[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]




                               before the


                                 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


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
J.D. HAYWORTH, Arizona

                     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

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.

                            C O N T E N T S



Advisory of September 8, 1997, announcing the hearing............     2


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



                      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:]




                                                CONTACT: (202) 225-9263

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 
    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.


    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.''


    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.


    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit at least six (6) 
single-space legal-size copies of their statement, along with an IBM 
compatible 3.5-inch diskette in ASCII DOS Text or WordPerfect 5.1 
format only, with their name, address, and hearing date noted on a 
label, by the close of business, Thursday, October 2, 1997, to A.L. 
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 
deliver 200 additional copies for this purpose to the Subcommittee on 
Social Security office, room B-316 Rayburn House Office Building, at 
least one hour before the hearing begins.


    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
    1. All statements and any accompanying exhibits for printing must 
be typed in single space on legal-size paper and may not exceed a total 
of 10 pages including attachments. At the same time written statements 
are submitted to the Committee, witnesses are now requested to submit 
their statements on an IBM compatible 3.5-inch diskette in ASCII DOS 
Text or WordPerfect 5.1 format. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
    4. A supplemental sheet must accompany each statement listing the 
name, full address, a telephone number where the witness or the 
designated representative may be reached and a topical outline or 
summary of the comments and recommendations in the full statement. This 
supplemental sheet will not be included in the printed record.
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press 
and the public during the course of a public hearing may be submitted 
in other forms.

    Note: All Committee advisories and news releases are available on 
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.


    Chairman Bunning. The Subcommittee will come to order, 
    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 
    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 
    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 
    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.


    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 
    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 
    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 
    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 
    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.


    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 

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 
    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 
    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 
    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 
    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 
     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 
     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 
    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 

    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 
    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 
    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 

                                            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 
    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 

                         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 
    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 
    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.


    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 

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 

    The transition to the new pension system has in reality not 
yet begun. Still, there are some observations to make on the 

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 

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 
    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) 
     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)
     Organization of exchange of information and 
experience between members (conferences, seminars)

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 
    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 
    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.


    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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.


    Ms. Ghilarducci. If you use your hands, it goes better. 
    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 
    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 
    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 
    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 
     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 
     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 
    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 
    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 
    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, 
    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 
    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 
    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 

          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, 

       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.


    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, 
    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 
    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.


    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' 
    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 
    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 

                             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 
    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 
    \2\ World Bank, Averting the Old Age Crisis (1994).
    Chile used five methods to finance the transition to a PSA 
    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.


    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 
    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 
    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 
    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 


    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.) 
    \2\ Shah, Hemant. 1997. ``Toward Better Regulation of Private 
Pension Funds.'' Paper presented at the World Bank, LAC Division, 1-16-
    \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 
    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 
    \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.


    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 
    \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).

                      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 
    \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 
    \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 

                            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).


    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.

                     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.


    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.


    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


    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 
    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 
    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 
    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, 
     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 
     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 

    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 

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; 
     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 
    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 
    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 
    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 

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 
    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 
    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.

                        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 
    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. 
    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 
    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


    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 

             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 
    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 
    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 
    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 
    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.


    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 
    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 
    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 
    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.
    Chairman Bunning. The Subcommittee will return to order, 
    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 
    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 
    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 
    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 
    Chairman Bunning. In other words, a commission of some 
    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 
    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 
    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 
    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 
    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 
    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 
    Mr. O'Sullivan. Yes; not just those five. The whole of the 
insurance and superannuation industry is covered by a set of 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    Did you find ways to keep administrative costs of the funds 
    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.


    Pