
formula implies that the pension is raised in accordance with
inflation, regardless of growth in the economy. Thus, when
there is a low growth in the economy, then the pension cost as
a percentage of GDP gets higher than when there is a high
growth. To come to grips with these problems a completely new
pension system has been designed. The principles were passed by
the parliament in 1994. Five of the seven major political
parties today representing about 80% of the electorate are
committed to this change.
3. Pensions
3.1 The current pension system
3.1.1 Basic features
The current public pension system consists primarily of two
parts, the flat rate basic pension and the earnings related
supplementary pension. Included in the public pension system
are also additional pension benefits, as well as housing
supplements and partial retirement pensions.
Everyone who has lived in Sweden for at least 40 years, or
has worked for at least 30 years, is entitled to an unreduced
basic pension. The basic pension provides a single person with
96% of a base amount. Married persons receive 78.5% of the base
amount. The base amount corresponds currently to about 5,000
USD. This basic pension is fairly high, taking into account the
fact that those who have no other pension income get special
supplements.
A person who has worked for at least 30 years is entitled
to an unreduced supplementary pension. The pension is
calculated on the basis of the average covered income during
the 15 best years. The covered income is subject to a ceiling
of about 35,000 USD at current exchange rates. Both pension
credits earned and pensions paid out are increased with
inflation.
The basic pension is financed partly out of general revenue
and partly out of employers' contributions. The supplementary
pension is financed by employers' contributions, based on the
wage bill, without any ceiling. The supplementary pensions are
based on the pay-as-you-go (PAYG) financial principle with a
fairly large reserve fund.
3.1.2 Key problems in the current system
One problem is that there is an imbalance between the
trends in revenues and in outlays. Pension payments are
financed out of contributions, based on wages. Pension payments
are indexed according to the consumer price index. If real
wages increase, the burden of financing the pensions will be
lower than if they do not. The increase in real wages has
significantly slackened since the 1950's and the 1960's. As a
consequence, the burden on the active population to finance the
pension system is now heavier than in earlier decades.
Another problem concerns the portion of peoples' incomes
that is covered. If real wages increase, the ceiling for
pensionable income is successively lowered, relative to wages,
since the ceiling is indexed according to prices.
A third problem is that pensioners live longer. In the year
2000 there will be 30 old-age pensioners for every 100
economically active persons. 25 years later this number will
have increased to 41.
Other problems include unemployment. During the period
1990-1993 the cost of old-age, disability and survivors'
pensions rose dramatically, from 24.5% to about 30% of the
contribution base, to a large part due to unemployment eroding
the contribution base.
The link between an individual's income, contributions and
benefits is weak. The national supplementary pension scheme
favors those who have had an uneven flow of income, or who have
worked a limited period during their active years.
Many people receive only a small pension in proportion to
their work in comparison to those who have not worked at all or
for very short periods, due to various basic pension
supplements to those who have not accrued pension credits for
an income related pension.
Savings: The national supplementary pension scheme no
longer contributes to savings to any significant extent.
The first three problems mentioned above are the most
important ones. I will discuss them below. First, however, let
me describe the new pension system.
3.2 The new system for public pensions in Sweden
Main differences between the current pension system and the
new one are that the old system bases benefits on only the
years of highest earnings, whereas the new bases benefits on
the full career, that the old is indexed to prices and the new
to wages, that the old system does not adjusts benefits for
changes in life expectancy, whereas the new one does. The
current basic pensions will be abolished. In the new system
they will be replaced by a fairly high minimum guaranteed level
for low-income earners.
3.2.1 Basic Features
Like today's system, the new one is a compulsory national
scheme. In addition to an earnings related part there will be a
guarantee level for those who have not earned enough pension
credits. For an old-age pensioner who is not entitled to an
earnings-related pension, the guarantee level will be
approximately equal to the amount required for a minimum
standard of living. The guarantee-level will be price-indexed.
Child care, military service and studies after a certain
age will count toward pension rights in a similar way as
gainful employment.
The ceiling for pensionable income will be indexed
according to wages, not as today according to prices. The same
ceiling will be introduced for contributions payable by the
employees.
The earnings related part of the scheme will contain a
fully funded supplement. This new premium reserve pension
scheme will be administered separately from the pay-as-you-go
system and insurance alternatives will be offered to the
public. Pensions from this part of the system will be based on
financial investments and their return.
The pay-as-you-go part of the earnings-related pension will
have the following characteristics:
The coverage will be related to all lifetime
earnings.
Acquired pension credits will be indexed according
to wages.
The pension amount will be dependent upon the
cohort's average life expectancy upon retirement after age 61.
Pension benefits will be indexed in relation to
wages.
The retirement age for an individual will be
flexible after age 61.
There will continue to be a reserve fund in the
PAYG system, serving as a cushion for demographic fluctuations.
3.2.2 Specific aspects of the new system
Contributions to the new system
The reform will link the benefits more closely to the
workers' contributions, both in the calculations and in the
optics of how the contributions are collected. In the future
system a fixed contribution of 18.5 per cent of the
individual's yearly earnings are to be paid into the pension
system. Contrary to the present situation, where the employer
pays the entire contribution, half of the future contribution
will be paid by the insured persons themselves and the other
half by their employers. The former part of the contribution
will be subject to a ceiling.
Out of the total contribution 2 percentage points will be
set aside for the fully funded pension system.
Contributions will be credited to individual notional
accounts and indexed to wage growth
Earnings, hence contributions, over the lifetime of work
starting at age 16, will be used for calculating the pension.
Instead of recording earnings as today and index them to
prices, contributions will be credited to individual notional
accounts, and indexed in accordance with the growth of wages.
The contribution total will be continuously updated each year
to reflect wage increases (just as a savings account balance
rises to reflect interest earnings).
This indexation can be regarded as a kind of ``interest''
on the contributions paid. If there is an increase in the real
wages in society, the value of the pension credits will
increase as well, and if there is a decline in the level of
real wages, the pension credits will decrease accordingly.
The coverage will be related to lifetime earnings
All lifetime earnings (measured by the contributions paid)
will be taken into account. This is a radical shift from the
current system, in which only 30 years with pensionable income
are needed for a full pension, which is then calculated on the
basis of the 15 best. To earn a pension with a 60% replacement
rate in the new system, 42 years of participation with a wage
that increases with the average for the economy will be
required. Earnings used as a basis for calculating the pension
amount are subject to the same ceiling as the contributions
paid by the employees. The ceiling is approximately 50% above
the average wage level for an industrial worker in full-time
employment.
In this context it might be well worth pointing out that
the fact that the size of the pensions is based on lifetime
earnings comprises a radical change of focus for what is
considered socially acceptable. The risk for an inadequate
benefit level stemming from an uneven flow of incomes over a
lifetime will be switched from the state to the individual.
The amount of the old-age pension will depend on life
expectancy
At retirement, accrued pension capital (the contributions
indexed to the rate of growth of wages) will be divided by a
figure, based primarily on average life expectancy at the time
of retirement and a ``norm'' real rate of return.
This rule means that as life expectancy increases, there is
a built in incentive to work longer or to save more prior to
retirement or both or to accept a lower yearly pension.
Pension benefits will reflect wage growth
The ``norm'' real rate of return used to compute the
annuity will be 1.5%. If real wages increase as much as the
norm, the outgoing pensions will be adjusted exactly by the
inflation rate. If, however, the growth in real wages turns out
to be less than the norm, full compensation for inflation will
not be paid. If, on the other hand, wages increase more than
the norm, the pensioners will share in the rising standard of
living.
The result of the method used for indexing outgoing pension
is that there will be no guarantee that the pensioners will be
fully compensated for inflation. This is one of the key
features of the reform, whereby the pensioners are made to
share with the active population the problems following a weak
economic growth.
Flexible retirement age
Starting in the year 2001, the regulations concerning
flexibility in retirement age will be changed significantly.
Everyone will, as today, be entitled to draw an old-age pension
at age 61. The method for computing the pension will, however,
be different. The later the pension is drawn, the higher the
annual pension will be, in the new system due to more pension
credits earned and a lower remaining life expectancy at the
time of retirement. There will not be any upper age limit for
this recalculation.
Reserve fund
A reserve in the PAYG-system will play a vital role as a
cushion for demographic fluctuations. In times when the number
of pensioners is high compared to the size of the working
population, contributions for a strict PAYG-system must be
increased, compared to times when there are fewer pensioners.
These variations are dealt with by letting the size of the fund
fluctuate.
There is presently a reserve in the current PAYG-system,
that corresponds to five-and-a-half years of pension payments
with the new system. This reserve will slowly fall to about one
year around 2040 and then increase again as the ratio of
workers to pensioners increases
3.2.3 The Transition
The new system is planned to start operating 2001. Changes
in basic principles for old age pensions as radical as the ones
described here cannot be introduced without a very long
transition period. People have planned for their retirement on
the assumption that pension promises will be fulfilled. And
pension reform depends on general public support. Therefore,
the new pension system will be introduced successively over a
20 year-period for persons born up to 1954. Persons born 1954
and later will be entirely in the new system.
4. National budget and macro-economic effects of the reform
4.1 Financial dependence on a high level of economic growth
This table shows that the contributions that the active
part of the Swedish population has to pay to cover the pension
costs in the current Swedish pension scheme vary strongly
according to economic growth. Future old-age, disability and
survivors' pension costs \1\ (current scheme) as a percentage
of the contribution base with different GDP growth levels.
---------------------------------------------------------------------------
\1\ These are gross costs. Pension income is taxable income in
Sweden. The average top rate for pensioners is about 30% of total
income.
------------------------------------------------------------------------
0% 1% 2% 3%
------------------------------------------------------------------------
1990.................................... 22.5 22.5 22.5 22.5
2005.................................... 34.3 29.1 25.7 26.9
2025.................................... 49.2 33.6 23.8 17.4
------------------------------------------------------------------------
With stable 1% growth in GDP, a contribution rate of
roughly 34% will be necessary in 2025 to totally finance all
old-age, disability and survivors' benefits. In the case with a
stable growth of 2%, the contribution rate can be maintained at
approximately its 1990 level, i.e. 23%.
We can not know for sure today what growth rate we will
have in the future. What we know, however, is that we can
afford the evolution of costs if we reach around 2% growth,
since the cost profile at 2% growth, as just mentioned, does
not rise above today's contribution level in the long run. This
observation is the reason for the new indexation method for
outgoing pensions described above. That indexation method will
be applied even for existing pensions. This method has been
called ``flexible indexation.''
4.2 The ceiling
With continued economic growth, the earnings of most people
will eventually be above today's ceiling in the pension system.
This follows from the fact that the ceiling currently is price-
indexed. With a yearly growth of 2%, a man born in 1980 will
have reached an income level, equivalent to 12.7 base amounts
during his 15 best years before retirement. A woman born in
1980 can expect to reach an income level of 9.1 base amounts
with a continuous 2% growth. Thus, if the ceiling of the system
continues to be indexed to prices and not to the real growth of
wages, a normal supplementary pension will be a fixed amount,
based on an income of 7.5 base amounts (approximately 35,000
USD at current exchange rate).
The ceiling strongly affects the financial pattern in the
future. With the current ceiling, the contribution rate, needed
to cover the expenses for pension purposes diminishes in the
long run with a yearly growth in the economy of 2% or more. The
diminution is due to the fact that an increasing part of the
income of the working population does not give pension credits,
while the contribution, according to the present regulations,
is still being paid on their entire income, i.e. including the
part of the income that is above the ceiling.
When, as the intention is in the new system, the ceiling
will be indexed to the growth of average earnings, the system
will provide the same relative benefit for tomorrow's
generation as for today's.
4.3 Dependence on demographic fluctuations
The third key problem is that of the aging population and
demographic fluctuatis. Contributions must be raised if average
life expectancy increases, but also when the cohorts of new
pensioners are growing for other reasons, for instance as a
consequence of fluctuations around a general trend. This is the
``baby-boom-problem.''
The remedy for the first problem, a general trend to higher
life expectancy figures, is quite simple; either higher
contributions or an increase in the retirement age. The new
system ``solves'' this problem by taking increased life
expectancy into account in the benefit calculation. In
practice, this could be expressed as an indexation of the
retirement age to life expectancy.
In order to handle the fluctuations around a general trend
it is proposed that resources from the pension funds should be
used as a demographic cushion, which could be accomplished by
letting the funds fluctuate. The fluctuations in the size of
the funds will, consequently, be quite important. This is,
however, unavoidable in a system in which one tries to
stabilize contributions.
By the measures described here, i.e. linking the pensions
to the growth of income, indexing the ceiling for pension
carrying incomes, linking the pensionable age to life
expectancy for each cohort and using the reserve fund as a
demographic cushion, it will be possible to achieve a constant
contribution rate for the Swedish pension system, in a fairly
broad interval of different growth rates and various
demographic fluctuation patterns, while retaining the basic
PAYG-principle.
5. The reform process
The National Social Insurance Board is under the present
law requested to submit to the Government every fifth year an
analysis of the financial situation for the public pension
system. Based on such analyses the Board suggests a
contribution rate for the following seven years. In earlier
years the Board restricted its work to a long term analysis of
the development of the pension system as such. The scope of the
analysis was, however, gradually broadened. The interconnection
between the public pension system and the public economy in
general was highlighted. It became clear that the pension
system was financially unstable, as I have discussed above.
This was pointed out by the Board already in the early 1980's.
Only after a fairly prolonged timelag, the politicians and the
general public came successively to realize that something must
be done to counter this problem.
A special governmental commission was set up in the mid-
eighties to study the pension system, its problems and possible
remedies. The commission's conclusion was that as the problems
would become acute only ten to fifteen years after the year
2000, nothing needed to be done for the time being.
The conclusion from the governmental commission was not
correct. Namely, when financial problems in pension systems
become acute, it is too late to cure them! This was realized by
a new Government, and a new commission was appointed under the
responsibility of the cabinet minister for social security at
that time, Mr. Bo Konberg. Much of the analysis leading to the
final proposal was produced by the National Social Insurance
Board. This commission put forward its proposals early 1994 and
they were accepted by a broad majority in the parliament in
1994.
The Swedish experience illustrates the need for interaction
between experts and politicians. It has been essential for the
result that the analysis has been performed and presented by a
non-political authority. The questions are so technically
complicated that the demand for expertise is great if there is
to be a comprehensive basis for a well-prepared decision. It
has given opportunities for debate on a technical and
scientific level, and it has given opportunities to accustom
people to the need to reform the pension system.
An important observation is that the complexity of the
issues makes them hard to understand and, hence, accept by the
ordinary citizen. In Sweden the Social Democratic Party, the
party that is now in power, have given an extra year for
consideration to get acceptance for the new reform by their
members. Recently the parties behind the agreement once again
agreed to fulfill what had been settled in the agreement of
1994.
New problems now seems to mount for the political process.
There are many issues remaining, some of them of great
political significance. It is not yet clear if they can be
solved within the political alliance behind the 1994 decision.
If this proves not to be the case, the whole reform might very
well collapse. The danger for this is aggravated by the fact
that the final decision must be made by the parliament next
spring to avoid that this politically sensitive issue remains
open over the election campaign before the September 1998
General Election.
6. Remaining issues to be solved
Disability and survivors' benefits still need to be changed
The new pension system comprises only the old-age pension
system. Neither a new disability pension system, nor a new
survivors' pensions system are yet decided upon. The
consequence is that the politicians do not know of the overall
financial framework for the new old-age pension system.
Furthermore, this means that we still do not know how much will
remain of the existing reserve fund for the new old-age system.
Hence, the basis for calculations on the future of the new old-
age pension system is weak.
There has been a strong criticism in the political debate
against the fact that the whole new pension system has not been
decided upon at the same occasion. Final decisions by the
parliament on the remaining issues concerning the old-age
pension system must now await the proposals regarding
disability and survivors' pensions.
Indexation
The exact form for indexation has not yet been decided.
Neither the growth norm, nor the exact formula that will be the
basis for this indexation is constructed. As those who are
experienced in actuarial analysis very well know, this means
that a basic feature for the financial stability of the new
system is not established.
Employee contributions
In the current system the employers pay all the
contributions. The plan is to share the contribution between
employers and employees equally. This has caused great
political trouble, and there is yet no decision on how and when
(and if) the change will be done.
The funded part of the new system
How the funded part of the new system will be constructed
is not yet decided upon, it is not even investigated. There
again substantial practical and political problems remain to be
resolved.
Changes in the current system
The norm to be used to create financial stability vis ` vis
benefits earned under the old system remains to be decided. The
same observation applies to the question of the retirement age
in the current system.
The basic theory of the new system
The new Swedish model is neither a defined benefit system
nor a defined contribution system. It is a completely new
concept, which borrows features both from a traditional funded
defined contribution system and from defined benefit systems.
The new Swedish model may, theoretically speaking, be
constructed so as to be financially stable in all
circumstances. In practice, taking political and social
consequences into account, it will be stable within certain
limits when it comes to levels of economic growth, demographic
fluctuations, rates of inflation and so forth. A problem is
that the flexibility of a traditional PAYG pension system is
abolished. In the traditional PAYG systems it is possible to
reduce benefits, increase contributions or raise the
pensionable age in order to meet changes. In the new Swedish
model these adjustments are meant either not to be made, or
they are made automatically. Therefore, the system is more
inflexible than the current one, when it comes to meet
substantial changes in the environment. It is a weakness of the
model that the basic features have not been analyzed, we do not
know in what intervals for economic growth, inflation and
demographic fluctuations the new model is really stable.
7. Problems faced during the transition, and how to cover transition
costs
The transition to the new pension system has in reality not
yet begun. Still, there are some observations to make on the
subject.
7.1 The prolonged process
The reform process is arduous. Decision-makers themselves
must understand the problem and then create acceptance for the
necessary changes. There might be no alternative to a process
of successive steps to ``educate'' the people. All the same,
such a prolonged process tends to influence peoples' feelings
and their trust in the public pension system as such, more than
to open up for a constructive debate on how to change the
system to make it reliable and sustainable. This seems to have
been the effect in Sweden and in many other countries too.
7.2 Enactment
Due to the way in which the decision making process has
been designed, i.e. beginning with decisions in principle, and
then coupled to a tight implementation schedule, has created
substantial difficulties. The risk that this kind of
difficulties are under-estimated in the political process is
evident.
7.3 Administrative implementation
Administrative implementation of the new system is the
responsibility of the National Social Insurance Board. The
Board has experienced considerable difficulties in trying to
meet the tight schedule for the new system. In that process the
Board has had to try to figure out the new system in concrete
details, without knowing what will be the ultimate legislation.
The result of this has been an inefficient use of resources.
The Board has also faced difficulties in designing a
computer system with the ability to meet the need for
complicated calculations that will follow from the detailed
regulations in various fields.
The costs for the administrative implementation are covered
by special ``loans'' granted to the National Social Insurance
Board by the Government. Ultimately, these costs will be
charged as interest and amortization to the future
administrative costs for the pension system.
8. The degree to which the Swedish experience might be applicable to
the situation in the United States
I do not think that I am in the position to give any
recommendations to this great nation, when it comes to solving
your own problems. All the same, I venture to share with you,
distinguished members of this Committee, a few thoughts about
some of the particulars of our reform and of our problems that
I think might be of interest to you.
We might say, that we face similar problems. Sweden is a
mature post-industrial state with important social commitments,
and we have realized that we have problems. Our Social
Insurance programs are neither financially stable nor adapted
for encouraging continued work force participation for older
workers. I think that the same situation prevails in many other
countries.
The social insurance system must be kept in balance with
the size of the economy, i.e. the size of the social
expenditures must in the long run respond to (the changes in
the growth of) the economy.
An economically sound pension reform can be brought about
without a switch to a fully funded system by introduction of:
so called Notional Accounts,
indexation of pensions to (contribution-related)
wages,
demographic reserve funds,
adaptation of benefits to average life expectancy.
The US system contains two strong redistributive features,
redistribution from high to low income earners, and from two
career couples to one career couples.
It will be impossible to replicate these redistributional
effects in a Notional Account system. The question is, how can
we create security for low-income pensioners? In Sweden a
fairly high guarantee level will be introduced. This takes care
of the redistribution between high- and low-income earners.
This part of the total system will be financed solely out of
general revenue.
9. ISSA and the stockholm initiative
As President of the International Social Security
Association I would like to mention something about the ISSA,
its tasks and the very special challenge we have named the
Stockholm Initiative an activity strongly connected to the
discussion here today.
9.1 ISSA, the International Social Security Association
ISSA is a member of the UN family, but is different from
other UN organizations by not being a governmental
organization. The ISSA is financed by contributions from social
security organizations which belong to the Association. At the
present time the ISSA has a total of 350 member organizations
in 135 countries.
ISSA activities include:
Information dissemination (publications,
information center, on line data bank)
Research
Organization of exchange of information and
experience between members (conferences, seminars)
Training
9.2 The Stockholm Initiative
In recent years the structural adjustment plans of many
economies have for various reasons led to questioning social
protection systems. ISSA members throughout the world have
urged the Association to support them in the internal and
international debates on the issues. ISSA has taken up the
challenge.
The Stockholm initiative: The Social Security reform
debate; In search of a new consensus is an extrabudgetary
effort to facilitate a dialogue on the most important social
protection issues and to promote a debate and subsequently a
new consensus about acceptable approaches to social security.
This project will assist policy makers and social security
organizations throughout the world to understand the arguments
and to choose reform alternatives best suited to their
circumstances.
This Initiative is now well under way in a first step. That
step concerns analytical questions in the area of pensions. Mr.
Lawrence H. Thompson, Senior Fellow of The Urban Institute,
Washington, D.C., has prepared papers addressing a wide range
of issues in the pension reform debate. Those papers will soon
be published, and will be used in the world-wide debate. The
Initiative will explore other issues in close co-operation with
sponsors and experts.
This Initiative is in its entirety financed by ISSA member
institutions in all parts of the world, such as social security
institutions, governments and private sector companies. We hope
that the Initiative will bring into focus the broad concept in
which social security is a part and create a better balance
between the different options in the reform process, and we
invite all concerned to join us in this vital undertaking!
There are many organizations now engaged in trying to
broaden the debate in order to cope with the tremendous task to
reform social security systems, among those the pension
systems. The World Bank, IMF, EU, ILO and OECD can be mentioned
alongside with ISSA. All these bodies realize that public
confidence in the reform process and a reconciliation of
economic and social policy are key elements in this process.
10. Conclusions
The reforms implemented in Sweden were partly forced by the
economic situation. We are still in a process of realizing that
resources are not endless and that politicians will have to
deal with promises for the future in a more cautious way than
was the case before. There is still a need for efforts to
strengthen the economy and thus create a basis for sustainable
growth in the future. Still, nearly everyone in Sweden agrees
that a general welfare policy, with stable social security
rules concerning sickness, parenthood, unemployment and old-age
is an important part of economic and social policy in Sweden.
My concluding opinion on the situation in my home country
is that the Swedish politicians and the public administration
are working concretely with the challenge to take into account
new knowledge in this field; knowledge about the interaction
between the economy and social security and a deeper
understanding of peoples behavior. Sweden is now, and this is
my feeling and sincere hope, in the process of building a new
Swedish model, based on the best in the old model while trying
to avoid earlier mistakes!
11. Acknowledgments
This report is based on official documents from the Swedish
parliament and Government and from the National Social
Insurance Board. It also draws on reports from various
international conferences made by myself, by Mr. Goran
Smedmark, Director and Head of the International Secretariat of
National Social Insurance Board and by Ms. Lena Malmberg,
Principal Administrative Officer at the National Social
Insurance Board. We have together written this report, and I
thank both of them for their support. I also thank Professor
Edward Palmer, head of the Research Division of the National
Social Insurance Board for his valuable comments on a draft to
this report.
Mr Chairman, distinguished Members of the Committee, I
appreciate very much to have had this opportunity to share with
you some experience from the social security reform efforts in
my home country. Thank you for listening. I am prepared to
answer any questions occasioned by my presentation.
Chairman Bunning. Mr. Finkelstein.
STATEMENT OF DANIEL FINKELSTEIN, DIRECTOR OF CONSERVATIVE
RESEARCH DEPARTMENT, CONSERVATIVE PARTY OF BRITAIN'S POLICY
DEVELOPMENT AND BRIEFING UNIT, LONDON, ENGLAND
Mr. Finkelstein. Mr. Chairman, Members of the Subcommittee.
First, may I thank you for your invitation to address the
Subcommittee about the changes that have been made to the
British pension system over the last 10 years.
As director of the Conservative Research Department, I work
closely with the Prime Minister and ministers of the Department
of Social Security to develop plans for Social Security reform
and it is this experience that forms the observations I will
make this morning.
Let me start with three facts. First, although the ratio of
pensioners to the population of working age in the United
Kingdom is forecast to rise from 30 percent in 1995, to 38
percent in 2030, the ratio of public expenditure on pensions to
GDP is expected to fall over the same period from 4.2 percent
to 3.3 percent.
Second, United Kingdom private sector pension funds have
more than 600 billion pounds worth of investments, which is
more than the rest of the European Union put together.
Third, over the past decade, pensioner incomes have risen
by 50 percent. There have been increases at all points in the
pensioner income distribution, and pensioners are no longer
concentrated right at the bottom of the population income
distribution.
How has this been achieved? What more needs to be done and
what lessons can be learned by countries with different
systems? I intend to touch on each of these points briefly. It
might be helpful if I begin with a brief description of the
pension system inherited by the conservative government when it
came to power in 1979.
Since the National Insurance Act, passed by the 1945 labor
government, Britain has had a nonmeans-tested basic State
pension. Those who paid national insurance contributions as
part of their tax bill during their working life are eligible
for this benefit, and it has always been done on a pay-as-you-
go system.
When the system was originally proposed by the social
reformer, William Beveridge, during the war, he intended that
the pension should be phased in over 20 years, but it was
decided to pay them in full from the outset.
In 1975, another labor government added a second tier to
the United Kingdom State pension system. They introduced a
State earnings-related pension, SERP, in an attempt to narrow
the differentials between pensioners with a private
occupational pension and those without.
SERPs provided a pension based on 25 percent of the average
of the best 20 years of earnings. The crucial second reading of
the bill to introduce SERPs was unopposed. When conservatives
came to power under Margaret Thatcher in 1979, they inherited
an ailing economy, a fast-rising Social Security budget, and
commitments far in excess of our ability to pay for them.
In addition, as Nigel Lawson put it, our Chancellor of
Exchequer at the time, it is clear to anybody who took the
trouble to analyze SERPs that it was a doomsday machine, so
clearly reform was necessary.
Let me describe our three-stage reform program. First, we
removed the link between pensions and wage increases and linked
the basic State pension to prices instead. The decision was
controversial, but it was accepted because of the obvious
crisis in the United Kingdom economy in 1980, and because there
were no losers in real terms.
Second, in 1985, the government turned its attention to the
long-term problem of SERPs. The government didn't just want to
abolish SERPs, since the arguments for the creation remained
good ones. Instead, it decided to offer taxpayers two
alternatives. One option was to remain in a somewhat less
generous SERPs. For example, the percentage of your income that
you would be paid would be reduced from 25 percent to 20
percent.
The other alternative was to contract out of the scheme and
have the State pay a part of your national insurance
contributions into a private fund. Takeup of this second
alternative was encouraged by a number of measures. For
example, those who decided to contract out would receive an
extra 2-percent rebate above that strictly necessary to make
their pension the equivalent of SERPs for the first 5 years.
The government also created a new private portable pension
providing tax relief on contributions, and companies were
forbidden from bringing employees to their own scheme.
I shan't detain you with the detailed description of all
the financial details, but suffice it to say they greatly
exceeded expectations in terms of takeup. The Department of
Social Security's working assumption was that about 500,000
would take out personal pensions and the number might
ultimately reach 1.75 million. In the event, the takeup reached
4 million by the end of 1990, and by 1993-94 had risen to 5.7
million.
This success didn't, of course, end the debate. Some wanted
a much larger compulsory private pension. Margaret Thatcher was
one and told her chancellor they had such a pension in
Switzerland. ``Yes, Prime Minister,'' he replied, ``but in
Switzerland everything that is not forbidden is compulsory.''
The most important debate of all concerned the basic State
pension. It remained a large item of government expenditure,
yet current and future recipients believed it was inadequate.
So a third stage of reform was proposed. A basic pension-plus
plan published in the new year would involve replacing the
basic State pension and SERPs with a State guarantee.
New entrants into the work force would be given a rebate
from their taxes paid into their choice of private plans. If,
when they reached retirement age, their private plan was not
large enough to replace the basic State pension, the State
guaranteed to make up the difference.
In reality, this would not happen very often, if at all,
and the advantages of a funded scheme would yield the average
pensioner a much more generous pension than they would
otherwise get.
How was such a radical reform plan possible? Because in
Britain, like in America, pensions are an extraordinarily
sensitive subject, and no government could survive unscathed if
it made a gross mistake in this area. I think the program's
success teaches a number of political lessons.
First, the reforms were the result of a debate about the
long term, the security of young people, and the country's
finances. Budgetary problems were often the ally of reformers,
but they would not seem to be the main reason for reform.
Indeed, in the short run it was all cost.
Second, victory in the debate about long-term reform would
have been useless if pensioners feared their income was under
threat. At every stage it was necessary to ensure that there
were no losers among current recipients and that as far as
possible future recipients felt, they were making a one-way
bet. The sacrifices this involved that were there could be no
short-term savings and the reforms would have to be phased in
over very long periods.
Third, the reforms were not introduced all at once. Voters
were more inclined to support the next stage of reform because
they could see the previous changes had not left them worse
off. It was also less easy to attach the proposals as
unworkable, or to defeat the entire package by concentrating on
its weakest point.
Finally, the provision of choice was vital. The reforms of
the mideighties were not imposed on future pensioners. They
were given a choice and a financial incentive to choose the
private option. The popularity of the scheme depended on the
feeling that the government was providing the opportunity to
get a better deal. If voters thought instead that they were
being forced into a scheme to save money, they would have been
much more resistant.
In conclusion, your natural political instincts will, I am
sure, make you suspicious of the idea that in the United
Kingdom we found the perfect formula for painless reform, and
natural political instincts would, of course, be right.
Pensions remain a controversial topic and throughout the 18
years we spent in government, Conservatives had to face
criticism of the scheme we were developing. Yet there is now
remarkable consensus that the basic decisions were the right
ones, that in general they have helped rather than hindered the
Conservative Party at the polls, and that the new labor
government is far more likely to extend the program than it is
to reverse it.
[The prepared statement follows:]
Statement of Daniel Finkelstein, Director of Conservative Research
Department, Conservative Party of Britain's Policy Development and
Briefing Unit, London, England
Mr. Chairman and Members of the Committee, first, may I
thank you for your invitation to address the committee about
the changes that have been made to the British pension system
over the last ten years. The experience and advice of American
policy analysts and law makers has been of great value to the
British people over the many years of friendship between our
countries. I hope that you will find some of the things we
discuss today of similar use.
As Director of the Conservative Research Department, the
British Conservative Party's policy development and briefing
unit, I worked closely with the Prime Minister and Ministers at
the Department of Social Security to develop plans for social
security reform. This experience and my work as Director of one
of Britain's leading welfare reform think tanks, the Social
Market Foundation, informs the observations I will make this
morning.
Let me start with three facts. First, although the ratio of
pensioners to the population of working age in the United
Kingdom is forecast to rise from 30% in 1995 to 38% in 2030,
the ratio of public expenditure on pensions to GDP is expected
to fall over the same period from 4.2% to 3.3%. Second, UK
private sector pension funds have 600 billion worth of
investments , more than the rest of the European Union put
together. Third, over the past decade pensioner incomes have
risen by 50%, there have been increases at all points in the
pensioner income distribution and pensioners are no longer
concentrated right at the bottom of the population income
distribution.
How has this been achieved? What more needs to be done? And
what lessons can be learnt by countries with different systems?
I intend to touch on each of these points briefly and would
then be happy to answer any questions that you may have.
It might be helpful if I begin with a brief description of
the pension system inherited by the Conservative Government
when it came to power in 1979. Since the National Insurance Act
passed by the 1945 Labour Government, Britain has had a non
means tested basic state pension. Those who have paid national
insurance contributions as part of their tax bill during their
working life are eligible for this benefit. It has always been
paid for by Government out of current revenues, rather than out
of investment funds. In other words, each generation pays for
the pensions of its elders. When the system was originally
proposed by the social reformer William Beveridge during the
war, he intended that the pensions should be phased in over 20
years. Labour decided to pay in full from the outset. The
judgement of Britain's foremost welfare state historian
Nicholas Timmins is that ``although it was a mighty expensive
decision, almost certainly nothing else would have been
politically tenable.''
Beveridge's aim was to eliminate means testing as far
possible. As in other areas of benefit provision, however, both
the problem of providing housing for the less well off and the
difficulty of setting means tested rates below non means tested
ones frustrated him. Around a third of pensioners in the UK
receive means tested benefits in addition to their basic state
pension.
In 1975 another Labour Government added a second tier to
the UK state pension system. They introduced a State Earnings
Related Pension (SERPs) in an attempt to narrow the
differentials between pensioners with a private occupational
pension and those without. SERPs provided a pension based on
25% of the average of the best 20 years of earnings. The
crucial second reading of the Bill to introduce SERPs was
unopposed. According to Lord Lawson, later as Chancellor an
important player in the design of the reform programme, the
Conservatives were ``clearly wrong to do this'' but believed
``that pensions ought not to be a political football.''
When the Conservatives came to power under Margaret
Thatcher in 1979, they inherited an ailing economy, a fast
rising social security budget and commitments far in excess of
our ability to pay for them. In 1950 social security spending
represented 5.1% of national income, by 1980 it represented
8.4%. By far the largest group of beneficiaries were elderly
people and by 1965 the cost of pensions was twice that which
Beveridge predicted. In addition, as Lord Lawson puts it, ``it
was clear to anyone who took the trouble to analyse SERPs that
it was a doomsday machine.'' Clearly, reform was necessary.
The best description of the welfare reform strategy of
Conservative Governments between 1979 and 1997 was given by its
last and longest serving Social Security Secretary, the Rt Hon
Peter Lilley MP in his 1993 Mais Lecture. In the lecture he
explained the principles behind the reforms across the welfare
field. He set out ten propositions. First ``there are no easy
solutions. That should be self evident, since if there were, I
or my predecessors would have adopted them.'' With this he
dismissed such pet solutions of right and left as merging the
tax and benefits system or using tax credits to save money.
He went on to say ``My second proposition is that any
effective structural reform must involve either better
targeting, or more self provision, or both.'' Yet he did not
accept that targeting need lead him to an exclusively means
tested approach. His third proposition was that ``disincentives
are inherent in statutory benefits. When there is a choice
between universal and means tested benefits there is a trade-
off between imposing disincentives on the claimants or on
taxpayers.'' He continued by saying: ``My fourth proposition is
that means testing is not the only way of targeting benefits
more closely on need.'' Alternatives included changing the
categories of people eligible for benefit (for example,
changing the pension age), defining need differently by
tightening the rules of receipt for certain benefits), tighter
enforcement, imposing new conditions for receipt or using the
contributions test. He claimed as his fifth proposition that
``the existing array of benefits--contributory, universal and
income related--are rather more targeted than some comments
suggest.''
Next, Lilley entered the debate about allowing people to
opt out of the system and make their own provision. A
particular target has been the basic state pension. The
Secretary of State's sixth proposition was that ``no one has
the right to opt out of contributing to help those who cannot
provide for their own needs. But there is no reason in
principle why people should not (in addition to contributing to
others) opt to make provision for themselves privately rather
than through the state system.'' His seventh proposition was
connected--he pointed out ``that contracting out inevitably
involves a switch from pay-as-you-go to fully funded
provision'' and that, particularly in the case of pensions,
this would leave a gap in the public finances until the
policies mature.
His final two propositions were first that ``the more the
provision for needs and risks is monopolised by the state the
less the incentive to work and save to provide for them'' and
second that ``reform of something as vast as the social
security system is best carried out sector by sector rather
than by the `big bang' approach. Comprehensive big bang reforms
invariably result in imposing elegant intellectual and
bureaucratic structures on the inconvenient diversity of the
real world.''
This is an admirable description of the principles behind
the Conservative Government's three stage reform programme:
First, it removed the link between pensions and wage
increases and linked the basic state pension to prices instead.
The decision was controversial, but was accepted because of the
obvious crisis in the UK economy in 1980 and because there were
no losers in real terms.
Second, in 1985 the Government turned its attention to the
long term problem of SERPs. The Government didn't just want to
abolish SERPs since the arguments for its creation remained
good ones. Instead it decided to offer taxpayers two
alternatives. One option was to remain in a somewhat less
generous SERPs. The percentage of your income that you would be
paid, for instance, would be reduced from 25% to 20%. The other
alternative was to contract out of the scheme and have the
state pay a part of your National Insurance contributions into
a private fund. Take up of this second alternative was
encouraged by a number of measures. Those who decided to
contract out would receive an extra 2% rebate above that
strictly necessary to make their pension the equivalent of
SERPs. The Government also created a new private portable
pension, provided tax relief on contributions, and companies
were forbidden from binding employees to their own schemes.
I shall not detain you with a detailed description of all
the financial details and safeguards that were put in place to
ensure the scheme was popular and secure. These are set out in
the Heritage Foundation's admirable paper on Social Security
Privatisation in Britain. Suffice it to say that take up
greatly exceeded expectations. The Department of Social
Security's working assumption was that about 500,000 would take
out personal pensions and the number might ultimately reach
1.75 million. In the event, take up reached 4 million by the
end of April 1990 and by 1993-4 it had risen to 5.7 million.
This success did not, of course end the debate. Some wanted
a much larger compulsory private pension. Margaret Thatcher was
one and told her Chancellor that they had such a pension in
Switzerland. ``Yes Prime Minister,'' he replied ``but in
Switzerland everything that is not forbidden is compulsory.''
Others were concerned about the security of private pensions
and after the newspaper owner Robert Maxwell was found to have
stolen from the Mirror Newspaper pension fund the Government
introduced safeguards to prevent swindles and incompetence
depriving pensioners of their income. Still others believed
SERPs remained too expensive and pressed for its abolition.
Once again this option was rejected, partly because some
pensioner's contributions to SERPs were too small to pay the
administrative costs in the private sector. Instead the
Government once again reduced long term SERPs entitlements but
compensated with reforms to make it more worthwhile for older
people to opt out.
Yet the most important debate of all concerned the basic
state pension. It remained a large item of Government
expenditure, yet current and future recipients believed it was
inadequate. So the third stage of reform began. Over the summer
of 1996 Peter Lilley began to work on new proposals to deal
with the problem. His Basic Pension Plus plans were published
in the New Year. Under these proposals, the basic state pension
and SERPs would be replaced with a state guarantee. New
entrants to the workforce would be given a rebate from their
taxes paid into their choice of private plans. If, when they
reached retirement age, their private plan was not large enough
to replace the basic state pension, the state guaranteed to
make up the difference. In reality, this wouldn't happen very
often and the advantages of a funded scheme would yield the
average pensioner a much more generous pension than they would
otherwise get. Of course, the scheme would cost money during
the long transitional period. Because young people would be
funding their own pension they wouldn't be paying for the
pensions of their elders. However, by the time this cost peaked
it would be offset by savings from an earlier reform to raise
the retirement age for women to the same as that for men.
Another critical change was to switch tax relief from the time
of saving to the time of receiving the benefit. This halved the
transition cost.
Lilley's proposals received a rapturous reception in the
press. The left wing Guardian newspaper, for instance, said
that ``like the concept of a share holding democracy, it could
also be empowering a new generation, which will have much more
control over its retirement arrangements.'' The defeat of the
Government in the General Election in May mean that Lilley's
plans have not become law, but it is widely anticipated that
the new Government will conclude that some sort of funded basic
pension system is necessary.
How was such a radical programme of reform possible? In
Britain, like in America, pensions are an extraordinarily
sensitive subject. No Government could survive unscathed if it
made a gross mistake in this area. I think that the programme's
success teaches a number of political lessons.
First, the reforms were the result of a debate about the
long term, the security of young people and the country's
finances. Budgetary problems were often the ally of reformers,
but they were not seen to be the main reason for reform.
Indeed, almost all the reform involved spending money in the
short term and a recognition that without this, long term
change was impossible.
Victory in this debate was not inevitable. As late as 1992
Labour made large increases in the basic pension its central
election promise and it also promised to restore the wages
link. Yet when they were defeated in this election Labour
realised that the voters didn't believe their promise could be
delivered and didn't, in any case, want to pay for it. They
dropped the pledge and quickly began to join in considering
long term reform and the control of costs.
The result of winning the debate was that when a Labour
spokesman weighed in against Peter Lilley's new pension plan,
press reaction made the Party backpedal very quickly. The next
day Tony Blair welcomed the way Lilley had widened the debate.
It is thought by some press analysts that the unsuccessful
attempt by some Labour members to raise scares about Lilley's
plan lost the Party the endorsement of The Times newspaper.
Second, victory in the debate about long term reform would
have been useless if pensioners feared their income was under
threat. At every stage it was necessary to ensure that there
were no losers among current recipients and that, as far as
possible, future recipients felt they were making a one way
bet. The sacrifices this involved were that there could be no
short term saving and that the reforms would have to be phased
in over very long periods. Basic Pension Plus would have
yielded only costs until nearly half way through the next
century. Where savings had to be made to offset these costs,
they too were phased in over a long period and did not leave
any current recipients worse off. To ensure that fears were not
allowed to take hold, the Government was always very clear
about the costs of its schemes and the nature of the guarantees
it was giving.
Third, the reforms were not all introduced at once. Voters
were more inclined to support the next stage of reform, because
they could see that the previous changes had not left them
worse off. It was also less easy to attack the proposals as
unworkable or to defeat the entire package by concentrating on
its weakest point. The temptation to demonstrate how radical
the Government was and its farsightedness, by announcing the
entire programme in advance was also eschewed. Each part of the
programme was advanced on its merits and given time to work
before further innovations were considered.
Finally, the provision of choice was vital. The reforms of
the mid 1980s were not imposed on future pensioners, they were
given a choice and a financial incentive to choose the private
option. Much of the popularity of the scheme depended on the
feeling that the Government was providing the opportunity to
get a better deal. If voters thought, instead, that they were
being forced into a scheme to save money, they would have been
much more resistant.
Your natural political instincts will, I am sure, make you
suspicious of the idea that in the UK we have found the perfect
formula for painless reform. You instincts would be right.
Pensions remain a controversial topic and throughout the 18
years we spent in Government Conservatives had to face
criticism of the system we were developing. Yet there is now a
remarkable consensus that the decisions were the right ones,
that in general they have helped rather than hindered the Party
at the polls and that the new Government is far more likely to
extend the programme than to reverse it.
Chairman Bunning. Thank you, Mr. Finkelstein.
Dr. Ghilarducci.
STATEMENT OF TERESA GHILARDUCCI, PH.D., ASSOCIATE PROFESSOR OF
ECONOMICS, UNIVERSITY OF NOTRE DAME, NOTRE DAME, INDIANA
Ms. Ghilarducci. If you use your hands, it goes better.
Ghilarducci.
As you heard, during the last 20 years in the United
Kingdom and in Latin America, and especially Chile, cut the
government's role in providing retirement income security has
drastically changed. They have done it in favor of a model of
individual pensions. Australia's Government and the employees
in the unions there agreed also to reduce the State control of
a very regulated--it is very different than these other
models--labor and employer-controlled pension system.
And it is true, most Organization for Economic Cooperation
and Development, OECD, nations like the World Bank report that
you just quoted from indicates, are looking to cut benefits by
raising retirement ages and by reducing pensions in various
ways.
Emerging democracies, notably in Eastern Europe and in
China, are struggling with new models for providing for
retirement. The old communist model wasn't working so what do
they adopt? And U.S. policymakers want to know what lessons
from abroad can inspire Social Security reform here.
You have asked me, and I am really glad to be here, to
comment on what factors have inspired these reforms; what
macroeconomic goals were hoped for; what governments paid in
transition costs; the benefits and cost to workers; and what an
international overview can teach us.
And I want to look at some other factors that you did
overlook in your list because these factors have become starkly
clear in my scholarship and, in my travels in the last 3 years.
And I have been everywhere. I have been in Madrid, London,
Paris, Geneva, Rome, Palermo, Amsterdam, Bonn, Buenos Aires,
Santiago, Mexico City, Kiev and last I was in Beijing. I also
went to Ft. Worth and Mishawaka, Indiana. In all of those
places I either worked for the governments, the labor unions,
for the State Department, or for the United Nations to examine
their pension systems.
Six months ago, my 100-page report on China went to the
United Nations. Therefore, I speak with some conviction that
what you need to look at, and what policymakers need to look at
when we consider pension reform, is the effect on work effort.
The effect on employers--employers have really been written off
in this pension reform--and therefore what effect it will have
on economic productivity.
I have seven findings for the Subcommittee. Let me
summarize: First, if the United States supplanted our Social
Security for individual pensions, and there are lots of
suggestions out there how to do that, retirement income and
adequacy and equity goals would be weakened. Maybe it would be
for a good reason, but we have to recognize that there would be
losses there.
For instance, in the United Kingdom and Chile, workers with
low incomes and frequent breaks in employment, pay large
administrative costs and they also have a reasonable bias
toward investing conservatively. We see Americans do that in
their 401(k) plans, especially for those with lower income.
Workers in personal pensions face what we call the
longevity risk, the risk of living too long. Buying an annuity
is very expensive for insurance and market failure reasons. And
women especially have a much higher longevity risk. It is an
odd way to talk about living too long, but it is a risk when
you are dependent on a fixed income.
In the United Kingdom women were found to be particularly
vulnerable to their choice, because their choice involved being
convinced by salespersons in advertising campaigns and they
were found to be choosing plans of extremely poor value. They
found that their company plan, what they opted out, was
actually much better because of their up front administrative
costs.
Second on these labor force effects, in the United Kingdom
and Chile workers are entitled to a minimum pension. In Chile,
this could mean that you could work for just a short period of
time, be entitled to a minimum pension, and then really have no
financial incentives to stay in the system. So evasion is a big
problem. Fifty percent of people with an account in Chile who,
at any one point are not contributing--they are not active
members--but they are still paying administrative costs.
This subtle long-term effect of having individual based
pensions on tax evasion affects me quite a bit. I am chilled to
the bone by the cynical evasion that I found in the Ukraine and
in Chile. That because employers were not involved in the
system like they were in the past, there began a kind of social
norm to game the system. Spain's Social Security director just
spoke in Argentina 3 weeks ago and said, look, the Chilean
model will never work in Spain, but we do have to focus more on
tax evasion.
Third, a lot of you, Mrs. Kennelly, you especially,
emphasize the effect of savings growth on these private
pensions. But mind you that you could have demographically
driven financial markets that are very unstable. Just think
about the United States. We have a baby boom generation pouring
money into the mutual funds, into the stock market, driving
asset values up.
John Shoven from Stanford and Sylvester Schieber, from
Watson Wyatt published a paper that showed what drove the asset
values up will also drive them down in 2020 or 2030. So we are
looking forward to asset fall off by 25 percent, the value of
financial assets and houses, just because of the demographics.
We have to look at these long-term consequences of these
demographically driven financial markets.
Fourth, what an individual pension does is break the link
between what you get and what you contributed. This is
something that Sweden really wants to reconnect. Right now we
have a system where people who live side by side and have the
same employment history, get the same thing out of Social
Security. It is not a welfare program. You get what you get
because of your work history.
If you have an individual pension, you get what you get
because of luck, good advice, or other vagaries so that you
have this real break between your work effort and what you
finally get from your pension.
In fact, the Office of Fair Trading in the United Kingdom
has been very critical of the system, not as laudable as my
colleague from the Conservative Party, and actually
characterized the process in the United Kingdom as when you
select a pension fund, it is almost like selecting a lottery
ticket. It is almost like playing the lottery.
Fifth, the international experience shows that if the
United States moved toward mandated individual accounts, it
will really have one clear group of winners and those winners,
of course, will be financial institutions and actually
advertising firms. Wall Street will gain a lot from
privatization here.
You will hear a lot today about the fees that these for-
profit companies in the United Kingdom and Chile are charging
workers for maintaining their accounts. There are lots of
inefficiencies in those markets. There is name brand, if you
are the first entrant, because of exaggerated dependence on
advertising, and because workers do not know they made a bad
choice until later. There are lots of reasons why market forces
do not work well when you are selling pensions.
Sixth, a lot of people say that transparency is one of the
most important aspects of cutting back the State system and
introducing individual pensions. Transparency, the Spanish word
even sounds better, the idea that workers should know what they
are being promised and should see through their benefit
promise.
Well, in the United Kingdom in 1997, over 570,000 workers
are being investigated--or rather, the pension plans they
bought are being investigated--because they might not have had
that transparency. They couldn't see through the sales
practices and they might have made a bad choice. One-third of
workers in the United Kingdom don't even know if they have
opted out or not. So if you ask average worker in the United
Kingdom what plan they are in, they don't even know.
The macroeconomic effects were really overexaggerated. In
Chile they are practically nil. In the United Kingdom savings
rates were not the kind of problem that they are here. The
United States low savings rate could be due to this very unique
situation that we are in. We do not mandate retirement.
All OECD countries, Latin American countries, require that
65-year-olds leave the labor force. We do not allow that. Now,
that is good for freedom, but it might have a perverse effect
on savings because one out of four Americans when asked, ``Are
you saving?'' says, ``No, I will just work until I die.'' So we
may need to look at these institutional factors affecting
savings. Thank you.
[The prepared statement follows:]
Statement of Teresa Ghilarducci, Ph.D, Associate Professor of
Economics, University of Notre Dame, Notre Dame, Indiana
The United Kingdom, in 1976 and in the mid 1980s, and many
Latin America nations, following the lead of Chile's 1981
privatization, drastically cut their government's role in
retirement security in favor of individual pensions.
Australia's government, employers, and unions also agreed to
reduce state central control for a highly regulated, labor and
employer controlled, compulsory system of individual pensions.
Most OECD nations have cut benefits and emerging democracies,
notably Eastern Europe and China, are struggling with new
models in the face of maturing populations. U.S. policy makers
want to know what lessons from abroad can inspire Social
Security reform in the U.S.
An international survey shows the U.S. system has superior
features. We have a mixed employer, personal, and state system.
Social Security works well because it is based on work not
welfare. The tax rates are relatively low so coverage is
large--92% of all workers. Social Security is also portable.
The U.S. stands apart from most other nations because we outlaw
age discrimination and forced retirement. This could lower the
savings rate by reducing retirement planning as some employees
anticipate working past 65 (Farkas, 1995).
I am complying with the committee's request by addressing
the following factors in international pension reform: the
factors that led up to the reforms;
the macro-economic goals and effects (primarily
savings);
the transition costs;
the benefits and costs to workers; and,
what lessons and counter lessons can be gleaned
from the experience for the U.S.
I add three other important factors:
How pension reform can promote or diminish
evasion--workers not keeping up with their contributions;
How pension reform can promote or diminish
productivity through its effect on labor management
relationships;
How world wide accumulation of capital may cause
sharp increases and falls in asset values.
1. The Promises of Mandated Pay-Go Systems and Their Retrenchment
A nations' pension system can help shape its economic
development. Pensions and other social insurance contributes to
political stability in market economies where people can lose
their ability to support themselves through no fault of their
own. Pensions can promote productivity in three ways: pensions
can enable workers to move between jobs to find their best use
of skills; pensions can ease the retirement of older workers,
and pension systems can help tie employers and workers to
employment that is regulated, scrutinized, and upon which taxes
are paid. So-called formal employment helps prevent substandard
working conditions and helps foster skill development, as well
as, a national tax base.
Pension systems also have to protect people against their
persistent optimism about their long-term personal health,
ability to work, and the generosity and ability of their adult
children to provide for them in old age. Mandatory systems
overcome workers short sightedness, optimism, and risk
averseness. Universal and mandatory pension systems also
correct the insurance markets failure to overcome adverse
selection problems--the people with the most risk buy the
insurance. Gaps appear because for profit insurance companies
avoid the social insurance markets or charge prohibitively high
premiums. Universal mandatory coverage solves this problem by
spreading the cost of the premiums across high and low-risk
groups.
There are seven goals in a nation's social insurance
system. A good national social insurance system provides
adequate benefits; helps promote economic growth and stability;
is equitable--it treats people in similar situations in similar
ways; is efficiently run; redistributes to those who need
benefits the most; and provides social stability. Mandatory
social security schemes, like the U.S. system, meet most of
these goals.
Reasons for Change: UK and Chile
Universal government systems succeed in meeting many goals.
They provide mobility between jobs and industries and spread
the risk of retirement and superannuation across industries,
firms and workers. They overcome private market failures and
provide social insurance efficiently. Then why did some nations
dramatically reform their mandatory systems? For example, UK
and Chile moved to dismantle their systems in the last twenty
years.
The Chilean and UK changes were due, in part, to the
increasing costs of their systems and also adherence to
political goals for a smaller economic role for the state.
Issues of savings rates, productivity, equity, and retirement
security were secondary. Therefore, to understand the reforms
one must understand the imperatives--reduce state's costs and
manage the political opposition from labor and old age groups
while doing so This motive, coupled with eager private sector
insurance companies and financial institutions to sell personal
pensions, helps explain the individual-account approach in both
nations.
In 1976, UK workers could opt out of the pension system if
the replacement was as good as or better than the state system.
In 1986, in an effort to promote the dismantling of the state
system, the Thatcher government dropped the guarantee and
boosted the reward for leaving the system. (The national
insurance fund would pay 2% of earnings (within limits) and had
some guarantees of a fixed payment for 5 years.) Prime
Minister's Thatcher's government had originally proposed to
abolish the system; but, the financial institutions wanted the
lowest paid workers to stay in the government system since
their potential individual accounts were not profitable (Ward,
1996).
The aggressive marketing and the lump sum incentive
prompted many more, 5.5 million to leave the system than had
been expected. The government also boosted the demand for
individual, personal pensions by forbidding employers to
mandate that their workers belong to the employer's plan.
Studies reveal that over 570,000 workers, predominantly lower
paid and female, made the wrong choice when they opted out of
their employers' systems (Office of Fair Trading, 1997). The
insurance companies are now having to change their advertising
practices.
The circumstances surrounding Chile's abolishment of the
Social Security system was much more dramatic. Eight years
after the military coup, the Pinochet government introduced a
mandatory individual plan in 1981. The government praised the
new system because workers could clearly see their benefits and
that it promoted the idea of individual destiny and interests.
The Chilean Labor Secretary under the Pinochet dictatorship,
Jose Pinera reflected on the 1981 reform in 1988, ``We do not
harbor a single doubt that this capitalization system will
benefit the silent majorities, which were systematically fooled
by the PAYGO system.'' He described the political goal. The new
system will provide ``a dramatic increase in individual
freedom, which with the participation in social life and
economic progress will constitute an insurmountable barrier
against communism.'' (Pinera, 1988)
2. The Long Term Macro-Economic Effects
Recent studies in Chile show that, though the growth in
private pensions was large, the growth in foreign investment
and profits was larger and contributed far more to national
savings (Uthoff 1994). Chilean pensions accounted for 2% of the
increase in national savings.
The long run savings effects of privatization may not be
always positive either. Contrary to the proponents' claims,
Social Security privatization may reduce national savings. Once
people are compelled to have an individual account they may
likely cut back other saving and give up on retiring at all.
Another concern is the long run effects of advanced funded
pension systems on global financial stability. U.S. baby
boomers will start retiring in 12 years and by 2030, 100
workers will support 36 retirees, up from 21 in 1995. However,
just as their demand for financial assets lifts stock and bond
prices, their sell-off starting in the year 2020 will lower
asset values. The de-accumulation period will start at about
2025 (Shoven and Schieber, 1994). This de-accumulation could
cause asset values to fall. The hope for the source of demand
to buy the surplus assets in 2020-2035 is the young populations
of Mexico, Brazil, and China and India. This works if these
nations have private pension systems that invest in foreign
assets. This may explain why the World Bank's effort to
privatize pension systems spans the globe.
3. How Do Workers Do Under Individual Accounts
Who are the winners and losers in pension reform that make
individual pensions dominant? The winners when the private
sector takes over a government function are, first and
obviously, the vendors--the pension administration industry.
Employers gain in the short term because they are exempted
from paying pensions. However, employers lose because they lose
the commitment of a long term relationship with workers who
would otherwise be encouraged to stay longer to accrue pension
benefits.
Certain workers gain--those who do not live long, and are
savvy or lucky in investing and do not have drop out years when
they are not contributing regularly in the formal sector.
Disabled workers, workers working outside the formal markets,
long livers or cohorts who contribute through a financial
market bust lose. In the UK, the state system was cut
drastically (mainly by linking pensions with prices rather than
earnings growth) and now only provides 15%-20% of pre-
retirement earnings and by 2030, 9%). The lowest earners are
encouraged to try to do better but when they have personal
pensions they invest very conservatively. An OECD (1997) report
by analyst E. Phillip Davies concludes, ``Evidence suggests
that individuals are myopic in accumulating wealth for their
retirement and the low paid particularly so...personal pensions
may by their nature be unsuitable for the low paid.'' (Davies
1997, 4). Women receive smaller annuities because they are
presumed to live longer.
Women and low income workers with sporadic employment also
do poorly under the Chilean system. The Chilean government
guarantees 25% of the average real wages to anyone who
contributed twenty years by supplementing a puny pension. This
rule means that a women contributing all her life, with a five-
year break for child rearing and retiring at the mandatory age
of sixty would have to earn an estimated 7% on her pension
account with real wages only growing at 1% annually to earn
just as much as the minimum pension guarantees. In the absence
of high returns and low growth rates low paid workers will fall
back on the government (Barrientos and Firinguetti 1996).
The principle of horizontal equity loses. Two workers with
the same employment circumstances may get widely different
pensions because of investment strategies.
Workers gained transparency--they can see what is in their
accounts. However, there is concern in Chile about the hidden
sources of power and influence represented by personal
pensions. Some of the largest AFPs, (for example, the president
of largest and oldest AFP, Provida, and his brothers who own
textile and metallurgy firms) have interlocking financial
interests and a heavy investment of workers money in their own
stock. Jorge Bustamonte, the Superintendent of Pensions,
ordered greater transparency--a reporting of cross ownership in
1995. (Just four funds own approximately 55% of all corporate
bonds (in the US the same percentage is spread out across
thousands of managers.)) Yet, no report has been issued.
In the UK, confusion about the state system may have been
replaced by expensive confusion about the private system. In
the UK one-third of workers did not know if they had a personal
pension (Office of Fair Trading, 88) and most only depended on
one source for advice--the seller of a investment product.
In sum, workers with personal pensions in a market economy
face longevity risks--the risks of living long after the
ability to earn a living;
market risks--the regular risks of financial
market cycles;
timing risks--being retirement when asset values
are low;
inflation risks, the risk of asset values falling
due to price increases.
Personal pension are said to help workers because of the
reduction in political risks and the gains in transparency.
4. Transition Costs
The UK government state lost in the short run. The
transition costs in UK were high--the state spent 9.3 billion
pounds and saved only 3.4 billion pounds.
In Chile, the transition costs were paid for by a cut in
the national health insurance and the federal surplus the state
was running at the time. Unlike gaps in coverage the potential
liability to the government is not admitted. The government
guarantees a minimum pension and if returns low and growth
rates are low, low paid workers will fall back on welfare. This
projected liability is not booked and it is likely to be larger
if workers avoid working in the formal economy after twenty
years because they will get no return from the contributions--
they are guaranteed the same pensions without the extra
contributions.
5. The Winners: The Professional Management Industry
Efficiency is lost. Marketing and administrative fees in UK
are 20% and in Chile the estimates are 15 -30%. In contrast,
the administrative costs in the U.S. Social Security system are
largely borne by the firm who must collect and redeem the
payments and the state. The costs to the state are less than
.01%. Chilean and UK workers lost the economies of scale in
administration and the zero marketing costs when they opted out
of the state system.
The pension industry in the UK is concentrated--ten
companies have 80% of the business. Prudential is the largest
with a ten percent market share.
The profits of the private companies that administer the
AFPs were over 22% since 1995. Strict competition,
theoretically, is the only regulating influence designed to
keep these fees low, but the five largest AFP's control 80% of
the market and have formed an implicit cartel. Instead of
forcing fees to fall, competition has increased costs as AFP's
hire more sales staff to lure workers from fund to fund. In the
last 4 years, the number of sales persons leaped from 4,000 to
12,000. Solomon Brothers, notices that this hefty turnover is
taking place ``in an industry in which it is very difficult to
differentiate among companies. If AFP's under-perform the
average they pay a penalty. Therefore, the portfolios are
similar and the returns are similar. These are classic
monopolistic competitive inefficiencies--barrier to entry is
high, the product is nearly the same, but competitors still
must advertise. It is also a market that encourages advertising
because people do not know if the product is defective until
many years after choosing the AFP.
6. Private Pension can Distort Labor Markets
The World Bank is continually assessing the labor market
effects, such as tax evasion. This is a real threat in Chile
where 50% of workers with pension accounts do not currently
contribute. Pension reforms have a dramatic effect on labor
markets and incentives to evade taxes and formal employment. A
high degree of evasion undermines democratic governments and
well-functioning high skilled labor markets. The evasion stems
from a two tiered system. If minimum service and contributions
will garner a pension then extra work in the sector that pays
taxes--the formal sector--is unrewarded as far as more pensions
are concerned.
Of very serious concern but very little study is the effect
on national productivity effects of an eroded employer pension
system. Although defined benefit pension plans ``penalize short
stayers'' they reward workers for loyalty and skill
acquisition. These effects on productivity and stability have
been long recognized by labor economists and have been little
studied by pension reform analysts (Dorsey and McPhearson,
1996).
7. Lessons From the International Experience For The U.S.
If the U.S. reduced Social Security in favor of more
personal pensions we could face an erosion in adequacy and
equity as lower income workers, and those with frequent breaks
in employment, end up with small pensions, that pay large
administrative costs and were conservatively invested.
If there is a welfare tier, a significant number of workers
may work in the underground economy after getting the minimum
number of years of credit. The government may face big welfare
outlays in a few decades, and more aged poverty. More
importantly, tax evasion takes away from social stability.
If the U.S. encourages more accumulation of assets by
reducing Social Security in favor of advanced funded pensions,
then demographically-driven financial markets will soar as the
population bulge reaches middle age and crash when the bulge
sells to finance retirement. The link between pensions and work
will be further broken as demographic position and luck
predominately determine a worker's retirement income.
Economists now speculate that demographic aging will cause a
20% decrease in asset values in the U.S. in 2020.
The international experience shows that a U.S. move toward
mandated individual accounts would clearly benefit financial
institutions and advertising firms. Personal pension
administrative costs are large in the U.K. and Chile as much as
29% of contributions.
The U.S. non-means tested Social Security program meets the
horizontal equity test. U.S. workers in like employment
situations now have similar pensions. Under a two tiered plan
the ``pension/-work'' link is broken and those in need (perhaps
because they were spendthrifts) pensions and those who got
better investment advice and were lucky get a better pension.
In the UK reported performance of the funds differs from survey
to survey, so that according to the Office of Fair Trading,
``selecting a fund is something of a lottery'' (p.71).
Workers in personal pensions face increased longevity
risks, because annuities are so expensive in UK and Chile, that
people may opt to live on their funds. Women have a higher
longevity risk. In the UK, women were found to be particularly
vulnerable to sales practices and choosing personal plans of
extremely poor value. Their company plan was often better and
they pay huge fees because administrative costs are paid at
first and bear heavily on those who leave the labor force early
and do not amortize the costs.
In Chile, the political risk of not having political clout
to obtain improved pensions or that the government would
default was perceived to be high (the government had been taken
over by the military). (Diamond, 1991). The conservative
government in UK cut benefits drastically. Political risk is
low in the U.S.. The Social Security system--not Medicare--is
financed until 2030 and then can pay 75% of benefits if nothing
is done.
Transparency is said to be better under the private pension
system. However, in the UK in 1997 over 570,000 pension plans
are being investigated for being missold--workers would have
likely done better had they stayed in their employers' pensions
(Office of Fair Trading, p. 32). One-third of works do not know
if they opted out of the employer plan for a personal pension
(Office of Fair Trading, 88). Most only depended on a
commercial, non neutral, source for pension advice.
In Chile, the AFPs increased sales staff and the
Superintendent of Pensions announced his intention in require
AFP's to reveal interlocking directorates in 1995 but no report
has been issued Former Chilean Labor Secretary Rene Cortazar
conceded that new concentrations of power may forming ``in the
shadows'' of the privatization of capital (Cortazar, 1995).
Last, some hope that the U.S. low savings rate might be
boosted by an advanced funded pension scheme displacing Social
Security. First, the transition costs are high--rough estimates
for some proposals are 2% of national income for 75 years. Net
savings will not be increased we will replace private savings
for government spending. The evidence that the Chilean plan
increased savings is dubious; though it seems to have boosted
personal savings in U.K., but government losses were 5.9
billion pounds. The U.S. low savings rate could be due to the
easy access to debt and a weak retirement motive because the
U.S. outlaws mandatory retirement.
In sum, much of the world wide reforms are attempts to
limit the state presence in favor of a mixed system of
retirement income support. My experience and reading is that
many OECD nations and emerging nations, China and Poland, in
particular, are interested in the U.S. model.
A 1997 three volume report from the UK Government consumer
affairs office, the Office of Fair Trading (dedicated to act
directly on the activities of industry and commerce by
investigating and remedying anti-competitive practices and
abuses of market power, and bringing about market structures
which encourage competitive behavior) recommended a major
overhaul of the UK system for a system that is passively
managed, nearly universal, fully indexed, with low fixed and
open fees, provides unbiased advice, and maintains fully
portable pensions (1997). In other words, the suggested reform
of the current UK model looks a lot like the U.S. Social
Security system. At this point in time the U.S. system is an
export, though there are many ways to improve coverage, equity
and efficiency along the margins. There is no compelling
international model to import.
References
Barrientos, A. and L. Firinguetti (1996) ``Individual
Capitalisation pension plans and old-age pension benefits for low-paid
workers in Chile.'' International Contributions Labour Studies (1).
Cortazar, R. (1995). Interview with Teresa Ghilarducci. August
1995, Chile
Davis, Phillip. E. OECD, Private Pensions in OECD Countries--The
United Kingdom Labor Markets Social Policy Studies, No. 21, Paris,
OECD, 1997.
Dorsey, Stuart and David A. McPherson 1997. ``Pensions and
Training.'' Industrial Relations 36, 1 (January): 81-96.
Diamond, P. (1994). Insulation of Pensions from Political Risk,
National Bureau of Economic Research., Working Paper No. Cambridge,
Massachusettes
Diamond, P. a. S. Valdez.-Prieto. (1994). Social Security Reforms.
The Chilean Economy. B. P. Bosworth, . Rudiger Dornbusch, Raul Laban.
Washington DC, The Brookings Institution.
Farkas, Stephen. Promises to Keep: How Leaders and the Public
Respond to Saving and Retirement. A report from the Public Agenda in
collaboration with Employee Benefit Research Institute, Public Agenda.
Washington D.C. 1994.
Office of Fair Trading, U.K. Government Report of the Director
General's Inquiry into Pensions: Volume One: Summary, background, the
issues, provision overseas, conclusions and recommendations, glossary
and bibliography, Office of Fair Trading, 15-2 5 Bream's Buildings,
London 1997.
Pinera, J. (1988). Fundamentos de la Reforma Previsional. (Seminar
presentation at the Instituto Chileno de Relaciones Industriales,
November 14, 1980). Sistema Privado de Pensiones en Chile. S. Baeza and
R. Manubens. Santiago, Centro de Estudios Publicos: 319-338.
Shoven , John B., Sylvester J. Schieber, Series, National Bureau of
Economic Research: ``The Consequences of Population Aging on Private
Pension Fund Saving and Asset Markets'' Working Paper No. 4665
Steurele, Eugene and Jon, Bakija Retooling Social Security for the
20th Century. Washington D.C., The Urban Institute, 1995.
Uthoff, A. (1994). Pension Systems Reform in Latin America: What is
Difficult in a Transition to an Individual Capitalization Scheme?
Revista de Analisis. 9: pp. 211-235.
Ward, Sue, ``Pensions in the European Community--The British
Experience'' in conference proceedings of ``Pensions in the European
Union: Adapting to Economic and Social Change'' organized by the
European Network for Research on Supplementary Pensions, Munster,
Germany, June 13-16, 1996 Association for Social Security Research and
Policy
World Bank, Averting the Old Age Crises: Policies to Protect the
Old and Promote Growth. Oxford, Oxford University Press, 1994.
Chairman Bunning. Thank you. Let me remind the panel that
we have a reasonable amount of time set aside for each person,
and I don't want to have to gavel you silent, but I will if you
continue to run over.
And that is not a threat, Doctor. Doctor Pinera.
STATEMENT OF JOSE PINERA, PRESIDENT, INTERNATIONAL CENTER FOR
PENSION REFORM, SANTIAGO, CHILE; COCHAIRMAN, CATO INSTITUTE
PROJECT ON SOCIAL SECURITY PRIVATIZATION; AND FORMER MINISTER
OF LABOR AND SOCIAL SECURITY
Mr. Pinera. Mr. Chairman and distinguished Members of the
Subcommittee. I am very honored to be here. I am a Chilean
citizen, but I spent many years in your country and my eldest
son has been born in this country so if our experience in Chile
can be of any help to your country, I will be very proud and
very happy.
As you know, 17 years ago in Chile we faced a very
difficult dilemma. Our pay-as-you-go Social Security system
that began in 1925, 10 years before the United States signed
the Social Security Act, was going bankrupt. It was like the
Titanic ship going directly toward the iceberg of an aging
population. There was no way of saving that system. But we do
believe in the noble idea of Social Security, so in order to
save Social Security, we decided to radically change the way it
is provided.
The basic idea in Chile was to allow workers to put their
full payroll taxes into individual retirement accounts. The
basic idea is that for a long time investors have known the
extraordinary power of compounded interest. The fact that money
saved during a long period of time gets interest over interest,
and therefore you are able to build a huge amount of wealth.
But generally workers have not been able to benefit from this
extraordinary force because they do not have enough money to
make additional savings.
So the basic idea of the Chilean system is to allow all
workers of the country to benefit from the magic of compound
interest and, therefore, to save during their lives and build
wealth so that when they reach the retirement age they have a
huge capital of their own.
Every Chilean worker carries a passbook like this. I always
carry a set of them. There are many of them. It is a pension
passbook where every month the 10-percent payroll tax goes into
their account. They cannot take it during their working life.
This money is protected by the constitution and the law. The
workers are empowered because they know that they can decide
which company can manage their money. They can even move from
one to the other whenever they want. So when they reach
retirement age, they do not look for the government to provide
them a retirement check, but rather they get an annuity out of
the capital accumulated in this account.
The system gives government two very important roles.
First, of regulation. That is, we have created a very technical
supervisory body in order to assure that this money is invested
in a very safe portfolio of bonds and shares. And second, the
government provides a safety net. If after 20 years of
contributions you reach 65 and you have not accumulated enough
wealth to provide a minimum annuity, then the government fills
the account of the worker out of general tax revenues.
We place three basic rules for the transition to this
system. The first one is we guarantee the elderly their
benefits. That is, we protected our grandmothers' retirement
checks. The elderly shouldn't be harmed because of this pension
reform and they were not in Chile.
Second, we gave every worker the free choice that if they
liked the government-run Social Security system, they can stay
there. But we allowed them the free choice of moving out to
this new system of individual retirement accounts. And when
they did, we gave every one of them a recognition bond
recognizing their past contributions. And the third rule was
that new entrants into the labor force enter into the system so
that we know then that in time the new system will be the only
system in place in Chile.
The results have been extraordinary, first, for the
workers. When I explained the system, because I was Secretary
of Labor at that time and I did a huge education effort, I told
workers that only with a 4-percent real rate of interest they
will be better than the old system. During 16 years, the
average real rate of return, real, above inflation, has been 12
percent a year.
If you take the administrative cost of 1.3 percent of
assets on average, that means the real rate of return of 10.5
percent a year for 16 years. That is incredibly good for the
workers. So this has meant a big benefit to every worker in the
country and especially the very poor who are able to benefit
from the power of compound interest.
Second, on macroeconomic grounds, the results have been
extraordinary. Chile has been growing at 3.5 percent during all
this century. Now we are growing at a rate of 7 percent a year
during the last 12 years. That means if we go another 8 years
growing at 7 percent, in 20 years Chile will have multiplied,
GNP, gross national product, by 4. When you multiply your GNP
by 4 it is a new country, it is an economic, social, even a
political revolution.
And finally, and maybe the most important thing this has
given workers is more personal freedom, has empowered them and
allowed them to participate in the benefits of the economy. In
Chile when share prices go up, every worker benefits because
they know they have their money in the market.
In a system rewarding in the world the accumulation of
wealth, we have allowed workers to also benefit from owning
wealth and not only having income. This has created also a
sense of belonging of the workers, have given them more dignity
because they can confront employers owning wealth, and it has
led to a very successful economic and political system in
Chile. Thank you very much.
[The prepared statement follows:]
Statement of Jose Pinera, President, International Center for Pension
Reform, Santiago, Chile; Cochairman, CATO Institute Project on Social
Security Privatization; and Former Minister of Labor Social Security
Mr. Chairman, distinguished members of the subcommittee:
My name is Jose Pinera and I am a Chilean citizen. I spent
several years of my life at Harvard University, earning a
Master in Arts and a Ph.D. in economics, and my eldest son was
born during those years in Boston. Today, I am president of the
International Center for Pension Reform in Santiago, Chile, and
co-chairman of the Cato Institute's Project on Social Security
Privatization. As Minister of Labor and Social Security from
1978 to 1980, I was responsible for the privatization of the
Chilean pension system.
I want to thank Chairman Bunning for his invitation to me
to testify. In keeping with the truth in testimony
requirements, let me first note that neither the Cato Institute
nor the International Center for Pension Reform receives any
government money of any kind.
The Worldwide Pension Crisis
The real specter haunting the world these days is the
specter of bankrupt state-run pension systems. The pay-as-you-
go pension system that has reigned supreme through most of this
century has a fundamental flaw, one rooted in a false
conception of how human beings behave: it destroys, at the
individual level, the essential link between effort and
reward--in other words, between personal responsibilities and
personal rights. Whenever that happens on a massive scale and
for a long period of time, the result is disaster.
For example, the OECD projects that government retirement
benefits alone will exceed 16 percent of GDP annually in
Germany, France, and Italy by 2030. According to the OECD, the
current unfunded liabilities of the public pension systems in
France, Germany, and Japan are well over 100 percent of their
respective GDPs. In the United States, your Social Security
system will begin running a deficit in just 15 years.
Two exogenous factors aggravate the results of that flaw:
(1) the global demographic trend toward decreasing fertility
rates; and, (2) medical advances that are lengthening life. As
a result, fewer and fewer workers are supporting more and more
retirees. Since the raising of both the retirement age and
payroll taxes has an upper limit, sooner or later the system
has to reduce the promised benefits, a telltale sign of a
bankrupt system.
Whether this reduction of benefits is done through
inflation, as in most developing countries, or through
legislation, the final result for the retired worker is the
same: anguish in old age created, paradoxically, by the
inherent insecurity of the ``social security'' system.
When I was secretary of labor and social security in Chile,
we faced similar problems with our social security system. In
1981, we decided to replace our U.S.-style pay-as-you-go system
with a new system based on individually-owned, privately
invested accounts, details of which I will provide in a few
minutes. This system has been an overwhelming success for 16
years and is now being copied throughout the world.
The success of the Chilean private pension system has led
three other South American countries to follow suit. In recent
years, Argentina (1994), Peru (1993), and Colombia (1994)
undertook a similar reform. Mexico, Bolivia, and El Salvador
have already approved laws that will reform their state-run
pension systems following the Chilean model. The new system in
those countries will begin operation in the next few months
(for example, July 1 in Mexico).
As an indication of the power of ideas, even officials from
the People's Republic of China have come to Chile to study the
private pension system. Indeed, I have just returned from a
conference in Shanghai, where I met with top government
officials who demonstrated a clear interest in Chilean-style
pension reform.
The Chilean PSA System \1\
Let me tell you a little more about the Chilean model. In
1980, Chile approved a law (D.L. 3500) to fully replace a
government-run pension system with a privately administered,
national system of Pension Savings Accounts.
---------------------------------------------------------------------------
\1\ This section follows Jose Pinera, ``Empowering Workers: The
Privatization of Social Security in Chile.'' Cato's Letter No. 10, Cato
Institute (1996).
---------------------------------------------------------------------------
The new system began to operate on May 1, 1981 (Labor Day
in Chile). After 16 years of operation, the results speak for
themselves. Pensions in the new private system already are 50
to 100 percent higher--depending on whether they are old-age,
disability, or survivor pensions--than they were in the pay-as-
you-go system. The resources administered by the private
pension funds amount to around 42 percent of Chile's GNP. By
improving the functioning of both the capital and the labor
markets, pension privatization has been one of the key
initiatives that, in conjunction with other free-market
oriented structural reforms, has pushed the growth rate of the
economy upwards from the historical 3 percent a year to 7.0
percent on average during the last 12 years.
In a recent work, has stated that, ``The [Chilean] pension
reform has had important effects on the overall functioning of
the economy. Perhaps one of the most important effects is that
it has contributed to the phenomenal increase in the country's
saving rate, from less than 10% in 1986 to almost 29% in 1996.
He goes on to say that, ``The pension reform has also had an
important effect on the functioning of the labor market. First,
by reducing the total rate of social security contributions it
has reduced the cost of labor. Second, by relying on a
capitalization system it has eliminated the labor tax component
of the retirement system.''
Under Chile's Pension Savings Account (PSA) system, what
determines a worker's pension level is the amount of money he
accumulates during his working years. Neither the worker nor
the employer pays a social security tax to the state. Nor does
the worker collect a government-funded pension. Instead, during
his working life, he automatically has 10 percent of his wages
deposited by his employer each month in his own, individual
PSA. A worker may contribute an additional 10 percent of his
wages each month, which is also deductible from taxable income,
as a form of voluntary savings.
A worker chooses one of the private Pension Fund
Administration companies (``Administradoras de Fondos de
Pensiones,'' AFPs) to manage his PSA. These companies can
engage in no other activities and are subject to government
regulation intended to guarantee a diversified and low-risk
portfolio and to prevent theft or fraud. A separate government
entity, a highly technical ``AFP Superintendency,'' provides
oversight. Of course, there is free entry to the AFP industry.
Each AFP operates the equivalent of a mutual fund that
invests in stocks and bonds. Investment decisions are made by
the AFP. Government regulation sets only maximum percentage
limits both for specific types of instruments and for the
overall mix of the portfolio; and the spirit of the reform is
that those regulations should be reduced constantly with the
passage of time and as the AFP companies gain experience. There
is no obligation whatsoever to invest in government or any
other type of bonds. Legally, the AFP company and the mutual
fund that it administers are two separate entities. Thus,
should an AFP go under, the assets of the mutual fund--that is,
the workers' investments--are not affected.
Workers are free to change from one AFP company to another.
For this reason there is competition among the companies to
provide a higher return on investment, better customer service,
or a lower commission. Each worker is given a PSA passbook and
every three months receives a regular statement informing him
how much money has been accumulated in his retirement account
and how well his investment fund has performed. The account
bears the worker's name, is his property, and will be used to
pay his old age pension (with a provision for survivors'
benefits).
As should be expected, individual preferences about old age
differ as much as any other preferences. The old, pay-as-you-go
system does not permit the satisfaction of such preferences,
except through collective pressure to have, for example, an
early retirement age for powerful political constituencies. It
is a one-size-fits-all scheme that exacts a price in human
happiness.
The PSA system, on the other hand, allows for individual
preferences to be translated into individual decisions that
will produce the desired outcome. In the branch offices of many
AFPs there are user-friendly computer terminals that permit the
worker to calculate the expected value of his future pension,
based on the money in his account, and the year in which he
wishes to retire. Alternatively, the worker can specify the
pension amount he hopes to receive and ask the computer how
much he must deposit each month if he wants to retire at a
given age. Once he gets the answer, he simply asks his employer
to withdraw that new percentage from his salary. Of course, he
can adjust that figure as time goes on, depending on the actual
yield of his pension fund or the changes in the life expectancy
of his age group. The bottom line is that a worker can
determine his desired pension and retirement age in the same
way one can order a tailor-made suit.
As noted above, worker contributions are deductible for
income tax purposes. The return on the PSA is tax free. Upon
retirement, when funds are withdrawn, taxes are paid according
to the income tax bracket at that moment.
The Chilean PSA system includes both private and public
sector employees. The only ones excluded are members of the
police and armed forces, whose pension systems, as in other
countries, are built into their pay and working conditions
system. (In my opinion--but not theirs yet--they would also be
better off with a PSA). All other employed workers must have a
PSA. Self-employed workers may enter the system, if they wish,
thus creating an incentive for informal workers to join the
formal economy.
A worker who has contributed for at least 20 years but
whose pension fund, upon reaching retirement age, is below the
legally defined ``minimum pension'' receives that pension from
the state once his PSA has been depleted. What should be
stressed here is that no one is defined as ``poor'' a priori.
Only a posteriori, after his working life has ended and his PSA
has been depleted, does a poor pensioner receive a government
subsidy. (Those without 20 years of contributions can apply for
a welfare-type pension at a lower level).
The PSA system also includes insurance against premature
death and disability. Each AFP provides this service to its
clients by taking out group life and disability coverage from
private life insurance companies. This coverage is paid for by
an additional worker contribution of around 2.9 percent of
salary, which includes the commission to the AFP.
The mandatory minimum savings level of 10 percent was
calculated on the assumption of a 4 percent average net yield
during the whole working life, so that the typical worker would
have sufficient money in his PSA to fund a pension equal to 70
percent of his final salary.
Upon retiring, a worker may choose from two general payout
options. In one case, a retiree may use the capital in his PSA
to purchase an annuity from any private life insurance company.
The annuity guarantees a constant monthly income for life,
indexed to inflation (there are indexed bonds available in the
Chilean capital market so that companies can invest
accordingly), plus survivors' benefits for the worker's
dependents. Alternatively, a retiree may leave his funds in the
PSA and make programmed withdrawals, subject to limits based on
the life expectancy of the retiree and his dependents. In the
latter case, if he dies, the remaining funds in his account
form a part of his estate. In both cases, he can withdraw as a
lump sum the capital in excess of that needed to obtain an
annuity or programmed withdrawal equal to 70 percent of his
last wages.
The PSA system solves the typical problem of pay-as-you-go
systems with respect to labor demographics: in an aging
population the number of workers per retiree decreases. Under
the PSA system, the working population does not pay for the
retired population. Thus, in contrast with the pay-as-you-go
system, the potential for inter-generational conflict and
eventual bankruptcy is avoided. The problem that many countries
face--unfunded pension liabilities--does not exist under the
PSA system.
In contrast to company-based private pension systems that
generally impose costs on workers who leave before a given
number of years and that sometimes result in bankruptcy of the
workers' pension funds--thus depriving workers of both their
jobs and their pension rights--the PSA system is completely
independent of the company employing the worker. Since the PSA
is tied to the worker, not the company, the account is fully
portable. Given that the pension funds must be invested in
tradable securities, the PSA has a daily value and therefore is
easy to transfer from one AFP to another. The problem of ``job
lock'' is entirely avoided. By not impinging on labor mobility,
both inside a country and internationally, the PSA system helps
create labor market flexibility and neither subsidizes nor
penalizes immigrants.
A PSA system is also much more efficient in promoting a
flexible labor market. In fact, people are increasingly
deciding to work only a few hours a day or to interrupt their
working lives--especially women and young people. In pay-as-
you-go systems, those flexible working styles generally create
the problem of filling the gaps in contributions. Not so in a
PSA scheme where stop-and-go contributions are no problem
whatsoever.
The Transition
One challenge is to define the permanent PSA system.
Another, in countries that already have a pay-as-you-go system,
is to manage the transition to a PSA system. Of course, the
transition has to take into account the particular
characteristics of each country, especially constraints posed
by the budget situation.
In Chile we set three basic rules for the transition:
1. The government guaranteed those already receiving a
pension that their pensions would be unaffected by the reform.
This rule was important because the social security authority
would obviously cease to receive the contributions from the
workers who moved to the new system. Therefore the authority
would be unable to continue paying pensioners with its own
resources. Moreover, it would be unfair to the elderly to
change their benefits or expectations at this point in their
lives.
2. Every worker already contributing to the pay-as-you-go
system was given the choice of staying in that system or moving
to the new PSA system. Those who left the old system were given
a ``recognition bond'' that was deposited in their new PSAs.
(The bond was indexed and carried a 4 percent real interest
rate). The government pays the bond only when the worker
reaches the legal retirement age. The bonds are traded in
secondary markets, so as to allow them to be used for early
retirement. This bond reflected the rights the worker had
already acquired in the pay-as-you-go system. Thus, a worker
who had made pension contributions for years did not have to
start at zero when he entered the new system.
3. All new entrants to the labor force were required to
enter the PSA system. The door was closed to the pay-as-you-go
system because it was unsustainable. This requirement assured
the complete end of the old system once the last worker who
remained in it reaches retirement age (from then on, and during
a limited period of time, the government has only to pay
pensions to retirees of the old system).
The financing of the transition is a complex technical
issue and each country must address this problem according to
its own circumstances. The implicit pay-as-you-go debt of the
Chilean system in 1980 has been estimated by a recent World
Bank study \2\ at around 80 percent of GDP. (The value of that
debt had been reduced by a reform of the old system in 1978,
especially by the rationalization of indexing, the elimination
of special regimes, and the raising of the retirement age.)
That study stated that ``Chile shows that a country with a
reasonably competitive banking system, a well-functioning debt
market, and a fair degree of macroeconomic stability can
finance large transition deficits without large interest rate
repercussions.''
---------------------------------------------------------------------------
\2\ World Bank, Averting the Old Age Crisis (1994).
---------------------------------------------------------------------------
Chile used five methods to finance the transition to a PSA
system:
1. Since the contribution needed in a capitalization system
to finance adequate pension levels is generally lower than the
current payroll taxes, a fraction of the difference between
them was used as a temporary transition payroll tax without
reducing net wages or increasing the cost of labor to the
employer (the gradual elimination of that tax was considered in
the original law and, in fact, that happened, so that today it
does not exist).
2. Using debt, the transition cost was shared by future
generations. In Chile roughly 40 percent of the cost has been
financed issuing government bonds at market rates of interest.
These bonds have been bought mainly by the AFPs as part of
their investment portfolios and that ``bridge debt'' should be
completely redeemed when the pensioners of the old system are
no longer with us.
3. The need to finance the transition was a powerful
incentive to reduce wasteful government spending. For years,
the budget director has been able to use this argument to kill
unjustified new spending or to reduce wasteful government
programs, thereby making a crucial contribution to the increase
in the national savings rate.
4. The increased economic growth that the PSA system
promoted substantially increased tax revenues. Only 15 years
after the pension reform, Chile is running fiscal budget
surpluses of around 2 percent of GNP.
5. In a theoretical state's balance sheet (where each
government should show its assets and liabilities), state
pension obligations may be offset to some extent by the value
of state-owned enterprises and other types of assets.
Privatizations in Chile were not only one way to contribute,
although marginally, to finance the transition, but had several
additional benefits such as increasing efficiency, spreading
ownership, and depoliticizing the economy.
The Results
The PSAs have already accumulated an investment fund of $30
billion, an unusually large pool of internally generated
capital for a developing country of 14 million people and a GDP
of $70 billion.This long-term investment capital has not only
helped fund economic growth but has spurred the development of
efficient financial markets and institutions.
Since the system began to operate on May 1, 1981, the
average real return on investment has been 12 percent per year
(more than three times higher than the anticipated yield of 4
percent). Of course, the annual yield has shown the
oscillations that are intrinsic to the free market--ranging
from minus 3 percent to plus 30 percent in real terms--but the
important yield is the average one over the long term.
Pensions under the new system have been significantly
higher than under the old, state-administered system, which
required a total payroll tax of around 25 percent. According to
a recent study, the average AFP retiree is receiving a pension
equal to 78 percent of his mean annual income over the previous
10 years of his working life. As mentioned, upon retirement
workers may withdraw in a lump sum their ``excess savings''
(above the 70 percent of salary threshold). If that money were
included in calculating the value of the pension, the total
value would come close to 84 percent of working income.
Recipients of disability pensions also receive, on average, 70
percent of their working income.
The new pension system, therefore, has made a significant
contribution to the reduction of poverty by increasing the size
and certainty of old-age, survivors, and disability pensions,
and by the indirect but very powerful effect of promoting
economic growth and employment.
For Chileans, pension savings accounts now represent real
and visible property rights--they are the primary sources of
security for retirement. After 16 years of operation of the new
system, in fact, the typical Chilean worker's main asset is not
his used car or even his small house (probably still
mortgaged), but the capital in his PSA.
Finally, the private pension system has had a very
important political and cultural consequence. Indeed, the new
pension system gives Chileans a personal stake in the economy.
A typical Chilean worker is not indifferent to the behavior of
the stock market or interest rates. Intuitively he knows that
his old age security depends on the wellbeing of the companies
that represent the backbone of the economy.
Mr. Chairman, I will not try to spell out in detail exactly
how a Chilean-style system can be established in the United
States. Let me simply say that I believe it is possible for the
United States to move to a social security system based on
individual accounts and private investment. The transition to
such a system will be technically tricky but can be done.
Several of your country's top experts are now at work designing
such transition proposals. I do not pretend that Chile's system
can be imported to the United States without any changes. But,
I do believe that you can learn from our successful experiment.
Thank you very much.
Chairman Bunning. Thank you, Doctor.
Mr. Kay, please.
STATEMENT OF STEPHEN KAY, PH.D. CANDIDATE, UNIVERSITY OF
CALIFORNIA AT LOS ANGELES, LOS ANGELES, CALIFORNIA
Mr. Kay. Mr. Chairman, thank you for this opportunity. I
spent the past 4 years researching Social Security reform in
Argentina, Brazil, Chile and Uruguay and I spent a total of 2
years in those 4 countries. Some people have suggested that
Chile's privatized pension system provides a model for the
United States. However, the Chilean system is not a compelling
model because, one, it would entail massive transition costs
and potentially high administrative costs; two, it would
introduce risk and uncertainty regarding the adequacy of future
benefits; and three, it would create distributional
inequalities.
The costs of transition to a private system are enormous
because governments must continue to pay benefits while
contributions are diverted to private accounts. Transition
costs in Chile are currently almost 4 percent of GDP. To
finance the cost of moving to a funded system, governments must
raise taxes, incur debt and/or cut other areas of public
spending. In other words, privatization would exacerbate the
problems of financing Social Security rather than solving them.
The pension fund market in Chile is dominated by a few
funds and competition has not driven down costs. Marketing and
operations expenses are very high as firms seek to capture the
25 percent of workers who switch funds every year. These costs
are translated into high commissions for workers. Approximately
17 to 20 percent of worker contributions go toward commissions.
Furthermore, pension funds that charge fixed commissions
take proportionately higher fees from lower income workers.
Once commission costs are considered, the system's highly
touted 12.7-percent average annual return was actually 7.4
percent.
Exposing individuals future Social Security benefits to
market forces creates unnecessary risks. Predictions for future
annual returns in Chile range between 3 percent and 5 percent.
However, these are only averages. Through chance or skill some
workers will do very well while others who make unwise
investments or suffer bad luck will be poor. Even if a Chilean-
style system did raise aggregate returns, a system that created
winners and losers would run counter to the goal of providing
basic retirement security for all citizens.
In Chile, the high evasion rates raise concern about the
number of workers that will be able to enjoy secure retirement.
Only 56 percent of workers affiliated with the system make
regular contributions. Most of the uninsured come from the
poorer sectors of the population.
By December, 1995, over a third of the contributors to the
new private system had accumulated less than $500 in their
accounts and half had less than $1,230. Chile's private pension
system also treats women differently than men. Because women
tend to earn less than men, spend more of their years outside
the labor force and live longer, they systematically receive
lower benefits than men.
In a sense, the Chilean system punishes maternity because
interrupted earnings inevitably lead to lower pensions. Even if
we assume identical wages during their working years, a woman
retiring at age 65 and purchasing an annuity would be paid a
monthly benefit equivalent to 90 percent of what a man would
receive.
Finally, current pensions under the new Chilean system are
not an indicator of future returns. These pensions were largely
funded by special bonds issued to compensate for contributions
made to the old pay-as-you-go system. The true test will come
in the future when workers who have contributed for most or all
of their lives begin to retire.
The Chilean case teaches us to ask the following questions:
How would the massive transition costs be distributed? Would
cuts come in education and health as in Chile? Would Social
Security continue to have an effective antipoverty component?
Would the risks of the marketplace, including the risk of
inflation, be placed entirely on the shoulders of individuals?
Would membership in a private system be optional as in
Argentina and Uruguay, or mandatory as it is for all workers
who have entered the work force since 1981 in Chile? Would
women systematically receive lower benefits? And finally, how
would administrative costs and commissions be minimized?
We should ask all of these questions when considering the
implications of privatization, thank you.
[The prepared statement follows:]
Statement of Stephen Kay, Ph.D. Candidate, University of California at
Los Angeles, Los Angeles, California
Mr. Chairman, distinguished members of the subcommittee:
My name is Stephen Kay. I am a doctoral candidate in
political science at UCLA and a political science instructor at
California State University, Fullerton. I have spent the past
four years conducting research and writing on politics and
social security reform in Argentina, Brazil, Chile, and
Uruguay. I spent a total of two years in these four countries.
Chile's 1981 pension privatization has garnered a great
deal of international attention, and some have gone so far as
to argue that it provides a case study in how to ``save'' the
U.S. Social Security system. The Chilean system has received
much praise for its simplicity, its important role in promoting
the development of capital markets, its high returns, and the
fact that it is well-regulated. However its weaknesses have
received less attention. The new private system deserves
criticism for its less than universal coverage, its high
marketing expenses, operations expenses, and commission
charges, and its gender inequity. Chile's new private system
does not provide us with a model that would justify dismantling
Social Security and adopting a system of individual
capitalization.
Background
Prior to recent reforms, South America's social security
systems were in varying degrees of disarray: aging populations
and massive evasion by both employers and workers meant that
fewer contributors were supporting more pensioners, surpluses
had been wasted on bad investments, benefits were highly
inegalitarian and financed regressively, deficits were
mounting, administrative performance was poor, and payroll
taxes were among the highest in the world.\1\
---------------------------------------------------------------------------
\1\ For a description of the ills of Latin America's social
security systems see Mesa-Lago, Carmelo. 1994. Changing Social Security
in Latin America. Boulder: Westview.
---------------------------------------------------------------------------
By the end of the 1980s (Latin America's ``lost decade'' of
economic development) there was consensus in the region that
reform was necessary; however intense political conflict arose
over the direction of reform. Reforms ranged from partial
privatizations in Argentina (1993) and Uruguay (1995), to an
aborted privatization drive in Brazil (the Brazilian reform is
still underway).
Chile became the pioneer of privatization when the Pinochet
dictatorship implemented the world's first-ever social security
privatization in 1981. Under the tripartite ``pay-as-you-go''
(PAYG) model used in most of the world (including the United
States), a combination of payroll taxes on workers and
employers, and government contributions are used to fund Social
Security benefits. In Chile's private system, workers are
required to contribute 10% of their salaries to individual
investment accounts, where funds are invested by private
pension fund companies in closely regulated portfolios. Pension
fund companies must guarantee profitability relative to the
average profitability in the pension fund industry.
The self-employed are not required to join a pension plan
while the military and police kept their relatively generous
PAYG systems. The government provides a subsidy to workers who
contribute for at least twenty years but do not accumulate
enough capital to earn a minimum pension. The minimum pension
is approximately 25% of the average salary, and is currently
around $120 a month for those under 70.
The Argentine and Uruguayan reforms, which were implemented
by democratically-elected governments, are partial
privatizations which differ from Chile's privatization in two
significant respects. First, both systems maintain a universal
public pay-as-you-go benefit, while Chile's PAYG system is
being gradually phased-out. Second, membership in the private
system is optional for Argentine and Uruguayan workers
(although workers in Uruguay must make contributions to either
a public or private pension fund on earnings between $800 and
$2500). In Chile the new private system was optional when it
was introduced (there was a financial inducement to join), and
it has been mandatory for all workers entering the labor force
since 1981.
Returns and Commissions
Since its founding, Chile's private system achieved
impressive average annual returns on investment. However once
commissions are factored in, the real average return is
considerably lower. While advocates of privatization like to
point out that the annual return on invested pension funds
between 1982 and 1995 averaged 12.7%, this figure does not
incorporate the commission charges that workers pay on
contributions. If you count the amount workers contributed and
deduct commission charges, an individual's real average rate of
return over this period was 7.4%. The disparity between these
two figures illustrates how commissions affect the rate of
return. Over shorter periods of time, the impact on the rate of
return is even greater since contributors may earn negative or
very low returns over the first four to five years (imagine a
mutual fund with a 17% ``load'').\2\ The 7.4% figure provides a
more realistic assessment of the returns of the system because
it represents what workers actually received on their entire
investment. Furthermore, fixed commissions have been a source
of regressivity in the new system because the charge consumes a
proportionately greater percentage of the contributions of low-
income workers (fixed commissions are becoming less common.)
\3\
---------------------------------------------------------------------------
\2\ Shah, Hemant. 1997. ``Toward Better Regulation of Private
Pension Funds.'' Paper presented at the World Bank, LAC Division, 1-16-
97.
\3\ See Arenas de Mesa, Alberto. 1997. Learning from the
Privatization of the Social Security Pension System in Chile:
Macroeconomcs Effects, Lessons and Challenges. Dissertation. University
of Pittsburgh, Pittsburgh (March) 1997. Arenas de Mesa quantifies how
commission charges affect low and high income earners due to commission
charges.
---------------------------------------------------------------------------
Although market competition should keep costs low, expenses
generated by marketing have helped keep costs high. Regulations
on minimal profitability and requirements that each pension
fund company can only administer one fund have restricted
diversity among fund portfolios as pension funds have largely
produced similar returns.\4\ Furthermore, the pensions industry
is oligopolistic,\5\ as three firms controlled 68% of all
insured persons in 1994. Chilean regulators have sought to
lower commissions, which have come down from their peak of
8.69% of taxable salary in 1984 to around 3.1% today (these
include a disability insurance premium of 1%); however
commissions still represent a sizable portion of a workers'
overall social security contributions.
---------------------------------------------------------------------------
\4\ Diamond, Peter, and Salvador Valdes-Prieto. 1994. ``Social
Security Reforms,'' in Barry P. Bosworth, Rudiger Dornbusch, and Raul
Laban eds., The Chilean Economy: Policy Lessons and Challenges
Washington D.C.: Brookings Institute.
\5\ Barr, Nicholas, 1994. ``Income Transfers: Social Insurance'' in
Barr, Nicholas, ed., Labor Markets and Social Policy in Eastern Europe:
The Transition and Beyond. New York: Oxford. See page 214.
---------------------------------------------------------------------------
Upon retirement workers face a number of options. The
accumulated funds may be used to purchase an annuity indexed
against inflation, or pensioners can elect to receive a
``programmed pension,'' paid directly by the pension fund
company, based on the accumulated funds in an amount that is
reassessed every year based upon the firm's performance.
Workers may also elect to withdraw funds in a lump sum, as long
as they leave enough capital to purchase an annuity in the
amount of 110% of the minimum pension. These options give
workers greater control over their funds, but they pose the
risk that workers may outlive their income (in the case of a
programmed withdrawal), or spend a large portion of their
retirement income at once and be left with a pension just
slightly above the minimum. Since these options are complex,
workers often hire independent consultants, who charge a fee of
between 3% and 5% of the total value of the individual's
account.\6\
---------------------------------------------------------------------------
\6\ Gillon, Colin, and Alejandro Bonilla. 1992 ``Analysis of a
National Private Pension Scheme: The Case of Chile,'' in International
Labour Review. Vol. 131, No.2, 1992, p. 171-195.
---------------------------------------------------------------------------
Chilean pension funds are often criticized for their high
marketing and operations costs. Private pension funds engage in
expensive sales campaigns to capture workers from competitors,
as 30% of affiliates in Chile switched pension funds in 1994.
These marketing costs absorb betweRoughly a third of these
administrative costs are generated by salespersons seeking to
persuade workers to switch funds.\7\
---------------------------------------------------------------------------
\7\ Fidler, Stephen. 1997. ``Lure of the Latin Model,'' Financial
Times, 4-9-97.
---------------------------------------------------------------------------
Returns and Pensions
Pensions granted in the next few years are not necessarily
indicative of future benefits because between 60% to 75% of the
funds accumulated in these individual accounts will come from
government ``recognition bonds.'' These bonds are paid to
pensioners upon retirement in recognition of past contributions
made to the old public system, and carry a real interest rate
of 4%.\8\ The true test will come in the future, when workers
who have contributed to the new system for most or all of their
lives begin to retire.
---------------------------------------------------------------------------
\8\ Arenas de Mesa, Alberto, and Veronica Montecinos. Forthcoming
(1998). ``The Privatization of Social Security and Women's Welfare:
Gender Effects of the Chilean Reform.'' Forthcoming in Latin American
Research Review.
---------------------------------------------------------------------------
While the system has achieved high annual returns thus far,
whether or not they can be sustained is uncertain. Chile's high
returns resulted from specific macroeconomic circumstances in
the 1980s. The economy had hit a low point in 1982 when GDP
fell by 14%. After the banking crisis in 1981-83, real interest
rates were very high. Pension funds invested heavily in
government debt instruments, and when real rates fell, they
realized large capital gains. Pension funds increased
investment in equities in the 1990s, and high real returns came
mostly from the impressive performance of the stock market.\9\
---------------------------------------------------------------------------
\9\ See Vittas, Dimitri. 1995. ``Strengths and Weaknesses of the
Chilean Pension Reform.'' Mimeo. Financial Sector Development
Department, World Bank.
---------------------------------------------------------------------------
Pension benefits depend upon worker-investor savvy and/or
luck, as well as the overall performance of the economy.
Predictions for future returns, which will determine pension
benefits, range between 3% and 5%. Pension benefits will vary
dramatically depending on which, if any, of these predictions
hold true. For example, a 3%, 4%, or 5% annual return on
retirement savings in Chile would lead to benefits representing
44%, 62%, and 84% of pre-retirement earnings for men.\10\ One
study estimated that for Chile to achieve the system's goal of
a 70% replacement rate, the system would have to have annual
returns of around 4.5% (leading some analysts to suggest that
the 10% worker contribution might not be sufficient to generate
a 70% replacement rate).\11\ This demonstrates how sensitive
pensions are to market returns. Of course these are only
averages. Except where government subsidies raise worker
benefits to the minimum pension, each individual worker-
investor bears the risks of the marketplace, and may do better
or worse than the average.
---------------------------------------------------------------------------
\10\ The figures on the rate of return and benefits are from Gillon
and Bonilla (1992). Cheyre predicts a 5% annual return (see Cheyre,
Hernan 1991. La Prevision en Chile, Ayer y Hoy. Santiago: Centro de
Estudios Publicos).
\11\ See Gillon and Bonilla (1992 p. 186) and Barr (1994 p. 213).
---------------------------------------------------------------------------
Gender Equity
While PAYG systems in Latin America generally reproduced
market inequalities, privatization marks the abandonment of
some equity-enhancing measures that were present in the public
PAYG systems. The most striking change concerns the treatment
of women. In the old PAYG system, women received more generous
benefits with fewer requirements, and the disparity in benefits
between men and women was smaller. The private social security
systems in South America favor men by placing men and women in
separate actuarial categories. Because they tend to earn less,
spend more years of their lives in unpaid labor, and have
greater longevity, women purchasing annuities upon retirement
will systematically receive lower benefits than men (benefits
are even lower if women opt for early retirement).
In a forthcoming study, economist Alberto Arenas de Mesa
and sociologist Veronica Montecinos project the rates of return
that women would need in order to achieve the same pensions as
men. For example, assuming identical wages and years of
contribution, a woman retiring at age 65 and purchasing an
annuity would receive approximately 90% of what a man would
receive. When we consider the actual disparities in income
profiles and years of contribution, the differences are even
more striking. The authors cite a 1992 study that found that a
typical woman retiring at age 60 and purchasing an annuity
after earning a 5% annual rate of return would receive a
replacement rate of 57% of former salary, while a man retiring
at age 65 would receive 86%. Arenas de Mesa and Montecinos
argue that Chile's new private system punishes maternity
because interrupted earnings inevitably lead to lower pensions.
This is a consfits with earnings, rather than providing both
redistribution and earnings replacement, as is the case in the
United States Social Security system.
Non-Compliance
While many believed that the private system would reduce
evasion because workers have a greater incentive to contribute
to their own personal retirement accounts than to a PAYG
system, evasion persists. Only 60 to 62% of workers are covered
by the new system, figures that are similar to the old
system.\12\ In the early 1990s, 54% of affiliates were active
contributors (defined as those making a contribution in
December of each year).\13\ In June of 1995, 43.4% of those
affiliated with the new system made no contribution \14\
(evasion levels have remained high in Uruguay and Argentina's
new private systems as well). The compliance rate also varied
by income level. Funds which catered to lower-paid workers
received contributions from 45-55% of their affiliates, while
those serving higher paid workers had a compliance rate of 80-
90%.\15\ To further illustrate the problem of evasion, as of
December 1995 over 35% of the 5.4 million contributors to the
private system had accumulated less than $500 in their
accounts, while more than half had less than $1228 in their
accounts.\16\
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\12\ See Fidler (1997).
\13\ See Vittas (1995).
\14\ Ruiz-Tagle, Jaime. 1996. El Nuevo Sistema De Pensiones En
Chile. Una evaluacion provisoria (1981-1995). Carmelo Mesa-Lago
reported that in 1991, 52% of those in private pension schemes
contributed regularly. See Mesa-Lago, Carmelo. 1994. Changing Social
Security in Latin America. Boulder: Lynne Reiner.
\15\ These figures are from 1990. See Barr (1994 p. 212).
\16\ See Shah (1997).
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Capital Markets and Savings
Although economists have had a difficult time quantifying
it, there is agreement that shifting to a funded pension system
has contributed to the deepening of Chile's domestic capital
markets, which in turn has had a positive impact on economic
growth.\17\ In a country like the U.S., with its well-developed
capital markets, the same process may not occur. As UCLA
economist Sebastian Edwards put it, ``It is not clear that
these mechanisms that have benefited Chile will be there in
other, more developed countries.'' \18\
---------------------------------------------------------------------------
\17\ See Holzman, Robert 1997. On Economic Benefits and Fiscal
Requirements of Moving from Unfunded to Funded Pensions. Santiago:
ECLAC. Also see Barr (1994 p. 214). Barr reports that according to some
commentators, ``this is the only substantial benefit of the pension
reform which could not have been achieved by redesigning the old PAYG
system.''
\18\ See Fidler (1997).
---------------------------------------------------------------------------
According to economist Nicholas Barr, the effect of a
funded pension system on economic growth is ``arguably the most
controversial area'' of this debate, and the ``experience of
countries in the West is inconclusive both theoretically and
empirically.'' \19\ Increased pension fund savings are likely
to be offset by a decline in government savings as payroll
taxes are diverted to private accounts. Individuals expecting a
larger retirement benefit may also elect to save less in other
ways. Although some have claimed that privatization explains
the meteoric rise of Chile's national savings rate (which
climbed from around 15% of GDP in the 1980s to 27% in 1995),
there does not seem to be a lot evidence to support this claim.
A recent study argues that increased corporate savings
resulting from Chile's 1984 tax reform played a large role in
boosting Chile's savings rate, and that the private pension
system's direct contribution to the increase was around 1% of
GDP.\20\
---------------------------------------------------------------------------
\19\ See Barr (1994).
\20\ See Arrau, Patricio 1996. Nota Sobre El Aumento del Ahorro en
Chile. CEPAL: Santiago. The 1% figure is from Titelman, Daniel. 1997.
``Impacto De Los Fondos De Pension En El Proceso De Ahorro Interno'' in
1er Seminario Internacional Sobre Fondos De Pensiones. Buenos Aires:
Asociacion Internacional de Organismos de Supervision de Fondos de
Pensiones.
---------------------------------------------------------------------------
Transition Costs
The enormous transition costs of privatization, and how
they would be distributed, is perhaps one of the most
overlooked issues in the privatization debate. In a privatized
system, workers stop paying social security contributions to
the government, but the government will continue to owe
benefits to individuals belonging to the old system. This
shortfall in revenue can only be financed through cutting other
areas of government spending, raising taxes, or debt. Prior to
privatizing, the Chilean government raised the retirement age
to 65 for men and 60 for women and eliminated privileged
retirement programs based upon years of service. The government
ran budget surpluses, privatized state-owned industries, and
issued bonds that were purchased by the new pension funds.
Since recognition bonds were not issued until retirement, some
of the transition costs could be postponed. In the 1980s,
transition costs were around 3% of GDP, and are expected to
range between 3% and 4% of GDP over the next five years.\21\ As
the transition costs grew in the 1980s, they consumed
relatively greater percentages of social spending, while
expenditures on health and education were cut.\22\
---------------------------------------------------------------------------
\21\ See Asociacion Internacional de Organismos Supervisores de
Fondos de Pensiones, 1996. Reformas a los Sistemas de Pensiones. Buenos
Aires: SAFJP. See p. 85.
\22\ Vergara, Pilar. 1994. ``Market Economy, Social Welfare, and
Democratic Consolidation in Chile,'' in Smith, William et al eds.,
Democracy, Markets, and Structural Reforms in Latin America. New
Jersey: Transaction--North/South Center. See page 254. Also see Gillon
and Bonilla (1992 p. 192-195).
---------------------------------------------------------------------------
Inflation
The biggest risk to any investment portfolio is inflation,
which is less threatening in a PAYG system, where most of
social security revenue is paid out as benefits. Only
government is capable of insuring against inflation through
prudent fiscal policy and the issuing of inflation-indexed
bonds, the only inflation-proof financial instruments.\23\ The
risk of inflation is uninsurable (it is not an independent risk
that can be pooled), providing an efficiency argument for
government guarantees.\24\ In the Chilean system, government
guarantees against inflation are provided for life annuities
which can be purchased upon retirement. Until workers purchase
annuities they are exposed to the risk that a market downturn
or inflation could diminish their capital.
---------------------------------------------------------------------------
\23\ Barr, Nicholas. 1992. ``Economic Theory and the Welfare State:
A Survey and Interpretation'' in Journal of Economic Literature. Vol.
30 (June 1992), p. 741-803.
\24\ Barr, Nicholas. 1987. The Economics of the Welfare State.
Stanford: Stanford University Press.
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Political Risk vs. Market Risk
One of the arguments for privatization is that it replaces
political risk with market risk. In Latin America, social
security benefits were constantly subject to political risk,
because unlike the United States, governments often failed to
index benefits against inflation, failed to take prudent steps
to finance the system, promised unrealistic benefits, or did
not pay what they legally owed. For example, until recently,
Argentine workers were legally entitled to social security
benefits equivalent to 70-82% of their former salary. In
practice, few people ever received such a generous pension. By
1994, underpayment of benefits led to the filing of 335,000
lawsuits against the Argentine government for failing to
fulfill its obligations.
In contrast, our Social Security system has always paid its
benefits on time, it is fiscally solvent, and it has never been
subject to the episodes of fraud and mismanagement that have
occurred in South America. Unlike their Latin American
counterparts, advocates of privatization in the US cannot
substantiate rhetoric about government inefficiency ruining
Social Security.
Conclusions
The social security systems in the Southern Cone of Latin
America suffered from financial and administrative problems
that we in the United States can scarcely imagine, and their
debates over privatization were informed by fundamentally
different political and economic realities. By most measures,
governments in Latin America had failed to provide adequate
social security coverage, and privatization offered an
alternative strategy. In contrast, our Social Security system
does not suffer the maladies that plagued South America's
social security systems. Several eminent scholars of Social
Security, including Henry J. Aaron, Robert Ball, Robert J.
Myers, and C. Eugene Steuerle, have suggested a range of
measures which would reform Social Security rather than
dismantle it. If economist Herbert Stein is correct that
``privatizing the Social Security funds would not add to
national saving, private investment or the national income and
would not allow the system to earn more income without anyone
earning less,'' we might ask whether privatization is worth the
risk and cost for resolving what is essentially a tractable
actuarial shortfall.
What do the Latin American cases teach us about
privatization? First and foremost, we need to consider how the
transition costs of privatization would be distributed. Would
they be paid for by new taxes, government borrowing, or cuts in
other areas of public spending? Would cuts come in health and
education, as in Chile? Would Social Security continue to have
an effective anti-poverty component? How much of the market
risks of privatization would be shoule government? Would
membership in a private system be optional as in Argentina and
Uruguay, or mandatory, as in Chile? How would pension fund
investments be regulated? By strictly linking paid employment
and pensions, would women consistently receive lower pensions
because of time spent outside the labor force? Would men and
women be placed into separate actuarial categories, with women
receiving lower benefits? And finally, how would administrative
costs and commissions be kept down? We should ask all of these
questions when considering the implications of privatizing the
United States Social Security system.
The debate over privatization is not merely technical, but
forces us to confront a fundamentally different vision of the
role of Social Security. A private system simply mandates
savings and investment for retirement, while each individual's
retirement fate is determined by the market. Our Social
Security system provides both earnings replacement and income
redistribution that keeps about half of our nation's elderly
out of poverty. Without some redistributive mechanism, millions
of retired workers would end up on welfare despite having
contributed to Social Security. It is a form of social
insurance where each of us knows that no matter how life turns
out for us, we (and our survivors) will be provided with an
adequate benefit. Even if a private system did raise aggregate
returns, it would not serve the purposes of Social Security to
create a system where some investors fared well and others
foundered. We are better off with a system that will continue
to provide a secure retirement for everyone.
Chairman Bunning. Thank you, Mr. Kay.
Mr. O'Sullivan, please.
STATEMENT OF ANTHONY BLUNN, SECRETARY, COMMONWEALTH, DEPARTMENT
OF SOCIAL SECURITY, AUSTRALIA; AS PRESENTED BY PAUL O'SULLIVAN,
DEPUTY CHIEF OF MISSION, AUSTRALIAN EMBASSY
Mr. O'Sullivan. Thank you, Mr. Chairman. Mr. Chairman, the
Secretary of the Department of Social Security unfortunately
couldn't be here today, but he has submitted a statement for
the record.
Chairman Bunning. Without objection. You are going to read
it, or shall we just enter the whole statement into the record
or are you going to summarize it?
Mr. O'Sullivan. No, I would rather do something else if
that is convenient to you and the Subcommittee. Rather than
summarize or read out of his statement, I thought it might be
more interesting if I made some comments about the political
and economic context.
Chairman Bunning. That is fine. We will enter his full
statement in the record without objection.
[The prepared statement follows:]
Statement of Anthony Blunn, Secretary, Commonwealth Department of
Social Security, Australia
Introduction
Australia, like other OECD countries, is facing a steady
ageing of its population. The Australian Bureau of Statistics
has estimated that between 1994 and 2015 the proportion of
Australians aged 65 years and over will increase from 11.9 per
cent to about 23 per cent of the population. Like other
countries, this projected demographic change has highlighted
the need to develop a retirement income policy that is fiscally
sustainable.
The Australian Government is committed to a retirement
income policy that provides encouragement for individuals to
achieve a higher standard of living in retirement than would be
possible from the Age Pension alone, but also ensures that all
Australians have security and dignity in retirement. This will
be achieved by:
encouraging people who are able to save for their
retirement to do so, particularly through superannuation;
ensuring the provision of an adequate public
safety net in the form of an age pension for Australians who
are unable to support themselves in their retirement years;
ensuring the system is predictable, but
facilitates choice and is equitable; and
ensuring the system is fiscally sustainable and
delivers an increase in national saving.
In the first section of this statement for the Sub
Committee we will briefly outline Australia's social security
system; and Australia's three pillar model of retirement income
provision and factors contributing to its evolution; before
turning in detail to describe the features of the
superannuation pillar.
The second section analyses the major issues arising,
including demographic and fiscal issues recent initiatives
which are foreshadowing some possible future directions for
Australian attention.
In conclusion, we outline the major advantages of the
Australian system, with reference to our own institutional,
political and economic context.
1. Australia's system--general features and context
The Social Security System
Unlike the United States, a national, general revenue
funded system of social assistance is the principal means of
providing social security payments in Australia. The historical
focus of Australian social security has tended towards adequacy
and income redistribution objectives rather than providing
earnings-related pensions. Income support payments are flat
rate, that is, the same rate of pension or benefit is paid to
everyone regardless of their previous earnings, but has regard
to current capacity for self support.
In Australia social security covers diverse target groups
including the aged, people with disabilities, the unemployed,
young people and families. Payments for families include sole
parent pension, maternity allowance and child support. The
Australian social protection system is financed from general
taxation revenue. Welfare expenditure in Australia comprises
37% of total government outlays, including payments to veterans
and child care. This represents 10% of GDP, or A$47 billion per
annum currently.
Australia's system provides means-tested income security
payments to over 4.6 million adults out of our total population
of 18.2 million. Categorical income support payments are
provided according to principles of ``need'' rather than
previous income. Need is assessed by an income and assets test.
Social protection mechanisms are also evident in a range of
Australian institutions and programs, including the recently
introduced family tax initiative for low to middle income
earners; superannuation; universal health insurance (Medicare);
subsidised child care; high levels of home ownership; and
award-based sickness benefits.
Australia's Retirement Income System
The Australian retirement income system can be described as
a three pillar model. The first pillar provides a flat-rate,
means-tested pension known as ``age-pension.'' The rate of
payment is not related to prior earnings. Rather, it is set at
25 per cent of Male Total Average Weekly Earnings (MTAWE) for a
single person. The married rate of pension paid to each partner
of a couple is currently 83% of the single rate. Eighty-four
per cent of all aged Australians receive this pension
(including Service Pensions). of the Age Pension recipients, 65
per cent receive the maximum amount and 35 per cent get a
partial pension.
The second pillar mandates compulsory concessionally taxed
saving for retirement through an employment-based system known
as the Superannuation Guarantee (SG).
The third pillar encourages individuals to supplement the
first two pillars, particularly through voluntary
superannuation assisted by tax concessions and other saving.
Age Pension
The first elements of a national social security system
began in l909, with the introduction of an Australia-wide, non-
contributory and means tested age pension scheme. There were
unsuccessful attempts to introduce a contributory social
security scheme in 1928, 1938 and 1975. In the 1980s a brief
trend towards a universal age pension was reversed when income
and asset tests were reintroduced.
Policy trends in recent years have encouraged self
provision, particularly through superannuation and private
saving, so that those who have the capacity to support
themselves without recourse to public assistance do so. This
has also been reflected in the modifications that have been
made to social security legislation and the income and asset
test in particular.
The Age Pension is one of the largest Commonwealth
government expenditure programs, with some 1.6 million
customers and program outlays of A$12.1 billion in l995-96, or
around 33 per cent of total DSS program outlays.
The Age Pension is paid to Australians who have been a
resident for a total of 10 years (unless modified under shared
responsibility social security agreements). It is payable to
men at age 65 and women at age 61 years. However, the age for
women is being slowly increased to 65 over the next 16 years
(reaching 65 years in July 2013).
Payment is targeted at those in financial need through the
application of income and assets tests. Under the income test
pension is reduced by 50c for each dollar of income over a
specified ``free area'' of income. Some pension can be received
until other income reaches $A806.40 a fortnight for single
people and $A1,347.20 a fortnight for couples. Under the assets
test, pension is reduced proportionally for assets over
specified limits. The test which results in the lower pension
rate is the one which applies.
The rate of age pension paid is indexed every March and
September, according to movements in the Consumer Price Index.
The single rate of pension is also benchmarked to 25 per cent
of MTAWE. As at 20 September 1997, the single rate of pension
will be $A347.80 a fortnight (25.3 per cent of MTAWE) and the
married rate of pension will be $A290.l0 a fortnight for each
member of a couple.
Superannuation (Private Retirement Provision)
The role played by superannuation in Australia's retirement
income policy has grown considerably in importance since 1983
and is expected to have considerably greater influence in the
future. It is important to have some knowledge of the way in
which occupational superannuation has evolved as it is unique
to Australia and other countries might not experience the same
circumstances.
Superannuation in Australia is a long term savings
arrangement that operates primarily to provide income for
retirement from paid employment. Since contributions are made
usually in the form of a percentage of earnings, superannuation
tends to provide end benefits that are related to pre-
retirement income.
Superannuation differs from social insurance in that it is
privately managed (albeit publicly regulated) and
occupationally based.
Australia expects that its superannuation arrangements will
lead to increased household and national savings in the long
run. The superannuation arrangements can be viewed in part as a
move by the Government from an unfunded age pension to a partly
Government partly private, funded retirement income scheme.
In 1983 less than 40 per cent of employees had some form of
superannuation coverage. These employees were concentrated in
the public sector and in higher income private sector
employment.
There was little regulation to ensure that superannuation
savings were preserved to deliver income in retirement. There
was limited opportunity for portability of benefits between
schemes, consequently, superannuation mainly served to provide
higher income earners with concessionally taxed windfalls on
change of employment.
only 5 per cent of such benefits taken as a lump
sum were included in a person's taxable income and taxed at
marginal tax rates.
A process of reform commenced in 1983. Firstly, the tax on
that component of lump sum benefits relating to employment
after June 1983 was increased to reduce the bias against people
taking benefits as annuities and pensions. A higher tax was
also imposed on benefits taken before age 55 to encourage
superannuation savings to be preserved until retirement after
that age. Also, rollover vehicles, namely approved deposit
funds and deferred annuities, were created in 1983 to provide
people with the opportunity to preserve their superannuation
benefits within the concessionally taxed environment until
retirement, and to facilitate the portability of superannuation
benefits when people changed jobs.
In 1986, the then Government sought to encourage the spread
of superannuation through the workforce by agreeing to support
the peak employee body, the Australian Council of Trade Unions
(ACTU), in seeking through industrial awards a universal 3 per
cent employer provided superannuation benefit in lieu of an
equivalent productivity based general wage rise. Award
superannuation was to be fully vested in the member and subject
to preservation until retirement after age 55. Endorsed by the
Industrial Relations Commission, industrial award
superannuation became the principal vehicle for increasing the
superannuation coverage of wage and salary earners.
Award superannuation played a principal role in extending
access to superannuation to some 72 per cent of employees by
July 1991. However, it suffered a number of problems,
including:
non-compliance by employers and the costs
associated with employers who did not fulfil their obligations;
the fact that not all wage and salary earners were
covered by awards and difficulties in ensuring award
superannuation provisions were reflected in all State and
Federal award jurisdictions; and
the difficulty of facilitating increased
superannuation contributions through the award system.
In an effort to overcome these problems and in recognition
of the fact that a voluntary tax assisted private savings
system could not of itself be relied upon to deliver a secure
retirement other than for the wealthy, Australia moved to
formally adopt a three pillar retirement income policy with the
introduction of the Superannuation Guarantee (SG) in 1992.
The SG is a compulsory, occupational based, defined
contribution superannuation system. Under the SG employers are
required to make on behalf of their employees prescribed
minimum contributions to complying superannuation funds. The
required minimum contribution was set at 3% of employee
earnings in 1992 rising to 9% of employee earnings in 2002-03.
Under the SG, assuming a 9 per cent contribution
rate, it is estimated that a person earning ordinary time
earnings can be expected to achieve a replacement rate of pre
retirement final net expenditure of 72%.
Superannuation coverage of employed people was
around 81 per cent at November l995.
Administration and Investment.
Superannuation funds operate as trusts with trustees being
solely responsible for the prudential operation of their funds
and in formulating and implementing an investment strategy.
Duties and obligations are codified and trustees are liable
under both civil and criminal law for breaches of obligations.
Superannuation funds face few investment restrictions. There
are no asset requirements or floors, no minimum rate of return
requirements, nor a Government guarantee of benefits.
As a result, superannuation funds tend to invest in a wide
variety of assets with a mix of duration and risk/return
characteristics. The recent investment performance of
superannuation funds compares reasonably with alternative
assets such as ten year bonds.
As at March 1997 there were 151,311 superannuation funds
with assets totalling around A$279.5 billion. However, some 98%
of all member accounts are held in approximately 8,000 funds.
Superannuation Industry Regulatory Framework.
The prudential regulation of the superannuation system is
currently the responsibility of the Insurance and
Superannuation Commission. Concurrent with the introduction of
the SG, a number of reforms were made to the superannuation
regulatory framework to enhance the security of retirement
savings. The new prudential regulatory regime is embodied in
the Superannuation Industry (Supervision) Act 1993 and
provides, in particular, for:
a significant strengthening in the role and
responsibilities of trustees;
an increase in the role and responsibilities of
key services providers, including actuaries, auditors and fund
managers;
greater participation by members in the management
of their fund, including through equal member representation on
trustee boards;
full and proper disclosure of relevant information
by superannuation funds to their members and a requirement on
funds to make available appropriate internal and external
procedures for resolving member complaints; and
increased enforcement powers for the Insurance and
Superannuation Commission.
Superannuation taxation arrangements and voluntary
contributions.
The income of complying superannuation (and approved
deposit funds) is generally subject to concessional taxation
under the Income Tax Assessment Act 1936 at a rate of 15%.
Superannuation pensions and lump sums (within specified
thresholds) are also subject to concessional taxation.
Additional voluntary contributions (up to a prescribed
reasonable benefit limit) also receive concessional treatment.
2. Social security reform in Australia--Issues
Forecast impact of social security reform
Currently around 84 per cent of Australians of Age Pension
age draw on the Age (or equivalent veterans' Service Pension),
with some two-thirds of pensioners being paid the full rate
pension. It is projected that expenditure on Age and Service
Pensions will rise from 3.2 per cent of GDP in 1994-95 to 4.7
per cent in 2050 taking into account the reduction in pension
outlays resulting from the superannuation savings accumulated
under the compulsory SG arrangements. Without the SG, pension
outlays would increase by a further 0.3 per cent of GDP by
2050.
Fiscal pressures and saving
The continued high levels of Australia's current account
deficit (CAD) are of major concern. Unemployment cannot be
reduced on a sustainable basis without adequate investment.
Therefore, unless additional savings are available, including
from the public sector, the CAD will not be reduced over time.
Increasing dependence on foreign savings, as reflected in
growing net foreign liabilities, exposes the economy to sudden
shifts in market confidence, leads to higher borrowing costs
for Australian business and makes the economy more vulnerable
to external shocks. Inevitably, the effect of these risks is to
place an external ``speed limit'' on the pace at which economic
growth can be sustained.
The Government's medium term fiscal strategy is to follow,
as a guiding principle, the objective of maintaining an
underlying balance on average over the course of the economic
cycle. This approach will ensure that over time the
Commonwealth budget makes no overall call on private sector
saving and therefore does not detract from national saving; it
will provide the Government with the flexibility to allow
fiscal settings to change in response to economic conditions
over the course of the cycle and to respond to external shocks.
The Government is committed to introducing legislation to
ensure greater fiscal discipline and enhanced reporting
arrangements in accordance with its election commitment to a
Charter of Budget Honesty.
There is also a need to increase private saving and
household saving in particular. Private saving comprises
household and corporate saving. After reaching a peak in excess
of 14 per cent of GDP in the mid-1970s, the gross household
saving rate trended steadily downwards with some small
temporary rises reflecting cyclical peaks in economic activity
before flattening out over the past five years at around 7.75
per cent of GDP. over the same period, the gross corporate
saving rate has risen from around 4.5 per cent to a peak of
6.75 per cent of GDP in 1993-94, with a small fall since then.
Despite six years of recovery since the recession of l990-
91, gross private saving remains at around l5 per cent of GDP
compared with an average 16 per cent in the 1960s and 18 per
cent of GDP in the 1970s.
Recent developments--measures introduced
Australia's retirement income policy faces a number of
challenges including to:
improve the equity, efficiency and flexibility of
the retirement income system;
minimise the incentives and opportunity for
retirees to dissipate superannuation savings rather than use
them to provide a genuine income in retirement;
improve the interaction between the age pensions
and superannuation aspects of the retirement incomes system;
and
provide for greater competition and choice in the
contribution and retirement phases of the system.
Towards this end, the current Government elected in 1996,
while generally endorsing Australia's current three pillar
retirement incomes policy, has introduced a number of reforms
aimed at successfully meeting these challenges.
These reforms have been strongly focused on improving the
operation of the retirement incomes framework including
incentives, and further enhancing the principles of self
provision and capacity to pay--underpinned by a commitment to
benchmarking the adequacy of the age pension. A number of
initiatives now serve to broaden choice within the third pillar
of retirement provision. These recent announcements are likely
to set the future direction for retirement policy reform in
Australia.
Specific reforms announced in the 1996-97 Budget and in the
Government's 1997/98 retirement income policy statement,
Savings: Choice and Incentive, by the Hon. Peter Costello MP,
Treasurer; and Senator, the Hon. Jocelyn Newman, Minister for
Social Security, are outlined below.
To improve choice and competition within the superannuation
system the Government introduced Retirement Savings Accounts
(RSAs) in the 1996/97 Budget to provide a simple, low cost, low
risk product especially suited to those with small amounts of
superannuation.
Certain institutions including banks, building societies,
credit unions, life insurance companies and prescribed
financial institutions may apply to the Insurance and
Superannuation Commissioner to become an RSA institution, that
is to provide superannuation without a trust structure. RSAs
are required to be ``capital guaranteed.'' The RSA Bill
provides that where an RSA provider undertakes poor investment
decisions which result in negative investment returns, these
cannot be passed on to the RSA holder to reduce the balance in
the holder's account. They are fully portable, owned and
controlled by the RSA holder, and are subject to the retirement
income standards applying to other superannuation products,
including preservation, contributions eligibility and
disclosure rules.
To ensure that superannuation savings are directed towards
producing an income in retirement the Government has announced
a phased increase in the preservation age from 55 to 60 by the
year 2025 and tighten preservation rules.
Further, the Government aims to make the Social Security
means test treatment of income streams simpler, more consistent
and more equitable. From 1 July 1998, income streams will be
more effectively classified and means tested on the basis of
their characteristics. Consistent with these changes, the
superannuation regulations will also be amended to provide
superannuants with greater choice as to which income stream
products qualify as ``complying'' pensions or annuities for
purposes of gaining access to the higher superannuation pension
reasonable benefit limits.
To improve the flexibility of superannuation arrangements
for low income employees, from 1 July 1998, people earning from
$450 to $900 per month from an employer (or $1,800 over two
months where the person is under 18 years of age) will be
allowed, with the employer's agreement, to choose to receive
wages or salary in lieu of employer SG contributions.
To enhance competition within and between superannuation
funds and RSA providers the Government has announced a measure
whereby employers will be required to give employees 28 days to
make a choice from among five (or more) complying
superannuation funds or RSAs nominated by the employer. For
existing employees, employers must provide a similar choice
within two years of the date of effect of the legislation.
Providing cost effective and equitable assistance to
household saving for life cycle needs in a manner which
recognises the importance of individual choice, a tax rebate
will be available to individuals who make undeducted (ie,
already taxed) member superannuation contributions, and/or who
earn net personal income from other savings and investments, up
to an annual cap of $3,000. The rebate will be phased in at a
rate of 7.5 per cent from 1 July (a maximum rebate of $225),
rising to l5 per cent (a maximum of $450 per annum) from 1 July
1999.
Finally, the Deferred Pension Bonus Plan offers people of
Age or Service Pension age a positive incentive to defer
retirement. Under the plan a person who defers retirement and
access to the Age or Service Pension will accrue a tax exempt
bonus of 9.4 per cent of his or her basic pension entitlement
for each year of employment beyond Age or Service Pension age,
up to a maximum of 5 years, when the bonus reaches 47 per cent
of entitlement for each of the deferral years. The starting
date for bonus accrual will be 1 July 1998. The bonus will be
paid as a lump sum on pension take-up. At current pension
rates, the maximum bonus would be $21,251 for a single person,
and $35,450 for a couple who qualify for the maximum rate of
pension.
Advantages--an Australian perspective
In recognition of the interests of the United States Sub
Committee on Social Security the advantages of the Australian
system focus in four main areas.
Firstly, the Australian Social Security system was
developed according to Australian needs and history and it
works appropriately for this country. Demographic conditions,
institutional arrangements and political circumstances have had
an impact on the direction that the social security system in
Australia has taken. Within this framework Australia has
developed its system to ensure that it meets the needs of
Australians in a comparatively equitable manner.
The provision of uniform and flat rate benefits result in a
high degree of equality and uniformity in pension and benefit
rates and the structure of rights is based in legislation with
a well established system of rights to appeal.
Secondly, the Australian Social Security system has been
historically based on the principles of adequacy and income
redistribution and is widely recognised as having one of the
most highly progressive tax and transfer systems. As a
consequence it is highly successful at directing social
benefits to the poorest sector of the community compared to
other countries.
Thirdly, Australia has demonstrated that it is possible,
under the right circumstances, to add an earnings related
scheme onto a non-contributory system. In particular,
Australia's experience--although it is clear that the system is
not yet fully tuned--demonstrates that major retirement income
reform can proceed incrementally according to a country's
institutional and other requirements.
The full impact of the use of superannuation in Australia
will not be evident until around. However increasingly, aged
people have access to more private resources. over time there
has been a sustained increase in the percentage of age
pensioners receiving a part-rate pension because of the level
of their private income. In June 1987, 25.6 per cent of age
pensioners received a part-rate pension; by June 1997 this had
increased to 32.6 per cent. This is expected to continue to
increase as superannuation coverage and benefits increase over
time.
Finally, as a consequence of well established legislation,
infrastructure and support, Australia has been able to fund its
Social Security system from general revenue without adverse
effects on the rate of Social Security payments. Australia's
efficiency in its administration of the means testing system
has assisted in keeping costs down. Recent data indicates that
the Australian cost of administering social security as a
proportion of total transfers was 3.8 per cent.
A major advantage of a targeted approach (via income and
asset testing) combined with general revenue financing is its
flexibility in dealing with economic, social and demographic
changes. Spending decisions are more likely to be based on
current and future priorities and economic conditions. Income
and asset testing of social security benefits in Australia has
also constrained social expenditure to levels far below those
in most other OECD countries.
Mr. O'Sullivan. Thank you, Mr. Chairman. The early eighties
saw a thorough reexamination of the Social Security system in
Australia and essentially there were four findings out of that
review which were relevant to subsequent policy choices. The
first is that there were too many Australians dependent on
Social Security age pensions as a primary source of retirement
income. At that time less, than 40 percent of Australian
workers participated in funded pension plans, and coverage was
essentially limited to government employees, finance sector
workers, professionals and senior business executives.
The second point was that although government funds were
defined benefit plans that paid out pensions upon retirement,
most private sector superannuation funds were simply tax-
deferred compensation schemes for high-income employees. Third,
dependence on Social Security age pensions reduced national
savings and hence depressed economic growth. And finally the
population was growing older. Australian age dependence ratio,
which is the number of persons age 65 or more divided by the
number of persons aged 15 to 64, will rise sharply from a
projected 18 percent in 2005 to 30 percent in 2031. So what to
do about those problems?
Well, the government at the time decided to implement a new
retirement income policy based on three goals. The first was to
provide more retirement income for future retirees. The second
was to increase national savings, and the third was to reduce
long-term budget pressures.
The government took the following steps to try and achieve
those goals: The first was to mandate that most workers save 3
percent of their income. Employers were responsible for
withholding that money and depositing the funds in a
superannuation plan.
In 1992, the government boosted the required level of
savings and extended the superannuation scheme to virtually all
workers. So by 2002 when this new phase is fully implemented,
all workers through their employers will have to save 9 percent
of their income.
In addition to those mandatory savings, the government of
the eighties made changes to the tax laws to encourage retirees
to use superannuation savings to purchase annuities rather than
making excessive lump sum withdrawals. The government also
implemented means testing. Under that policy, the government's
age pension is gradually reduced and eventually eliminated as
income from other sources rises.
Moreover, the government also imposed an assets test,
meaning that Australians can lose eligibility for age pension
if their savings or other assets exceeds a certain limit.
Those essential features have stayed in place, but there
were some adjustments when a new government took power in 1996.
They did essentially three things. First of all, they gave some
tax relief. To encourage additional voluntary retirement
savings, individuals would be given a 15-percent tax credit up
to an annual limit on savings income or additional
contributions to savings accounts.
Second, consumer choice was enhanced. When deciding where
their employers will deposit their superannuation savings,
private sector workers are given the right to choose amongst at
least five options. And third, more retirement income was
encouraged, because early hardship withdrawals are now
prohibited and the age at which withdrawals can be made will be
increased to 60 years of age by 2025.
In view of the time, Mr. Chairman, let me just make some
comments about how we have gone so far in achieving those three
goals that were specified as objectives of the program of
reform in the mideighties.
The first goal was to provide more retirement income for
future retirees. Well, private savings will result in
significantly higher retirement incomes for Australian workers.
Average-wage workers under the new system will be able to
retire with more than 75 percent of their preretirement income,
which is approximately three times the level they would have
received under the old system.
Second, the objective was to increase national savings. As
it has turned out, the funds in superannuation accounts have
soared from $40 billion in 1988 to more than $280 billion today
and projected to reach about $1,500 billion by 2020.
Not only that, voluntary contributions have gone up so that
all told, superannuation is projected to increase the national
savings rate by 4 percent of Australia's GDP. And finally the
objective was to reduce long-term budget pressures. Age pension
reform will have a positive long-term effect on Australia's
fiscal position. Had the government provided universal
benefits, budget outlays would have grown dramatically
consuming about 6.7 percent of GDP by 2050.
Under the current projections, outlays will climb to about
4.7 percent of GDP. And to grasp the magnitude of that shift, a
similar degree of savings in the United States would require
Social Security spending by 2050 to be cut by 320 billion 1997
dollars.
So, Mr. Chairman, the conclusion we reach is that we are on
our way to being able, I believe, to control long-run
entitlement costs while simultaneously increasing living
standards for the elderly. Thank you.
Chairman Bunning. Thank you, Mr. O'Sullivan.
Mr. Enoff.
STATEMENT OF HON. LOUIS D. ENOFF, ENOFF ASSOCIATES LTD.,
SYKESVILLE, MARYLAND; AND FORMER ACTING DEPUTY COMMISSIONER OF
SOCIAL SECURITY
Mr. Enoff. Thank you, Mr. Chairman, for the opportunity to
be here today. It is an honor and a privilege to be back here.
I want to say at the outset that the views I express today are
purely my own as a private citizen. Although I have
collaborated on a couple of papers in this area recently, these
views are mine that I garnered over 30 years with the Social
Security Administration and in the past 4 years as a self-
employed consultant in over 15 countries where I have consulted
on pension and Social Security issues.
I commend you, Mr. Chairman, and Members of the
Subcommittee, for holding this hearing and this set of hearings
on this vital subject that is so important to Americans of all
ages and for laying out a record of what we need to do and some
examples. The Social Security Program, which has been so
successful in bringing the elderly out of poverty and
protecting the income of millions of disabled workers and their
families and in keeping families of workers who die prematurely
out of poverty is headed for trouble. This problem is no secret
and neither is it in dispute. The Advisory Council, the Board
of Trustees, and nearly everyone who has looked at demographics
and the economic projections agree to the problem and the need
for a fix.
There is another major problem, I believe, and it is just
as critical and that is the loss of confidence in this program
by workers who are contributing to it. We all know that for a
national transfer program like Social Security to be successful
over the long term, the participants must have confidence that
they will receive promised benefits and that there will be a
fair return on their taxes paid. The need for reform is evident
and the need is for reform that will truly provide for
retirement security in the next century. Tinkering with the
current system will solve neither of these problems.
I urge you to look at the facts and to make a determination
to design and debate reform proposals to fit the needs of the
coming generations, as well as to protect those who are retired
or nearing retirement, and to design reforms which will restore
confidence in this bedrock of protection for American workers.
Around the world, aging populations and maturing pay-as-
you-go systems are causing nations to implement or plan
reforms. The four countries represented here today display some
of the most positive and innovative approaches that are being
taken in developed economies. We can certainly learn from the
successes and the failures of others in this respect.
In reviewing experiences of other countries, however, I
urge you to be sure that the results are conclusive, that you
have the facts and not just someone's observations, and that
the principles are applicable to the United States.
In looking at the four experiences described here today,
specifically, my view is that there are several lessons that we
can learn. One overriding lesson of which I am sure you are all
aware is that Social Security reform takes time and courage, as
well as the ability to sell and implement politically difficult
decisions.
More directly, in Sweden we see the beginning of an effort
to fund a formerly pure pay-as-you-go system with a unique
method of funding being proposed and a series of benefit cuts
to control future liabilities. Outside the lessons of bold
leadership and careful planning, there are as yet no
programmatic lessons to be learned here.
The success of the reforms in Chile is nothing short of
remarkable, despite some of the comments you heard today.
However, I believe that the economic, political and
programmatic differences make direct application of the Chile
model unfeasible in the United States.
Nevertheless, there are very valuable lessons to be learned
from the creation of privately managed pension funds and the
regulatory and administrative processes that are needed.
Although the results in Australia are rather early, I believe
that we can see there the need to gain broad bipartisan support
for any Social Security changes and to carefully design and
test models of proposed reforms so that we are not back here
every 2 years looking at Social Security financing.
I believe that the United Kingdom experience provides
several lessons for us. First, there is the popularity of
choices in the second-tier mandatory savings approach. Also, on
the positive side are the tremendous reductions in future
government unfunded liabilities and the lack of negative impact
on private savings, which is about twice the level of that in
the United States.
On the negative side, we see the need to provide
protections against unscrupulous fund managers and uninformed
investors. Finally, we need to see how the changes in tax
incentives affect the worker's choices to opt out of SERPs and
to determine if a reform in the U.S. system should include
options to move back and forth between private and government
pensions. As a result of these and other experiences, I would
suggest 11 principles for following in reforming the U.S.
system.
One, give priority to long-range security and long-range
goals. Be prepared to deal with some short-range costs, but
give the priority to the long term. Two, protect current
beneficiaries and those near retirement. You will have to work
the exact details out as a plan is developed.
Three, admit that there will be a short-term cost to move
to a funded program, but recognize that there is a cost to fix
the current program as well.
Four, work at simplifying the program. It is far too
complex. We could use much more transparency in the U.S.
system. Five, take extra care to protect long-term low-income
workers. There needs to be careful debate at the level of any
flat benefit and who would be entitled. Six, design any reform
to try and increase the overall savings rate. I think we need
to fully explore giving income credits to low-income workers
and also to fully explore earnings sharing for couples.
Seven, give workers some say in the level and investment of
their retirement funds. I believe that is the only way to gain
worker confidence in the system. Eight, design a comprehensive,
but reasonable regulatory framework to protect the retirement
investments of workers. Here, I think we have the Federal
Employee Retirement System, FERS, and the Federal Employee
Health Benefit Program to look at as successful startup models
that offer all kinds of protections.
Nine, educate the public about the principles and projected
outcomes of the reform program compared to the current program.
I wish that this was already done for the current program. It
hasn't been done, but I think an educational effort needs to be
taken with the participation of the Congress.
Ten, proceed expeditiously to design and carefully to
implement. We know and others have told us, that gradual
implementation works best, and we also know that while we have
time, each day of delay is costing us.
Finally, design reform for the retirement program, but
consider separately the reforms needed for the disability and
survivors program.
I would like to close by paraphrasing one of the remarks
made by one of our United Kingdom colleagues who said something
like, no one has the right to shirk the responsibility of
contributing to the welfare of low-income workers to keep them
out of poverty in old age, but neither should the government
deter individuals from providing what they can do better for
themselves.
Mr. Chairman, and Members of the Subcommittee, I urge you
to think boldly, to plan carefully, and to speak truthfully in
this endeavor. Thank you.
[The prepared statement follows:]
Statement of Hon. Louis D. Enoff, Enoff Associates Ltd., Sykesville,
Maryland; and Former Acting Deputy Commissioner of Social Security
Introduction
Thank you for the opportunity to come before you today. It
is an honor and a privilege to be here. I want to clarify for
the record that the views I express are strictly my own.
Although I have collaborated on two papers surrounding this
subject, these views are mine as a private citizen, shaped by
30 years of service in the US Social Security Administration
and the past four years as a self-employed consultant looking
at social security programs in over fifteen countries.
Mr. Chairman and members of the Subcommittee I commend you
for holding this hearing and the series of hearings dealing
with this vital subject. The US Social Security program which
has been so beneficial to so many Americans over the past 60
years is in need of reform. This program which has been so
successful in bringing the elderly of this country out of
poverty; in sustaining a modest lifestyle for millions of
disabled workers and their families; and in providing an
adequate income for millions of surviving families of workers
who have died prior to retirement; needs to be reformed in
order to meet these same needs during the next century.
This need for reform is not a secret, neither is the need
in dispute. The Social Security Advisory Council, the Board of
Trustees and just about everyone else who has looked at the
demographics and economic forecasts (optimistic and
pessimistic) agree that something needs to be done. The
demographics cannot be changed. Those who will be retiring in
the next 50 years have already been born. Except for the
possibility of a small change in immigration, the only
reasonable expectation would be an increase in longevity which
would only exacerbate the financial plight of the program.
The other major problem facing the Social Security program
is the tremendous loss of confidence with this program among
workers, particularly young workers. We all know that for a
major transfer program like social security to succeed in the
long term, those paying into the system must have confidence
that they will receive promised benefits and some kind of fair
return for the FICA taxes paid. Public opinion surveys show a
continuing loss of confidence in the program. One often cited
survey showed that most respondents believed they were more
likely to see a flying saucer than to collect promised Social
Security benefits. While this loss of confidence may be
somewhat attributed to the general loss of confidence in our
government, we must recognize that workers are becoming more
concerned about getting a return for their FICA taxes. The
current program will mean returns of only a fraction of the
returns received by previous generations of workers and will
actually produce negative returns for several cohorts of
workers.
Foreign Experience with Social Security Reform
Around the world the aging of populations and the maturing
of pay-as-you-go retirement systems are causing developed
nations to review the economic viability of existing programs.
In developing and transition economies there is a trend toward
providing old age security through defined contribution schemes
rather than the traditional defined benefit model developed in
western Europe. Our neighbors to the North in Canada are
developing a proposal for investing accrued retirement funds in
the market rather than their traditional restricted government
investments. They are also considering ways to curb the future
unfunded liabilities of their pension system. Efforts to reform
the system in Mexico are in progress as they are in several
Latin American countries. In addition to Chile, the Argentines
have implemented a comprehensive set of reforms and several
other countries are in the design or implementation phase.
There are lessons to be learned from the experience of
other countries. However, we must be sure that the results are
conclusive from these other country reforms and also be sure
that successful changes in other countries are applicable to
the situation in the US. The experiences of the four countries
you have heard from today represent a broad range of changes
that are generally viewed as some of the most positive and
innovative changes developed around the world. The
presentations by this distinguished panel has certainly given
much food for thought. I would like to be so bold as to suggest
some lessons to be learned from these experiences based on my
understanding of the current problems with the US system and
some view of what is desirable in a new program. One overriding
lesson to be drawn from the experiences of these countries is
that social security reform takes time and courage as well as
the ability to implement politically difficult decisions.
Looking at the experience of these countries individually
we must recognize that Australia is in the early stages of
realizing any results from their recent changes. As described
earlier, their social security retirement program previously
consisted of a strictly means tested benefit that was amended
in 1991 to create a tier of employer financed non means tested
benefits to be phased in over several years. As we have heard
from our Australian colleague these amendments have already
been revised because of the newly elected government's economic
forecasts and plans. These kinds of frequent changes tend to
work against building confidence in the retirement program. It
demonstrates the need for reforms in the US to include a broad
bi-partisan consensus and carefully tested models. With broad
consensus and sound forecasts, reforms to our pension system
can be relatively free from the need for amendments for many
years. This constancy will help in building confidence.
The success of the reforms in Chile are indeed remarkable
and deserve to be looked at. I believe that the economic,
social, and political situation and the status of the social
security program during the time of the reform in Chile differ
so radically from the current situation in the states that it
is unrealistic to look at the overall reform in Chile as a
model for the US. Having said that, I do believe that there are
several lessons to be learned. The creation and success of the
special pension funds known as AFPs can give us great insight
into structuring vehicles for investment of retirement funds by
individual workers. Also, the rules concerning workers
switching among the various funds and the protections provided
by the regulatory framework can be helpful to us in designing
the format for investment of individual funds.
In Sweden we see the beginning of an effort to fund what
was a pure pay-as-you-go system as a trend that is becoming
more popular around the world. Yet the method of implementing
this change and for using the accrued funds made it unique. As
you have heard, the changes are still under consideration and
have not been fully implemented. It would appear that Sweden
has taken a lead in showing how the social economies in western
Europe may deal with the looming fiscal problems of their
retirement systems. However, outside the general lessons of
leadership and planning I do not believe there are programmatic
models that can be adopted in the US.
As you know, I believe that the experience with reforms in
the UK over the last fifteen years offer significant lessons
for us. First, the UK experience shows that a mandated second
tier defined contribution plan can become very popular with
workers and can substantially reduce future unfunded government
liabilities. The British experience with unscrupulous or
fraudulent investment funds can also give some insight for the
need to carefully build protections into any privately managed
funds that are designated to provide security in old age.
Protection of current beneficiaries seems to have helped the UK
government convince the general population of the need for and
desirability of the reforms. The growth of several new and
innovative instruments for investing retirement funds should be
a signal that while protections must be carefully designed
there should be room for creativity and that market forces will
design viable programs to meet the needs and desire of
investors. Proposed changes by the new government may have the
affect of causing many of those workers who have invested in
their own plans to return to the government administered SERPS
program. While broad bi-partisan support may pre-empt the rapid
change of US pension reforms should a President of a different
party be elected, this does raise a question about the
structuring of a workers ability to move back and forth between
privately run or government run pension programs. Argentina has
a similar provision to their new pension system which allows
workers to move back and forth between private or government
run second tiers. While this ability to move between different
options in the second tier may be a good incentive, it works
against the goal of controlling future government liability.
Finally, from a macro-economic standpoint, the UK experience
shows that this mandated second tier of pension savings did not
have a negative effect on overall private savings which is
about twice that of the US.
Principles for Reforming the US System
With the benefit of applying the experience of these four
countries to the US situation, I would like to suggest a set of
principles for consideration in your effort to reform the US
Social Security program.
1. Give priority to the long range retirement security of
American workers. Short term budget considerations are
obviously important. However, it is time to look at the
retirement needs of workers over the long term. Tinkering
around the edges will not fix the current program and certainly
will not restore confidence to the workers. We need to develop
the most desirable retirement program from an economic,
political, and social perspective. Even the most ardent
supporters of the current program agree that if we were
starting afresh, they would not design the current program. The
transition plan and cost should only be tackled after a bi-
partisan agreement at least to the principles of the selected
approach.
2. Protect current beneficiaries and those near retirement
age. Assurances should be given up front that current
beneficiaries will not be harmed. The precise age of those to
be guaranteed these rights might vary with an option for some
age groups to join the new program or remain in the old. This
can be done obviously only after the full particulars and
projected effects of the new program are known. The nagging
question of the correct measure to be used for indexation of
benefits for the current program should be resolved on its
merits and costs or savings considered in the projection of
transition costs.
3. Admit that there will be a cost to transition from an
underfunded pay-as-you-go program to one that is adequately
funded or to any kind of funded program. There is general
agreement that returns on accrued funds can be improved by
investing them in some instruments other than government bonds.
This increase in returns will not be sufficient to offset the
transition costs in the short term. Therefore some funding
mechanism will have to be developed. This could take many forms
including notional accounts, increased contributions, increased
government borrowing. The actual cost developed here should be
recognized as only the net difference between the cost of the
new program and the realistic cost of really fixing the current
program.
4. Work at simplifying the program. The current program
started out with a rather complex benefit formula and has
become more complex over time. The average worker has a hard
time understanding how to compute a benefit even if all of the
necessary information is available. An easier to understand
program would help in restoring confidence.
5. Take extra care to protect long term low income workers
from poverty in old age. The current Social Security program
has always provided for a transfer of funds from higher income
workers to lower income workers. This transfer has been
accomplished through weighting of the benefit formula. Although
this transfer or welfare aspect of the Social Security program
has not often been well understood, the principle is generally
accepted and should be retained. A flat rate basic benefit paid
to all who work and contribute to the program for a required
minimum of years would accomplish this type transfer.
The level of any basic benefit should be carefully
determined considering the number of beneficiaries, the funding
source, and benefit amounts likely to be generated. Minimum
requirements for this basic benefit may determine whether the
level should be at or near the poverty level or higher in order
to recognize the work effort and contributions of the workers.
6. Design any new program so as to try and increase the
overall savings rate in the US. The savings rate in the US is
about half of that in the UK. There is general agreement on the
need to increase this rate if we are to remain competitive in
the next century. A social security retirement system
consisting of a first tier flat rate basic benefit and a second
tier defined contribution element could enhance the overall
savings rate in the country while meeting the social objectives
and creating a fiscally sound retirement program for workers in
the next century. One of the crucial elements for increasing
savings is to increase savings by lower income workers.
Favorable tax incentives alone have not proven successful in
encouraging low income workers to invest in retirement funds
based on our experience with IRAs. By mandating savings for
retirement and providing incentives and perhaps subsidies to
low income workers we would have an opportunity to increase
overall savings and provide greater security for these workers
while decreasing the need for needs based payments to the poor
elderly. An EITC type transfer directly to a retirement account
could ensure adequate retirement for low income workers while
relieving some financial strain during their working life. This
provides a type of transfer in an easily understood and fair
way. Adequate retirement benefits for long term low income
workers should reduce some of the need for SSI benefits for the
aged. There will still be a need to develop special programs to
meet the needs of part-time and intermittent workers. Earnings
sharing between married couples should also be carefully
explored as a means of providing adequate benefits for one
earner couples and especially to help provide equity to
divorced spouses.
7. Give workers some say in the level and investment of
their retirement funds. Many of the proposals to fix the
current program call for an increase in the normal retirement
age. Despite the current requirement raising the normal
retirement age from 65 to 67, there has not been a perceptible
increase in the age at which most workers retire. Continuing to
increase the retirement age could prove especially difficult
for some low-skilled or fairly manual occupations. A somewhat
personally controlled second tier of mandatory savings can have
the flexibility to allow workers to save above mandated levels
and thereby have some choice in the age or gradualness of
retirement. Ideally we as a nation must look at ways to
encourage older workers to remain productively in the
workforce. That effort will include programs and incentives
beyond this pension scheme. But the idea of a somewhat flexible
second tier (with a minimum base) should eliminate the need for
the cumbersome unpopular retirement earnings test. Tax
treatment of benefits and contributions obviously are critical
elements in making these decisions. Providing some individual
worker choices about the investment of their retirement
contributions is in my view the only way to really develop
worker confidence in the program. While this is a major
departure from the current program, times have changed since
the initial program was designed in the 30's. The bond market,
equities market, mutual funds, and other investment vehicles
have matured tremendously over the last 60 years and average
workers are much more familiar and comfortable with them. There
are areas that will need to be strengthened (such as
annuities), but I am confident that market forces will rise to
the occasion and meet the needs when the demand is seen.
However, even with this maturing of the markets and optimism, I
do not believe we are prepared to simply let the market forces
work.
8. Develop a comprehensive but reasonable regulatory
framework to protect retirement investments of workers. While
any person should have the right to invest their own money as
they see fit, this is a government program designed to protect
the security of workers in old age. A mandated savings program
requires a higher degree of protection to ensure workers
against fraudulent and unscrupulous activities and perhaps even
some protections against the potential fluctuations of the
market. While American workers have become more comfortable
with investment vehicles, many of us, perhaps a majority would
benefit from some extra protections at least in the initial
stages of a new program of this magnitude. The FERS and the
FEHBP programs offer some hands on experience with market
oriented programs with an extra degree of regulatory
protection. The framework of these programs could be used as a
model for designing the initial retirement investment approach.
I want to emphasize initial , because I would hope that the
regulatory framework would allow for expanded freedom as more
experience is gained.
9. Educate the public about the principles and projected
outcomes of the reformed program compared to the principles and
projected outcomes of the current program. Accurate education
of the public about the current program is sorely lacking. Too
many workers still think that they have an individual account
which they pay into during their working life and draw benefits
from during their retirement. Many other myths about the
program persist and as mentioned earlier very few people are
able to calculate their own benefit amount or understand why
their benefit differs from that of a friend or neighbor. It is
probably too late to complete a valid comprehensive public
education effort before beginning serious efforts to design
reform options. However, it is not too late to mandate that the
implementation of the new program be preceded by an objective
education effort to all age groups in the country. I would urge
you to make this an integral part of your proceedings and to
participate in the design and evaluation of the education
vehicle.
10. Proceed expeditiously to design and carefully to
implement. While we are not in a crisis, time is of the
essence. Each delay in correcting current problems in the
program will mean additional costs. Yet we and other countries
have learned that changes implemented incrementally are much
more readily accepted and more efficiently implemented. We have
not talked about potential administrative difficulties in
implementing any proposed changes or administrative
difficulties in the transition. With adequate lead times all of
the proposals offered in this testimony are administratively
feasible and indeed might well simplify some of the current
difficulties. The administration is just at the beginning of
implementation of the comprehensive effort to inform workers
about their contribution records and potential future benefits.
This effort (PEBES) may indeed show that recordkeeping for the
current program will require additional attention.
11. Design a reform of the retirement program but consider
separately reforms to the disability and survivors programs.
The current social security disability program has a number of
substantial problems. However, these problems have more to do
with administration of the program than with benefit levels now
or in the future. These administrative problems are complex and
have been around for years. I am speaking mainly of the length
and complexity of the appeals process, the dismal rate of
return to work by disabled workers, and the process problems of
initial adjudication and continuing disability reviews. While
these are substantial problems and need attention, because of
the amount of the cost and the adequate structure of benefits
in the disability program, it would be unwise to try to include
this program with reform proposals for the retirement program.
Fix the processes mentioned above and the cost of the
disability program should be maintainable for some time in the
future. The changes made to fix the existing process problems
may indeed lead to some suggestions for changes in financing if
any are needed. In the meantime, American workers should be
protected from loss of income due to a disability.
Likewise, the Survivors portion of the Social Security
program for families of workers who die prior to retirement is
relatively small compared to the Retirement portion of the
program. The retirement program should be reformed before
attempting to redesign benefits for survivors. While some
countries have opted to purchase group insurance from the
private sector to meet these needs, it is often inadequate to
meet the needs especially of young families. Once the
retirement program has been reformed, the best method for
protecting survivors in an adequate way should become clearer.
This vulnerable group should not be put at risk.
Conclusion
In summary, I would like to close by paraphrasing a quote
from our British colleague. One of the designers of the UK
reform effort said something like ``No one has the right to
shirk the responsibility of contributing to the welfare of the
low income worker to keep him from poverty in old age. Neither
should anyone give up the right to provide for themselves if
they can do it better.'' That statement should be a reminder of
the need to allow greater freedom in planning for retirement
for American workers. If that thought is kept before us, I
believe that we can design, model, and implement a program that
will increase security in retirement for workers at all wage
levels. This should be a program which will endure through the
next century and which will have the enthusiastic confidence of
the workers and employers who participate. At the same time we
can reduce unfunded government liabilities and increase our
overall savings rate. While this sometimes sounds like it is
too good to be true, who can question the remarkable
productivity and ingenuity of American workers and the
performance of the American economy? There will be a cost for
the transition to such a program. The potential benefits far
outweigh the costs and the alternative is not acceptable. Let
us be bold in our thinking, careful in our planning, and
truthful in our speaking.
Chairman Bunning. Thank you, Mr. Enoff. Thank you all for
your testimony and we will proceed. Put me on the time clock
also so we will have 5 minutes of questioning by Members.
Let me ask a general question of the total panel. Has
anyone here read the report of the Advisory Council on Social
Security that was done in the United States? You all have? Or
some of you have? OK. They had problems coming to conclusions.
They came to three separate conclusions and said, take your
choice of A, B, or C.
There seem to be mixed views among this panel also on
whether private, personal accounts raise or lower national
savings, since once individuals are compelled to have an
individual account, they may likely cut back on other types of
savings that they might use in retirement.
What has happened to your level of national savings since
you have implemented your pension reforms in the countries that
are implementing them? To what portion of any increase in
national savings do you attribute your pension reforms as
opposed to changes in the economy or any other things? So I am
asking those who have--go right ahead, Mr. Sherman.
Mr. Scherman. When it comes to the impact on the total
savings rate of these mandatory savings plans, I should say
that current knowledge in the scientific community tells us
that we really do not know what is the effect. I could tell you
that ISSA, the International Social Security Association, of
which I am the president, has launched an initiative in order
to try to find out better about what is the scientific state of
knowledge today. And our experts advise us that although you
can see on the surface certain effects of various arrangements
when it comes to the pension systems, in the long run we cannot
answer the question.
Specifically in Sweden, we have tried to find out what our
pay-as-you-go system and the implementation of that system
meant for the overall savings rate in the economy. We cannot
answer the question because there are so many complexities and
there are so many effects and countereffects that cannot be
measured.
Chairman Bunning. Mr. Finkelstein, do you have an opinion
on that?
Mr. Finkelstein. Similarly, the effect of measures are
quite complicated, but neither the introduction nor the reform
of SERPs significantly affected other savings. But the funding,
the placement of government rebates into a funding system has
significantly increased the amount of private sector savings,
although obviously there is a transition cost.
Mr. Pinera. In Chile, the rate of savings went from 10
percent of GNP to around 27 percent of GNP after the reform was
implemented. But it is true that there were also very important
reforms helping that movement. So it is very difficult to say
exactly the contribution of the pension reform.
Chairman Bunning. In other words, there were incentives
that were built in?
Mr. Pinera. Exactly, sir. There were incentives for
additional savings. There were a lot of technical measures to
increase savings, but it is difficult to know exactly the
result.
Now, the best papers on this, sir, the general case that a
reform like this would increase savings made in the United
States, is by Professors Martin Feldstein and Larry Kotlikoff.
And a professor at UCLA, Sebastian Edwards, has written a very
good paper called, ``The Chilean Pension Reform: A Pioneering
Program,'' presented at the National Bureau of Economic
Research conference in 1996, and his conclusion is that the
pension reform has clearly increased the rate of savings in
Chile.
Chairman Bunning. Australia?
Mr. O'Sullivan. Mr. Chairman, I said in my testimony that
part of the incentive for the reforms in the first part of the
eighties was that dependency on Social Security age pensions
had reduced national savings and depressed economic growth.
In fact, what had happened, to be more specific, is that
Australia's national savings rate had declined from an average
of more than 25 percent in the early seventies to about 16.1
percent in the 1991-92 period. So there is obviously an
incentive to reform the pension schemes and national savings
schemes to reverse that.
And as I mentioned, the effect so far, although it is not
yet fully implemented, but the effect so far of the reform of
pensions has been to boost superannuation accounts very
significantly, and to boost not only those accounts, but to
boost voluntary contributions as well. So that all told,
superannuation is projected to increase national savings rate
by 3.6 to 4 percent of GDP. At least initially the answer to
your question is that our experience has been a positive one.
Chairman Bunning. Thank you. The gentleman from California.
Mr. Becerra. Thank you, Mr. Chairman. If I could begin,
Professor Ghilarducci, you mentioned in your presentation the
fees that are charged workers for these private investments.
Can you give us a sense of how much those fees typically are,
as a percentage of the investment, compared to regular
investment vehicles?
Ms. Ghilarducci. Yes, they are high. And they vary. But on
average, in Chile, they could be up to 17 percent. So this is
17 cents on the dollar that is contributed. Also, if there is a
fixed fee structure, it means that people who have dropped out
of the labor force for a while, like women, are still paying on
their accounts, eroding itself even further. In the United
Kingdom, the fees are even a little bit higher. The estimates
have been 20 percent. They may be different, but they are also
not very transparent.
Mr. Becerra. What about the issue of transition costs, and
this I open up to anyone on the panel. We spoke a bit about the
Chilean model, and how the British also underwent a transition
to a private investment model. We are nowhere near where the
British were in getting to a more privatized system for Social
Security. Certainly the Chileans underwent a change at a point
when their entire economy and society was undergoing change.
What type of transition costs did those two countries
undergo, and what type of transition costs might we undergo if
we were to try to do something similar to either the Chilean or
the British model? I leave it open to anybody.
Chairman Bunning. Don't all jump up. Go right ahead.
Mr. Becerra. Anyone who wishes to answer.
Mr. Pinera. Yes, can I answer? There are no economic
transition costs, sir, in the sense that a movement to a system
like this improves the present value of your economy in a way.
There are cash flow costs, but the cost is already incurred
because you have an unfunded liability, in the United States
some put it at 7 trillion U.S. dollars. What the transition
does is recognize the unfunded liability that the pay-as-you-go
system already has, and, of course, there is a cash flow
problem that should be financed adequately. But over the long
term, the movement to the new system reduces the cost to the
economy of keeping with the old system going on.
Mr. Becerra. And in the case, let's talk about the
transition--you say they are not transitional costs, but cost
flow, or what did you call them?
Ms. Ghilarducci. Cash flow.
Mr. Pinera. Yes, it is cash flow. Teresa is right. It was
around 4 percent of GNP in the first 10 years. And the good
news in Chile is that we are running a budget surplus of 2.5
percent of GNP during the last 4 years. So after 16 years of
the reform, the results have been so extraordinarily good for
budget and finances that we now have a budget surplus.
Mr. Becerra. So in the United States if we diverted our
current payroll tax structure into a private system, we would
probably run a deficit of $1 to $2 trillion. How would you
address that for the U.S., how we would make up that $1 to $2
trillion deficit in the Social Security Fund?
Mr. Pinera. It depends how you define your transition. I
don't believe that you should define your transition the same
way we did it in Chile. You can do it in a much more gradual
way. It would depend on how----
Mr. Becerra. Doctor, Doctor, help me. If we let money come
out of the Social Security System so that people can
individually invest it, we have people who are already retired
who must be paid. Over the next 10 years, the estimate is $1 to
$2 trillion. How do we fund the system for those who are
retired or retiring during that period of time?
Mr. Scherman. Might I say that in Sweden----
Mr. Becerra. If I could ask Dr. Pinera first, and then of
course you, Mr. Scherman, you are welcome to answer as well.
Mr. Pinera. There are many ways to fund the transition.
Professor Martin Feldstein proposed using debt. Basically
recognizing the unfunded liability, that is not new debt.
Mr. Becerra. If I could stop you there. Using debt; in
other words, have the government run a deficit?
Mr. Pinera. Yes, of course, but you are recognizing the
unfunded liability----
Mr. Becerra. Let me stop you there. Let me stop you there.
Have the government run a deficit; that means that at some
point, we either had to cut spending in other programs or raise
taxes; correct? Is that correct?
Mr. Pinera. To whom are you talking?
Chairman Bunning. Let me relieve my good friend from
California. We have a vote on. But I want to ask the panel if
they will stay, because I have pages and pages of questions I
want to make sure that I get to ask.
I just want you to think about one question that I want to
ask. I want you to think of this question while we are away.
Did any of the countries have budget surpluses at the time
of your reform? And did any of you use the surplus to help
finance the transition? And if so, how did you do it? Maybe
none of you had surpluses.
Mr. Becerra. Mr. Chairman, when we come back, if anyone on
the panel could just conclude with the remarks in answering
that last question that I had, I would appreciate it.
Chairman Bunning. We will recess for a few votes.
[Recess.]
Chairman Bunning. The Subcommittee will return to order,
please.
Let me reask the question I asked before I left. Did any of
the countries that did a transition and/or a reform have a
budget surplus at the time of those reforms, and did they use
the surplus to help in that transition?
Mr. Scherman. No, we hadn't any surplus in the economy, so
we had nothing to use. And might I add that in Sweden it was no
way to fund the system and find any big financial flows from
anywhere. And that was one of the reasons why we are not
switching to such a funded system, taking only a slice of the
whole thing into a funded part.
We have no financial surpluses and we do not think that the
Swedish population will be prepared to pay both for the savings
for their own pensions and for the old pensions. So in a mature
economy I do not think it is possible.
Mr. Finkelstein. The United Kingdom was certainly assisted
when it started its SERPs Program by the fact that the budget
situation was good at the time and we had a surplus. But that
only helped one part of the problem, and that is because we
were encouraging so many more people to put their money into
private pensions, they were not paying tax on that income. And
so we did have a short-term cost, and we were able to fund it
by a short-term budget surplus. But most of the transition
costs are long term.
And for the program we put forward the last general
election, we had to think how to meet costs that were not going
to peak until 2020 or 2030, and so the way we addressed that
was by putting forward changes that would not happen until 2020
or 2030, one of which was the equalization of the State
retirement age; another of which were changes to entitlements
to SERPs; and the third of which, which I think was the most
important, was that the new entrants to the work force, we
changed the date of your tax relief. Previously, you got tax
relief before you paid into your pension. You paid your pension
out of pretax income, and when you got it back, it was taxed.
We changed that for new entrants and said that when you paid
into your scheme, you paid out of posttax income, and that held
the transition costs, and that was an important way of being
able to answer questions about transition.
Chairman Bunning. Mr. O'Sullivan, how about Australia?
Mr. O'Sullivan. The answer to the first question is, yes.
In a number of years in the eighties and nineties, the Federal
budget was in surplus, and it is now in structural surplus.
The answer to the second question is no, because there was
no transition in the sense that you are using the word, Mr.
Chairman, because essentially what happened is that a previous
safety net had added to it a privately funded compulsory
superannuation system.
Chairman Bunning. Private vendors have often been described
as winners in Social Security privatization. I am trying to
think of the numbers that I have heard some of you use, 17
percent and 20 percent for management fees related to certain
types of privatization.
Many of you have had wide and varied experience with
private vendors as you have moved to the privatization portion
of all of your pension schemes. Many of our constituents are
skeptical about the privatization and the costs associated with
privatization.
I was in the brokerage business for 25 years, so I am a
little familiar with costs involved in private investments. In
the United States, we have an awful lot of mutual funds that
are nonload, in other words, that are not--they do not have any
costs associated, except management fees, and usually, if they
are fairly large mutuals, the management fee is 0.6 of 1
percent, or 0.7, or 1 percent max.
I am wondering why there is skepticism of our ability to
move into some type of privatization, not totally, but a
portion of the system into privatization, without a huge cost
associated with it.
So if you would like to address that, Lou, go ahead.
Mr. Enoff. Yes, Mr. Chairman, I think because of some of
the high costs that were experienced in Chile and because there
were some unfortunate situations in the United Kingdom with
overselling those plans, I think people are skeptical for that
reason.
But I think if we look at what we do have here, like the
Thrift Savings Plan, the cost, we have an experience. We are
talking about a large volume of funds, I agree with you. And
maybe I would argue on the side of perhaps very careful
regulation at the beginning to ensure that we do not allow some
of those practices into the retirement system. I would like to
think it would not happen, but it could, and so maybe we need
to be extra careful in regulating that at the beginning, and we
are not prepared at this point.
Ms. Ghilarducci. One of the reasons why our Social Security
costs are so low is because employers pay a lot of it. They are
responsible for collecting the money and sending it to the
government. So a lot of cost of Social Security is actually
spread out amongst all of the employers.
So part of the increase in cost of a private system is that
workers would have to pay for the collection and also for the
distribution of the money. So it is not just the management
fees; it is also the administrative fees.
Chairman Bunning. Let me ask the question, since you have
been Commissioner and I have never been the Commissioner. I
have to find these things out for the record anyway. Why would
there be any associated cost if the individuals made the
investment on their own?
Ms. Ghilarducci. Because what we saw in Chile and the
United Kingdom, because the individual has to make choices
about where to go, advertisement----
Chairman Bunning. What if the government gave them 10
choices and said, these things are available, and you can do
like I do in my 401(k), and say I choose A or B or C?
Ms. Ghilarducci. Because there will be a lot of
advertising, a lot of coldcalling at dinner time. And also if
we have a choice to move from plan to plan, even the
advertising costs will accelerate. That happened in the United
Kingdom and in Chile.
Chairman Bunning. We can learn from their experiences.
Mr. Scherman. I said in my opening statement, that there is
a heated debate in Sweden today about the funded part. One of
the issues discussed are the administrative costs. And I think,
as has been said, that there will be competition between funds
with marketing costs and such things that are very high.
This is a big political issue in Sweden, and I think that
we are not going for a totally free competition between
Administradoras de Fondos de Pensiones, AFPs, as in Chile and
other South American countries. We will offer, I think, a
couple of options and then try to streamline the administration
of those funds.
Mr. Finkelstein. It is easy to eliminate the cost of
marketing if you eliminate markets. If you only give someone
one choice, then you don't have the problem of advertising to
them or having them pay any costs.
The costs are, indeed, reasonably high, but so are the
returns. And I think people would rather have a system which
institutes in Britain suggested might produce three times as
great a rate of return, even if they do pay a higher
administration cost.
Chairman Bunning. I don't argue that fact, but the fact of
the matter is, the 401(k) Federal retirement account has very
little cost associated with it because there are limited
choices. The more choices you give someone, obviously, the more
cost there could be involved in it. But if the individual is
making the investment choices, they ought to know what the
costs are before they do it.
Mr. Finkelstein. It is certainly true that the less choice
you have, the less there are costs of choice, but also the less
there are benefits of choice.
Chairman Bunning. There could be a combination to begin
with, and then expanding as you go down the road to more and
varied accounts, private investment accounts.
Anyone else on the subject?
Mr. Enoff. If I might, I think you are absolutely right,
and I think that the market adjusts. One of the things when you
look at the U.S. situation now, there are not a lot of
annuities available. And we would say, well, you would want to
have a more efficient annuity market.
Well, if these funds were there, the market would work, and
I think you would bring down the cost of annuities, and that
would happen. And I think you are right that we should start
carefully. We have experience with FERS and with Federal
employees health benefits, and those are real examples in the
U.S. economy, so we do not have to speculate about what could
happen on those.
Chairman Bunning. As we debate the possible Social Security
reforms and whether to adopt some degree of privately held
accounts, questions are raised about the payout of the
accounts. I would like to hear your experiences, if you have
some, regarding any restrictions you have placed on the account
before payout is allowed. For example, are individuals allowed
to access these accounts to buy a home or to pay for anything
else? In other words, anyone that has the experience with
private accounts now.
Mr. Finkelstein. You are not allowed to access those
accounts.
Chairman Bunning. You are allowed to?
Mr. Finkelstein. No, no, you are not, because you receive
tax relief on them.
We originally had a system whereby you had to purchase an
annuity when you retired in order to get the money out of your
account. The problem that we found was that sometimes people
were forced to buy an annuity at a point when the market was
low. So we changed the regulations to allow people to buy the
annuity at any time up to the age of 75, and between retirement
and 75 they can draw down on that account. They tend to prefer
not to do so, because drawing down is actually quite expensive
in terms of management costs. But they do have that choice.
Chairman Bunning. As you well know, we have individual
retirement accounts in the United States, and the Tax Code has
allowed various degrees of withdrawal, depending on what you
might want to use them for, whether it be for educational
purposes, medical purposes, or whatever, without penalty. You
have to, obviously, put it back some time between when you
access it and when you retire. Otherwise, it is taxable income
very quickly.
Go ahead.
Mr. Kay. In Chile, you can withdraw the money when you
retire as long as you leave enough to fund 110 percent of a
minimum pension.
Chairman Bunning. Others?
Mr. Scherman. In Sweden, according to the decision taken,
there will be no opportunity to use the money for other
purposes than retirement income.
Mr. Enoff. Mr. Chairman, if I might, one country not
represented here that I have worked in where they have allowed
people to withdraw for various purposes, and it has made what
started out as a retirement program become a program that does
not leave very much in terms of retirement. People use it for--
actually, they borrow the money and invest it in equities.
Chairman Bunning. Which defeats the very purpose for which
it was set up.
Mr. Enoff. Yes, and I think there have to be some solid
protections put up, and there will be temptations to people.
Chairman Bunning. In Australia, as of March, there were
over 150,000 superannuity funds, but 98 percent of all member
accounts are held in approximately 8,000 funds. Australia set
up a regulatory regime which included a number of regulations
aimed at strengthening these funds.
I would like to hear the experience of other panelists
regarding the degree to which they established regulations for
these funds. What types of regulations were established, and
what was the industry's reaction to them?
Mr. Finkelstein. Well, we have--you cannot, as a private
fund, accept rebates from the government unless you are a
licensed fund, and in order to be a licensed fund, you are
now----
Chairman Bunning. In other words, a commission of some
sort?
Mr. Finkelstein. Yes, a pensions operations board. And
there is also quite a large degree of self regulation.
Further regulations have been introduced to ensure that
particularly the occupational funds remain solvent and that
they do not end up investing all of their money in their own
company. That was after the experience we had with the
newspaper proprietor, Robert Maxwell, and we introduced a whole
variety of regulations to ensure that that didn't happen.
There is one further point, which is that the pension
misselling that has been mentioned in Britain certainly did
take place, and that is because people were encouraged out of
their occupational pension funds into their private pension
funds. It didn't have anything to do with the rebate that I
have been talking about in terms of the State and the private
sector; it is a separate question.
Chairman Bunning. How many different types of educational
programs or information programs did you have before your
conversion? In other words, that is going to be a major problem
with our transition into anything other than what we have right
now in Social Security. It is going to take a reasonable time
for our certain age groups to say, oh, by the way, what we pay
in Federal Insurance Contributions Act, FICA, tax right now is
going to be there, or at least I am going to be able to invest
a portion of it, and therefore I don't mind the transition cost
that will take a 30-year period.
Mr. Finkelstein. I was delighted to hear that only a third
of people didn't know that opted out. Since 42 percent of
people opt out through their employer, I would not expect a
whole lot of those to know, and there are a lot of statistics
as to why that should happen.
We did engage in quite a large program of education, and
that included the transition costs. I think you have to be very
transparent about the transition cost, and the press in the
last general election insisted that we were about our new
scheme. I spent most of a good part of a week talking to
journalists, just talking them through how we were going to
pay----
Chairman Bunning. You were actually able to get your
information correctly into newspapers?
Mr. Finkelstein. I didn't say that. I said I spent most of
a week trying to explain it.
Chairman Bunning. OK. We would have to draw it out very
concisely and make sure that there was no mistake and give it
to the newspapers, so that there would not be any
misinterpretations if we decided to transition from what we
have to something else, because I know there would be a lot of
misinformation about what we were trying to do.
Does anybody else have anything to say?
Mr. Scherman. I might add that in Sweden we think it is
very important to educate people. And I can say that the reason
why the reform is not enacted today is that there were some
failures in informing the public, and the result was chaos in
one of the big political parties, so they had to have another
year in order to be able to confirm their support for the
reform.
Mr. Enoff. If I might, Mr. Chairman, I think that along
with education about the new system, there needs to be
education about the current system in terms of what are we
changing from. I think it is a shame that most average college
graduates probably couldn't compute their Social Security
benefits in the States, assuming they had correct information
to use. It is very difficult. I think it is important that if
we are changing, we educate what we are changing from and what
we are changing to.
Chairman Bunning. Now that the Social Security system sends
out periodic information, whether you want it or not, on your
benefits and the amount of money that you have paid in in
relationship to the benefit that you would receive at age 65 or
67 or whatever you choose to ask about, they do it now, as you
know, Lou. There is access to that information on the Internet.
Mr. Enoff. Well, the Internet is a bit of a question. I was
pleased to see that you objected to that. I think that is the
question: What use is the calculation if you do not give the
earnings?
Chairman Bunning. Well, you can devise the earnings from
the calculation if you have any----
Ms. Ghilarducci. Mr. Bunning, there is a problem here that
education, though, will not solve. One is that low-income
people are going to reasonably be advised to take a more
conservative position in their investments, because if you are
saving and you only have enough to be a little bit above the
poverty level, you are not going to take risks. So we do not
see a lot of low-income people being uneducated about the
benefits of diversity. You are seeing a lot of people making
rational decisions about investing conservatively.
The other thing that education will not solve is that if we
have too much of our retirement income dependent upon the
financial markets, then we could have whole demographic groups
losing out if the market is low when they retire.
It is a lot like me and the housing market. I was just too
young to get in on it when the rates were going up. So we could
have a lot of people cheated due to the age group that they are
in because their retirement income is so undiversified in the
financial markets.
Chairman Bunning. Well, presently we have that same
problem.
Ms. Ghilarducci. No; it is more diversified, because we
have the Social Security System that yields you a benefit,
regardless of the financial markets.
Chairman Bunning. No, but there is some relationship to
what you pay in. It is a replacement of a percentage of income.
Ms. Ghilarducci. Yes, and that is based on your rate of
return as a worker in terms of your pay. And the other portion
of your retirement income is dependent on what you get in the
finance markets or your 401(k), and the other portion is
dependent on your relationship with your employer.
Chairman Bunning. But we have the same problem with the
low-income worker----
Ms. Ghilarducci. Right.
Chairman Bunning [continuing]. Now, because they do not
have any surplus to put away into savings, or if they do, it is
very small.
Ms. Ghilarducci. And conservatively invested, like I said.
Chairman Bunning. But the replacement income that we are
talking about in Social Security is proportionate to the amount
of money that you have put in over a certain amount of
quarters.
Ms. Ghilarducci. I agree, but if we replace the Social
Security System with those more dependent on financial markets,
then you have much more financial risk that all the education
in the world cannot solve.
Chairman Bunning. I can put all of my financial risk in a
government bond if I so choose right now.
Ms. Ghilarducci. Right. Right.
Chairman Bunning. I call on Mr. Portman. I am glad he
joined me.
Mr. Portman. It is a pleasure to be back.
You all ran off poor Dr. Pinera, I see. I had some
questions for him, so I will have to direct them to others.
I appreciated your testimony. I was here to hear almost all
of the testimony. I had to leave just prior to our last
witness. The input is very helpful.
One of the things that has not been discussed yet, I am
told, is how you put in place a system that deals with the
problem of some of the beneficiaries in a more privatized
system choosing more risk-averse investments.
I think that in the Chilean system, as Dr. Pinera described
it, there are a number of investment funds that people are
allowed to interact with, and those funds have a more
diversified portfolio.
What do you recommend?
I direct this more, I guess, at Mr. O'Sullivan and Mr.
Scherman and Mr. Finkelstein, who are looking at coming up with
a new national system of developing private savings.
How do you deal with that problem?
Mr. O'Sullivan. In the case of Australia, the employers are
required to offer their employees a choice of at least five
different funds to which their money could go. So they could
make a judgment about the degree of risk-averse funding or the
degree of high-risk-return funding that they wish.
Mr. Portman. Do each of those five then have a diversified
set of investments? Is there government regulation of those
five?
Mr. O'Sullivan. Yes; not just those five. The whole of the
insurance and superannuation industry is covered by a set of
regulations.
But in respect to the individual choices that people can
make, they can make a decision to go into a fund, into an
insurance broker who offers a range of choices, and those
choices can be more risk-averse or offer a high-risk-return
ratio.
Mr. Portman. Any ideas about how to protect individuals, if
that is necessary? Is that necessary?
Mr. Finkelstein. The schemes in Britain into which you put
your State pension have to be licensed. Ninety percent of
people put their money into schemes that are equity based, and
a lot have tended to invest in British equities and have tended
to perform at about the same rate as the market.
It should be remembered that under our current scheme,
people have a safety net of the basic State pension, and there
are also various means-tested benefits available to them. So
the issue of people managing to bust themselves through risky
investment didn't arise with our first stage reform.
With our next stage reform, the one proposed in 1997, it
did arise because we were proposing to remove the basic State
pension, but we overcame it by offering people the basic
pension guarantee. We said if your fund would for some reason
have fallen below the basic State pension, the State guarantees
to make up the difference. We didn't anticipate that we would
ever have to make good that guarantee, because we didn't
anticipate that anybody would be able to invest their money so
badly that they would invest it as badly as the government.
Mr. Scherman. As I said, we have no details on this part of
the new pension system in Sweden today, but I think it is a
very safe forecast that the Swedish system will be tightly
regulated, tightly supervised, there will be a limited range of
options, and high-risk funds will not be available in the
system.
Mr. Portman. Let me ask one other question that hasn't been
asked. It is really directed to Mr. Enoff, but others may want
to jump in. It has to do with political change or time.
In the British system, I know the Conservative Party put in
place a lot of these reforms and now the Labor Party is
responsible for implementing some of what you put in place and
moving forward on some of the next stages of reform.
But in this country, particularly, with a change in
leadership, what do you recommend, if anything, in terms of
avoiding people beginning to depend on one system and having
new leadership and the kind of change that is inevitable in a
democracy?
Mr. Enoff. I think that I said in my testimony, I think any
change in Social Security should have broad bipartisan support
and should be carefully modeled so that we do not have to be
looking at changes so that if the administration changes in 2
years or 4 years, that you are not coming back and trying to
redo the whole thing.
Now, it is easier to say that, obviously if there are tax
incentives. And I think we should have tax incentives for
savings. You might be more likely to change tax policy than
Social Security policy, but you have to carefully look at that
and get a consensus.
Mr. Portman. We have changed it 4,000 times since 1986. Why
would you think that?
Mr. Enoff. We have not really looked at financing Social
Security that often in this country. And I would hope that
there could be enough of a consensus that we could make a
change that would mean you would not have to go back and look
at financing every couple of years, because I think that takes
away from the confidence in the program.
Mr. Portman. That is a good point. I think your point is
well taken that it should be a substantial majority and
therefore bipartisan, and that is something that would direct
policymakers even at this point in terms of the options.
Mr. Enoff. And if I could add to that, Professor
Ghilarducci said a couple of times about all of this risk. But
if you have a basic benefit as they do in the United Kingdom,
you are not taking away anything from everyone; you are
guaranteeing what you are getting plus.
Mr. Portman. That is the upside that needs to be taken into
account.
Mr. Finkelstein. I have to admit that consensus in Britain
is not a natural thing; it had to be won by bashing our
opponents over the head with the ballot box in several general
elections. In 1992, the Labor Party ran on a platform not of
reversing the changes but increasing the State pension, and
they lost the election partly because the electorate didn't
believe the pensions would be increased. And after that, the
leader, who is now the Prime Minister, Tony Blair, decided he
should join the process of reform.
So you will not get this consensus naturally. It will
probably have to be politically fought, I don't know on what
basis. But eventually consensus will come, because I think
electorates will go for it and they will see that current
recipients are not losing and younger people are gaining.
Mr. Scherman. In Sweden, five out of the seven parties in
the Parliament are backing the reform, representing 80 percent
of the Members of Parliament. As a matter of fact, it has been
decisive for the design of the reform that the big parties
wanted to agree, because we have to restore confidence. The
only way of doing that is, to have a broad political majority
behind it. So the new pension system is a compromise, and that
is the good thing with it.
Mr. Portman. Thank you, Mr. Chairman.
Chairman Bunning. Yes, I would like to follow up with Mr.
Kay particularly.
You indicated we would be better off with a system that
would continue to provide secure retirement benefits. Yet we
all know that by the year 2029, our current Social Security
System will only be able to pay out about 75 percent of what is
currently being paid out.
What do you suggest doing to restore the solvency of Social
Security, except raise taxes, because that is not going to
happen.
Mr. Kay. Well, that is the question. I wasn't trying to
state that we do not have a problem; I was trying to state that
perhaps privatization is not the solution.
Chairman Bunning. You are speaking about total
privatization.
Mr. Kay. Yes, I was talking about the Chilean system.
Chairman Bunning. Not something that would guarantee people
aged 40 and over their benefits for life and those 40 and under
half their benefit if they want to opt out into some type of
privatization? Something that is a similar to what we have been
discussing with the United Kingdom representative?
Mr. Kay. Well, there is certainly a lot of room to discuss
things in between the Chilean system and what we have today.
But I know even the extent of the problem is, of course, a very
controversial issue. I do not have to tell you that, obviously.
Chairman Bunning. How do we restore public confidence for
the youth, our younger workers, it has been said many, many
times--believe more in UFOs than they believe that their Social
Security System will be there when they retire. How do we
restore that? See, because, obviously, we are transferring in a
pay-as-you-go from the younger to the older retiree right now.
Mr. Kay. Well, we have this problem that faces us 35 years
from now, and we have time to work on it.
Chairman Bunning. Each year we wait----
Mr. Kay. I am not saying that we should wait. I think the
sooner we deal with it, the better.
I would just refer to some of the studies done by people
like Henry J. Aaron and others, where they propose incremental
concrete technical steps--small and large--that can keep the
basic framework of Social Security intact without dismantling
it.
Chairman Bunning. I don't think anybody wants to dismantle
what we have. We know that we have a funding problem in the
future, and we have got to make a transition period where we
are going to guarantee certain benefits. Right now, we have
made a compact with our seniors that are retired and are about
to retire. We cannot go back on that.
But what are we going to do to restore the confidence in
the system that it will be here for my grandkids and my younger
children? We have got to have something that they can put their
hope in.
Mr. Enoff. Mr. Chairman, I think the Advisory Council was
unanimous in the fact that these funds should be invested
somehow that there was a greater return. No one is arguing
that. I don't even know that the two members of the panel who
object to the idea of privatization have said that there is not
a better return. So why not get a better return for those
funds? And some of these little technical fixes are really
benefit cuts and we ought to call them that. We are talking
about cutting benefits.
Chairman Bunning. If we move the retirement age from 67 to
70, there is a major change.
Mr. Enoff. And nobody likes to talk about the fact that we
have increased the retirement age to 67, yet people are
retiring younger and younger. Given the choice, that is what
they would like to do. The average retirement age is still 62
years and 10 months. It has leveled off a little bit.
But having those funds, and having some flexibility in
those funds, allows a person some choice in when they decide to
retire and how they decide to retire, maybe on a gradual basis.
And you could get rid of something like this complex earnings
test that we have in our system now.
Chairman Bunning. We tried for 8 years, as you know, and we
finally succeeded after 8 years to get it changed a little bit.
But wouldn't the treatment of Social Security retirement
benefits have a great deal of impact on how and when people
retire? In other words, now that we are taxing up to 85 percent
of Social Security benefits?
Mr. Enoff. It appears, from looking at Western European
countries, that it does have a great effect on when people
decide to retire.
Now I am in favor of us encouraging people to work as long
as they can in terms of productivity, but a person then has
some degree of choice in how much they want to work or when
they want to retire, and maybe can put extra funds away through
a tax incentive, so that they can have a better retirement, and
make some choice in that matter, rather than being mandated.
Chairman Bunning. There are quite a few other questions
that I have, and I would like to be able to submit them to you
in writing for your written response. I usually don't carry a
hearing over 2 hours; I try not to. I am due on the floor.
[Questions were submitted to the panel from Chairman
Bunning. The responses follow:]
The Responses of Mr. Scherman
Question 1. You mention in your testimony that your pension
reforms were decided by Parliament in 1994. Apparently, these
reforms are gradually being rolled out over time. You also
indicate that now there are many issues arising of political
significance, which. if not solved within the political
alliance behind the 1994 decision, may result in the collapse
of the reform. What, in your view, are the causes of this
backlash? Is the public now opposed to certain pension reforms?
I would not call it a ``backlash.'' What I have been
talking about is a risk that the political alliance behind the
reform will not succeed in carrying it to a successful end. I
think that such a complicated reform as this must contain
several issues that are potential dangers for the reform, and
this will be the case up until the final decisions by
parliament has been taken.
You also ask about whether the public is opposed to certain
pension reforms. Yes, I would say that there is a hesitation
among parts of the population about this reform. There are at
present three main fractions: First the members of the previous
government, who are opposed to changes in the original reform
proposal. Secondly, within the social democratic party some
want fairly far-reaching changes in the original proposal.
Finally, there are some who want to retain the old system
without regarding the consequences. To my mind the interesting
thing is that the opposition to this far reaching reform is not
stronger than it is.
I sense that you also have another question: What could
have been better? It is my opinion that if the internal process
in several of the political parties had been more intense, with
more open leadership from the party leaders, we would have seen
fewer problems in the final process.
Question 2. It appears that most of the changes you have
made to your pay-as-you-go earnings related pension result in
benefit cuts. How were you able to sell these to the public and
what was their reaction?
The overall reaction from the general public has been quite
calm, although there has been some fairly vociferous opposition
from within the social democratic party opposition. Basically,
I have the feeling that people in general do realize that the
current system is financially unsustainable in the long run and
must be changed. I think that the reason why the general public
seems to have accepted this reform is that they had realized
that benefit cuts were unavoidable even before the politicians.
The general feeling in society seems to be that younger people
began to question whether there would be any pensions at all in
the public system in the future. So what could be regarded as
big benefit cuts, can on the other hand for the general public
be regarded as a surprise: There will be a pension after all!
Another reason for the relatively calm reaction from the
general public is certainly the fact that there is such broad
majority behind the decisions taken so far. That means that the
general public can trust that very solemn work is done, and
nearly every person can see his or her representative's
partaking in the decision process.
Question 3. You recognize that it is impossible to
replicate redistributional effects in your Notional Account
System. Your answer is to introduce a fairly high guarantee
level, financed out of general revenue. How will this work?
Those who have earned a pension or only a low one will
receive a guarantee pension. The costs will be borne by the
state. In addition to the guarantee pension, there will
continue to exist a means-tested housing allowance. The extra
tax deduction for low-income pensioners will be abolished for
both present and future pensioners, but present pensioners will
be compensated through recalculated benefits. The level of the
new guarantee will also take this into account.
A single person with no pension credits at all, will
receive a guarantee pension of approximately 10.000 USD (at the
current exchange rate). A married person will receive at least
9.000 USD.
Low-income earners or persons who have worked for a limited
number of years and gained at least some credits will receive a
guarantee pension, which will depend on the sum of their
pension credits. A single old-age pensioner who has earned an
annual pension up to the guarantee level will receive the
guarantee level plus 25 per cent for the pension credits
earned.
Question 4. You indicate that under your new system,
pension benefits will reflect wage growth. The result of the
method for indexing outgoing pension is that there is no
guarantee that the pensioners will be fully compensated for
inflation. You say that this is one of the key features of the
reform, whereby pensioners are made to share with the active
population the problems following a weak economic growth. The
U.S. Congress has discussed adjusting our cost of living
increase for Social Security beneficiaries. This is an
extremely sensitive issue amongst our seniors. How were you
able to get public support for an initiative like this?
The sense of emerging long term financial crisis in the
pension system together with a deep economic recession 1991-
1993, that resulted in a decrease in the wage base, higher
contribution rates to cover existing commitments, a rapidly
increasing budget deficit; all contributed to a general feeling
of crisis and a general opinion that it was no longer possible
to unconditionally guarantee the purchasing power of the
pensions. In addition a broad political consensus, mentioned
above, made it difficult for any specific group to put its
interest before that of any other group.
Here it might be added that this form of indexation was
discussed many years before the reform decision was taken in
1994. The National Social Insurance Board had for years
highlighted this particular issue. In our proposal on how to
reform the system submitted to Government in 1991 this was a
central point. In other words, the issue had been public for
many years, and people had begun to understand the necessity
why unconditional price indexation was no longer possible.
Secondly, it is worth pointing out that during the economic
crises at the beginning of the 1980's and the beginning of the
1990's the indexation had been manipulated many times, so
people were used to this happening. What happened now was that
an automatic adjustment mechanism was proposed, that will
replace ad hoc political decisions.
Question 5. You say that your reform experience illustrates
the need for interaction between experts and politicians, and
that it has been essential that the analysis has been performed
and presented by a non-political authority. Such an authority
was set up in this country, yet even that authority could not
reach consensus. How were your experts able to reach consensus
on recommendations.
As early as the early 1980's, experts in Sweden were
already beginning to question the financial sustainability of
the pension system. A government commission was given the
mandate in the autumn of 1987 to review the pension system. In
their report published in 1990 they identified a number of
problems with the current system in addition to the perverse
link between economic growth and financial unsustainability.
Another serious problem was the untransparent
redistribution. Economists had shown that the system was
unfavorable for persons with long and steady contribution
careers, i.e. most blue collar workers. In addition there were
problems with rapidly increasing life expectancy and a downward
trend in the de facto pension age.
Experts more or less agreed on these problems, and saw as a
solution a system with stronger links between contributions and
benefits, and actuarial adjustment to changes in life
expectancy.
The National Social Insurance Board submitted to the
Government in 1991 a formal proposal that dealt with these
problems. This was the result of at least 6-7 years of work,
where experts and management from the National Social Insurance
Board together with its political board had worked closely
together discussing what was needed and what could be done. Of
course the National Social Insurance Board had contacts with
other institutions, such as universities, but basically the
work was carried out by the Board. The ideas of the Board were
discussed on many occasions by the press and other mass media,
and in that sense it was done in close contact with the society
as a whole.
Question 6. You point out that the complexity of the reform
issues is difficult for your country to understand and that the
party now in power has provided an extra year for consideration
to get acceptance for the new reforms. How are you education
the public about changes to your pension system?
The process of education is of course gradual. Part of it
has undoubtedly been the discussion of various aspects of the
reform in mass media. Another aspect is producing information
in the form of brochures with an explanation why the reform was
necessary, and the various aspects of the reform that are
important for the public to be aware of, including examples
with persons of different ages and earning careers. In early
1999 the first statements will be sent to all persons covered
by the system, in practice everyone with earnings from the age
of 16. This will be preceded in 1998 by a new information
campaign run, through mass media channels.
Furthermore, I should mention that the employees of the
social insurance organization have been participating in
training programs since the proposal went through parliament.
Already in 1995 it was possible for them to answer questions
about the reform.
In addition many important organizations, such as the major
trade unions and the Employer's Federation have published their
own information.
Question 7. Ms. Ghilarducci discussed the fact that in a
privatized system disabled workers, workers who work outside
the formal markets, those who live long, and cohorts who
contribute through a financial market bust, women, and low
income workers with sporadic employment, lose. In your system,
have these types of individuals been ``losers'' and what
protections do you suggest might be built into a system to
avoid negative impacts on these populations?
To begin with, the system is not privatized, but a public
mandatory system. However, the question what happens to the
disabled, low-income workers and persons with sporadic
employment is important.
Let us take the disabled first. Persons who have been
working for some time and then become disabled will have
contributions accredited to their accounts, both in the
notional PAYG-system and the mandatory second pillar with
privately managed individual financial accounts. The
contributions will be based on an imputation of the income up
to a given age, at which time the disability benefit will be
converted to an old-age pension.
Similarly, for the unemployed, contributions will be paid
from the unemployment insurance into the old-age system to
provide pension rights for periods covered by these benefits.
For women contributions will be accredited up to four years
per child from child birth. Calculations show, in fact, that
women in comparable careers to men may even do better than
their male counterparts due to this mechanism. Low-income
workers, for whatever reason, will be covered by the guarantee,
if this becomes necessary.
Older workers will in fact not be disfavored, since the
annuity calculated in both the PAYG and second pillar systems
will be paid out until death.
It is vital to point out that the guarantee is fairly high
and will guarantee everyone a decent standard of living. Also,
it is vital to point out that those who will not contribute to
the system do not benefit from it, for example those working
outside the formal market. It is one of the ideas of the reform
to have an incentive to work in the formal market in order to
get one's pension.
Finally, when it comes to the mandatory funded part of the
system with real financial investments, there will be no
financial guarantees, with the exception of bankruptcy. On the
other hand, the idea is to diversify the workers' total benefit
package between the PAYG-system, the return of which depends on
economic growth, and a funded system, that depends on financial
market growth.
Question 8. Are workers required to purchase or create life
annuities at the time they retire, or are they allowed to
withdraw large lump-sum distributions? and if annuitization is
optional, what is the government's obligation to persons who
exhaust their retirement funds prior to death?
As the proposal now stands, persons will not be allowed to
withdraw lump-sum payments. They will be requested to convert
to a life annuity upon retirement. Consequently, there is no
risk that anyone will ``exhaust hers or his retirement funds''
prior to death.
The Responses of Dr. Pinera
Question 1. You indicate that the average real return on
investment has been 12% a year, ranging from minus 3% to plus
30% in real terms. You mentioned, and I certainly agree, that
the important yield is the average one over the long term.
Nevertheless, I understand the minus 3% return occurred
relatively recently. How did the public react?
1. In 1995 all Latin American stock markets suffered a
decline following the Mexican peso crisis. As a result, the
Pension Savings Accounts (PSAs) suffered a negative return of
2.5 percent in that year. Some very small groups hostile to the
PSA system took advantage of the opportunity to advocate
unspecified changes to the private pension system. Defenders of
the system went on national television to explain the causes of
the decline; namely, the Mexican peso crisis and the
oscillations that are intrinsic to the free market. They also
reminded workers that the return that matters is the one over
the entire working life--of 40 years, for instance--not the
return in any particular year. Once workers understood that,
their fears were allayed and the attempts to weaken the private
pension system quickly died. Absolutely no change to the law
was approved or even attempted in Congress.
Question 2. The private Pension Fund Administration
companies (AFPs), who manage the pension savings accounts, have
charged high administrative costs. What exactly are these
costs? Have these costs increased, decreased, or stayed the
same over the life of your new system? Is there anything the
government is doing to influence the reduction of these costs?
2. The costs as a percentage of total funds managed have
decreased over time to less than 1.2 percent of total assets
managed and are projected to go below 1 percent in the near
future. Over the years there has been an excessive accumulation
of government regulations, among them, some unduly ones that
restrict the commission structure. Indeed there is an ongoing
debate in Chile advocating the removal of those distortions,
but regrettably the government has not yet produced results in
this direction.
Question 3. What is the average wage in Chile? What percent
of workers contribute to the program regularly? Is this percent
consistent for low wage workers as well?
3. The average monthly wage of workers affiliated to the
system is $500. About 63 percent of the total labor force
contributes to the program regularly, a percentage similar to
that of the old system. Two factors to keep in mind: a) Self-
employed workers are not required by law to contribute to the
system, and many of those choose not to participate in the
system to avoid having to disclose their income to the
government; and, b) Some older workers have already accumulated
enough funds in their PSAs so that they do not have to
contribute to them anymore. That does not mean, however, that
those workers have retired from the labor force.
Question 4. There seem to be mixed views on whether
privately-held personal accounts raise or lower national
savings, since once individuals are compelled to have an
individual account, they may likely cut back other savings or
put off retiring for a longer period of time. What has happened
to your level of national savings since you have implemented
your pension reforms? To what portion of any increase in
national savings do you attribute your pension reforms, as
opposed to changes in the economy, etc.?
4. The national savings rate in Chile has increased from 10
percent to around 26 percent of GDP since the reform was
implemented. The exact portion that can be attributed to the
reform is very difficult to measure since there were many
simultaneous reforms being implemented. Prominent economists,
both in Chile and around the world, credit the fully funded
pension system, and the way the transition has been financed,
for a substantial contribution to that increase.
Question 5. Private vendors have often been described as
``winners'' in Social Security privatization. Many of the
witnesses had wide and varied experiences with private vendors
when moving to privatize portions or all of their pension
schemes. Many U.S. citizens are skeptical about moving to
private accounts.
What discussions did your leaders have, and did you address
the issue of how to protect an individual from being too risk
averse in his or her investment choices, causing his or her
returns to be too low to yield an adequate retirement or the
individual selecting high risk equities or corporate bonds that
provide a lower than expected investment return experience?
5. This was a revolutionary reform executed in a
conservative way. There is a government agency, the AFP
Superintendency, that oversees the AFP industry and the reform
law sets rules on the kind of investments the AFPs can make. In
addition, should the return on an investment fall below the
lower end of a certain return band, the AFP has to make up the
difference and add it to the worker's PSA. In addition, workers
can choose AFPs with more conservative portfolios.
Question 6. Ms. Ghilarducci discussed the fact that in a
privatized system disabled workers, workers working outside the
formal markets, those who live long, and cohorts who contribute
through a financial market bust, women and low income workers
with sporadic employment, lose. In your system, have these
types of individuals been ``losers'' and what protections do
you suggest might be built into a system to avoid negative
impacts on these populations?
6. No worker participating in the PSA system can be
considered a loser. Under the PSA system, all workers have
visible property rights, protected by the Chilean Constitution,
over their pension contributions. Furthermore, those workers
with at least 20 years of contributions to their PSAs are
entitled by law to the legally defined minimum pension.
Disabled workers are receiving pension benefits under the new
system that are 100 percent higher than they were under the old
system. Low-income workers have particularly benefited from the
new system. (See, also, Pinera 1996.)
Question 7. As we debate possible Social Security reforms,
and whether to adopt some degree of privately-held accounts,
questions are also raised about the pay-out of the accounts.
What were Chile's experiences regarding the restrictions you
have placed on the accounts before you pay-put? For example,
are individuals allowed to access these accounts to buy a home
or pay for other expenses?
7. No, they are not allowed to withdraw money to buy a
house or for other expenses. The money in a PSA can only be
used as retirement income.
Question 8. In Australia, as of March 1997, there were over
151,000 superannuation funds, but 98% of all member accounts
are held in approximately 8,000 funds. Australia set up a
regulatory regime which includes a number of regulations aimed
at strengthening these funds To what degree has Chile
established regulations of these funds? What types of
regulations were established and what was the industry's
reaction?
Did you find ways to keep administrative costs of the funds
down?
How did you educate the public to avoid confusion or scams?
8. See 2 and 4 above.
Question 9. Are workers required to purchase or create life
annuities at the time they retire, or are they allowed to
withdraw large lump-sum distributions? And if annuitization is
optional, what is the government's obligation to persons who
exhaust their retirement funds prior to death?
9. See 6 above and Pinera 1996.
References
Pinera, J. (1996) ``Empowering Workers: The Privatization of Social
Security in Chile.'' Cato's Letter No. 10. Washington, DC., Cato
Institute.
The Responses of Mr. Blunn
Question 1. There seem to be mixed views on whether
privately-held personal accounts raise or lower national
savings, since once individuals are compelled to have an
individual account they may likely cut back other savings or
put off retiring for a longer period of time. What has happened
to your level of national savings since you have implemented
your pension reforms? To what portion of any increase in
national savings do you attribute your pension reforms, as
opposed to changes in the economy, etc?
Response. There is a number of Australian studies which
estimate the reduction in other financial savings because of
compulsory superannuation (the private saving offset) at
between 30 and 50 per cent. Using offsets of this order, and
estimates of effects of the policy on wages growth and taxation
revenue, the Retirement Income Modelling (RIM) Unit of the
Australian Treasury has projected the effect on national
saving\1\ (change in net worth) to be 0.9% of GDP in 1996-97
rising to 3.6% of GDP by 2019-20 (see Gallagher, Phil
``Assessing the National Saving Effects of the Government's
Superannuation Policy'' which is available on the internet at
www.treasury.gov.au/publications/RIM/).
---------------------------------------------------------------------------
\1\ National financial savings which exclude household dwelling
equity.
---------------------------------------------------------------------------
The actual growth of Australian superannuation fund assets
do closely match these RIM projections. However, in the period
concerned, changes in household borrowing trends have also
affected national savings. That is, the substantial growth in
superannuation assets has been virtually matched by an
equivalent growth in household borrowing, a trend apparent
since financial deregulation in 1986. The following table
summarises the changes in financial assets and liabilities and
their relationship to GDP.
Financial Accounts for Households
Year Ending June
----------------------------------------------------------------------------------------------------------------
March
1989 1990 1991 1992 1993 1994 1995 1996 1997
----------------------------------------------------------------------------------------------------------------
Technical reserves of Life:
Offices and Pension funds........... 145.5 164.4 178.3 203.1 218.2 238.3 254.3 280.6 303.1
Total financial assets.............. 381.9 415.3 436.8 462.1 501.4 564.6 587.9 635.1 690.4
Total financial liabilities......... 159.4 181.3 187.6 197.8 213.9 232.9 258.7 290.4 307.2
Reserves as % of Assets............. 38.1% 39.6% 40.8% 44.0% 43.5% 42.2% 43.3% 44.2% 43.9%
GDP (I) $B.......................... 339.2 370.0 379.3 387.5 405.4 429.7 457.3 487.6 509.8
Life Office and Superannuation:
Reserves to GDP..................... 42.9% 44.4% 47.0% 52.4% 53.8% 55.5% 55.6% 57.5% 59.5%
Total Financial Assets to GDP....... 113% 112% 115% 119% 124% 131% 129% 130% 135%
----------------------------------------------------------------------------------------------------------------
The reserves of superannuation funds and life offices have
grown from 43% of GDP in 1989 to 60% in 1997. The growth in
superannuation assets has therefore exceeded growth in the
economy.
There is evidence in Australia that the compulsory nature
of the Superannuation Guarantee system is adding to national
savings. Data published in the ``Insurance and Superannuation
Commission Bulletin'' demonstrate that one third to one half of
the growth in superannuation assets is due to net contributions
with the remainder being due to increasing fund earnings. This
provides evidence of growth in saving from the compulsory
contributions policy rather than the effects of improved
economic conditions on the valuation of fund investments.
The Australian National Accounts measure of Household
Saving Ratio has grown from 4.1% in June 1992 to 4.7% in June
1997. However, it is very difficult to relate this measure to
financial stocks or flows, let alone to superannuation.
Household Saving is calculated as the difference between
household disposable income and household private final
consumption expenditure. This residual reflects methodological
differences between the income and expenditure side of the
accounts. It is divided by household disposable income to
obtain the ratio. The direct use of financial assets data and
projections (see above) therefore provides more appropriate
means of answering the Committee's questions.
Question 2. Private vendors have often been described as
``winners'' in Social Security privatisation. Many of the U.S.
citizens are sceptical about moving to private accounts. What
discussions did your leaders have? Did you address the issue of
how to protect an individual from being too risk-adverse in his
or her investment choices, causing his or her returns to be too
low to yield an adequate retirement or the individual selecting
high risk equities or corporate bonds that provide a lower than
expected investment return experience?
Response. Primary responsibility for the viability and
prudent operation of superannuation funds rests with the funds'
trustees who are subject to a range of regulatory controls
under the national superannuation legislation, the
Superannuation Industry (Supervision) Act 1993 (SIS). Some of
the ``checks and balances'' in the SIS regime include:
a requirement on trustees to formulate and give
effect to an investment strategy (having regard to risk,
return, the benefits of diversification, liquidity and current
and future liabilities);
requirements for equal numbers of employer and
member representatives on the trustee boards of employer-
sponsored funds;
trustee approval processes for public offer funds;
extensive information disclosure requirements;
internal and external complaints handling
arrangements for members; and
strong monitoring and investigation powers for the
industry regulator, the Insurance and Superannuation Commission
(ISC).
As part of its supervisory role, the ISC conducts an
extensive national, strategically targeted audit program to
monitor compliance with the prudential standards. These audits
focus on confirming that the assets of the fund are securely
held and assessing the capacity of the fund's management to
maintain the future security of assets. This involves checking
the fund's compliance with superannuation standards and
monitoring prudential matters such as the quality of
investments, management controls and systems.
Although regulated under the SIS prudential framework, the
security of superannuation benefits and fund investment
performance are not guaranteed by the Government.
Public underwriting of benefits or fund investment
perforrnance is undesirable as it may tempt trustees to take
excessive risks, in the knowledge that the Government would
cover any down side losses. However, losses due to fraud can be
compensated if the Government judges this to be in the public
interest.
The SIS measures outlined above minimise the likelihood of
major fund losses through imprudent or dishonest management and
moderate the impact of adverse market movements or poor
commercial investment decisions on the part of fund trustees.
While the SIS requires trustees to formally implement an
appropriate fund investment strategy(s) largely for prudential
reasons, historically, most employees receiving only
Superannuation Guarantee contributions have been offered little
choice as to where their money is invested. However, some fund
trustees have offered their members a choice of investment
strategy.
In the 1997-98 Budget, the Government announced that it
will be giving employees greater choice as to the fund or
Retirement Savings Account into which their compulsory
Superannuation Guarantee contributions are paid. Among other
things, this will provide greater opportunities for employees
to choose between funds offering different investment
strategies. However, responsibility for the formulation of
those investment strategies will remain with the trustee.
the Australia Taxation Office, the agency
responsible for the choice of fund legislation, has been given
additional funding to conduct a public education campaign and
provide inquiry services to assist employees and employers
about choice of fund.
Question 3. One of the other witnesses discussed the fact
that in a privatised system, disabled workers, workers working
outside the formal markets, those who live long and cohorts who
contribute through a financial market bust, women and low
income workers with sporadic employment, lose. In your system,
have these types of individuals been ``losers'' and what
protections do you suggest might be built into a system to
avoid negative impacts on these populations?
Response. In general these particular groups have not been
``losers'' in terms of the retirement income system that exists
in Australia. This is because, unlike the United States, social
assistance is the major pillar in the Australian social
security system. Therefore, benefits are not ``residual'' in
the same sense that they are in many countries with a primary
system of social insurance.
Specifically, the basis of the Australian retirement income
system is a flat-rate, means-tested pension known as ``age
pension.'' The rate of payment is not related to prior
earnings. Rather, it is set at 25 per cent of Male Total
Average Weekly Earnings (MTAWE) for a single person. The
married rate of pension paid to each partner of a couple is
currently 83 per cent of the single rate. Eighty-four per cent
of all aged Australians receive this pension (including war
service pensions). Of the Age Pension recipients, sixty-five
per cent receive the maximum amount and thirty-five per cent
get a partial pension.
The emphasis on poverty alleviation in Australia, together
with elements of the social wage (such as public housing,
education and health provision) mean that, comparatively, the
Australian social protection system has achieved a high level
of income redistribution from those better off to the most
needy.\2\
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\2\ This conclusion is supported by a recent OECD study which shows
that direct taxes and transfers are more progressive in Australia than
in any of the other countries examined: Atkinson, A.B., Rainwater, L.
and Smeeding, T., Income Distribution in OECD Countries, OECD, 1995,
Paris.
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In addition to the age pension, the Australian retirement
income system consists of compulsory concessionally taxed
saving for retirement through an employment-based system known
as the Superannuation Guarantee (SG) and retirement income
supplementation by individuals, particularly through voluntary
superannuation assisted by tax concessions and other saving
(More details regarding Australia's retirement income system
may be found in the statement submitted to the Social Security
Subcommittee at the hearing on 18 September 1997).
In terms of a standard of living that is higher than the
maximum provision for age pension (25 per cent of MTAWE),
Australia acknowledges that some groups are at greater risk of
not having had a sufficient level of labour force participation
to build up their personal superannuation or private savings.
Groups that tend to fit within this category include lone
parents (mostly women), people with disabilities, low income
earners, women who have their employment record interrupted by
caring responsibilities and those facing long term
unemployment.
The Australian Government has brought in measures
specifically targeted at these groups to assist them to
supplement their retirement income. The Government has also
developed and enhanced strategies, over the last decade, which
focus on increasing labour market participation of people of
working age and which should assist those who are less able to
build up personal superannuation or private savings. Both of
these strategies are outlined below.
A. Recent modifications to the superannuation system to
increase choice and better tailored arrangements to individual
needs.
There have been concerns that certain groups, such as low
income earners, people with intermittent work patterns, people
who have left the workforce to care for others and long term
unemployed, many of these being women, find compulsory
superannuation contributions a financial burden and that their
needs may be better served by meeting their immediate
circumstances. There has also been debate as to whether these
target groups are able to gain easy access to superannuation
(and its benefits).
To improve the flexibility and responsiveness of
superannuation arrangements for these groups, the Government
has recently introduced a number of reforms to the private
pension system. Four specific initiatives are outlined below.
1. The introduction of retirement savings accounts (RSAs),
under which banks, credit unions and life insurance companies
will be able to offer over-the counter superannuation savings
plans. RSA's are designed to be a simple, low cost, low risk
product especially suited to those with small amounts of
superannuation, such as part time, temporary, casual and
seasonal workers, or those nearing retirement and wishing to
minimise risk. These accounts will be portable and will be
owned and controlled by the customer. These will be of special
value to women who traditionally have broken work patterns in
accommodating family responsibilities;
2. Since 1 July 1997 the Government has allowed a
contributing spouse to receive an 18 per cent income tax rebate
for contributions up to A$3,000 to a superannuation fund or
Retirement Saving Account of a non-income earning spouse or a
spouse earning below A$10,800 per annum. This will improve
access to superannuation for low income spouses, particularly
those with intermittent work patterns;
3. The Government has recently allowed for low income
employees (earning between $450 and $900 per month) to choose
between receiving superannuation guarantee contributions or the
equivalent in wages and salary under certain conditions. This
policy provides greater freedom of choice within the
superannuation system and recognises the pressing need of
people on very low incomes and interrupted employment patterns
to maintain their immediate living standards; and
4. Finally, individuals who leave the workforce, but who do
not retire, can generally continue to contribute to
superannuation for a further 2 years. More recently, the
Government has allowed individuals who temporarily leave the
workforce under a bona fide parental leave arrangement with
their employer to continue to contribute to superannuation for
a further 7 years. In addition, individuals, who are working,
can continue to contribute to superannuation up to age 70.
Incentives are also provided to encourage retirees to
purchase lifetime income streams where the underlying longevity
risk is borne by the income stream provider.
B. Strategies to increase the labour market participation of
particular groups
A major strategy for ensuring that a wide range of the
community gain the supplementary benefits of retirement income
involves improving labour market opportunities for vulnerable
groups. This strategy includes such programs as the Disability
Reform Package, for people with disabilities and the Jobs,
Education and Training (JET) program for lone parents, low
income partnered parents, widowers and carers.
The Disability Reform Package, introduced in 1991, aims to
increase the participation of people with disabilities in
employment, education, training and rehabilitation. A key
feature in pursuing these outcomes is the use of specialist
Disability Support Officers who take an active role in
identifying people who were likely to benefit from training,
rehabilitation or job search assistance.
The JET program, established in 1989, aims to improve the
financial circumstances of lone parents, widowers and carers by
facilitating access to educational, vocational training and
employment opportunities and, if required, child care.
Emphasis is placed on ensuring sustainable employment
outcomes by improving long-term labour market competitiveness
and career development through education and training. Low
income partnered parents will also become eligible for this
program from March 1998.
The JET program is voluntary and in the Australian
experience has tended to produce positive results relative to
the amount of funding invested.
Older workers are also encouraged to retain their labour
market contact or pursue a graduated retirement from the paid
workforce through the current retirement incomes system which
provides a possible span of retirement ages from 55 to 70
years. A pension bonus payment plan will be introduced from 1
July 1998 whereby workers will get a bonus for continuing to
work a maximum number of hours, beyond age pension age (men at
age 65 and women at age 61--as at July 1997) or war service
pension age (men at age 60 and women at 56--as at July 1997).
Also, measures to encourage labour market participation
have also been introduced for other target groups such as young
people and unemployed indigenous Australians.
On a structural level, the Australian Government has
encouraged labour market participation by developing a more
competitive employment assistance arrangement whereby private
and community based organisations, as well as a corporatised
public provider, will be contracted on a competitive basis to
provide a range of Public Employment Service (PES) services.
The new arrangements should boost the effectiveness of
employment services because contracted providers of intensive
individualised assistance will be paid for placing job seekers
in employment.
Question 4. As we in the United States debate possible
Social Security reforms, and whether to adopt some degree of
privately-held accounts, questions are raised about the pay-out
of the accounts. I'd like to hear your experiences regarding
the restrictions you have placed on the accounts before pay-
out. For example, are individuals allowed to access these
accounts to buy a home or pay for other expenses?
Response. The Government considers that superannuation
savings which have received concessional tax treatment should
generally be preserved for genuine retirement purposes.
Currently, superannuation savings are generally required to be
preserved until age 55 or until later retirement
Early release of benefits is allowed in the event of the
death of a superannuation fund member, permanent incapacity,
severe financial hardship, compassionate grounds, and where
benefits are taken as a non-commutable life pension on
termination of gainful employment.
The Government introduced several reforms to the
preservation rules in the 1997-98 Budget to reduce the leakage
of benefits from the superannuation system. These include:
requiring from 1 July 1999 that all future
contributions and earnings be preserved until retirement upon
reaching the preservation age (except in the limited
circumstances discussed above); :currently, certain member
(undeducted) contributions and certain employer contributions
are not preserved;
no longer allowing access to benefits prior to
preservation age on the grounds of permanent departure from
Australia;
confirming an increase in the preservation age
from 55 years to 60 years based on a sliding scale with people
born before 1 July 1960 subject to 55 years and those born
after 1 July 1964 subject to 60 years;
a new test for financial hardship based on
evidence of specified Commonwealth income support; and
the introduction of defined criteria as to what
constitutes compassionate grounds.
Currently, there is some debate over whether the Government
should assist low income earners in buying homes by allowing
them early access to some benefits. In response to this, the
Government released a discussion paper entitled ``Allowing
Access to Superannuation for Housing'' in May of this year.
The Government is currently considering the comments and
submissions from the superannuation, housing and welfare
sectors, as well as examining the implications of such schemes,
including for national savings.
Question 5. Are workers required to purchase or create life
annuities at the time they retire, or are they allowed to
withdraw large lump-sum distributions? And if annuitisation is
optional, what is the Government's obligation to persons who
exhaust their retirement funds prior to death?
Response. Australia's retirement income system does not
require retirees to access their superannuation savings in the
form of an income stream. Retirees can access their benefits in
the form of a lump sum at concessional (ie when compared to
marginal tax rates) tax rates up to the lump sum Reasonable
Benefit Limit (RBL) threshold, currently $454,718. Lump sum
benefits which exceed the lump sum RBL are taxed at the top
marginal tax rate.
Australia's retirement income system does, however, provide
retirees with incentives to access their benefits in the form
of an income stream. For instance, lifetime superannuation
pensions are assessed against a higher pension RBL, currently
$909,435, and are exempt from the social security age pension
assets test. The Government announced in the 1997-98 Budget its
intention to extend these concessions to life expectancy income
streams which meet certain required characteristics, such as
being non-commutable.
Age pension is paid to all Australians aged over 65 years
(for men) or 61 years (for women, legislated to rise to age 65
by 2013), subject only to residence qualifications and means
testing. There are no limitations placed on eligibility due to
prior receipt of superannuation lump sums, pensions or
annuities. Many retirees receive a part pension, in addition to
income from superannuation, investments or other sources.
The Australian age pension is non-contributory and is
financed from general taxation revenue. Eligibility is not
related to previous labour force participation.
The Responses of Mr. Enoff
Question 1. You stress the importance of educating the
public about the principles and projected outcomes of the
reformed program compared to those of the current program.
Considering your years of SSA experience, how would you see
that education taking place? Should or could SSA do it?
It is as usual a very insightful question.
The education should be provided (or at least approved and
monitored) by a joint legislative/executive branch effort. I
say this not because I fear that SSA would try to ``slant'' the
information, but because there is too much public suspicion and
posturing on several issues that should be addressed. SSA
should certainly play a major role in this effort and continue
to utilize any materials after the initial education phase. I
believe this type of joint effort would be a positive step in
attempting to prevent future misconceptions about the program.
Since there is now a permanent bi-partisan advisory board,
they should be involved along with input from CRS and GAO. I am
not a communications expert, but it seems to me that all media
forms should be utilized; i.e. written, audio, video, internet,
and public forums. While this might sound expensive I believe
it would be a far more effective use of funds than the flawed
PEBES mandate scheduled to begin soon. A special effort should
be geared toward developing materials to be included in
appropriate high school and college courses and public service
tapes for media and employer/union education activities.
In short, SSA could do it but should not do it alone. I
would be happy to work with the committee staff to develop some
draft proposals if you wish.
[The responses of Mr. Finkelstein and Dr. Ghilarducci were
not available at the time of printing.]
Chairman Bunning. I would like to thank the witnesses who
have shared their individual experiences and insight on Social
Security reform with the Subcommittee. I would like to offer
special thanks to those who have traveled so far to be here
today. We have learned a great deal from those of you who
represent other countries. Your reforms serve as a model that
we here in the United States can closely study and try to stay
away from some of the pitfalls before we jump. And we are going
to have to do much needed reform of the solvency problem in our
Social Security system.
Again, your input is deeply appreciated. And best wishes
for a safe trip home.
The Subcommittee stands adjourned.
[Whereupon, at 1:10 p.m., the hearing was adjourned.]
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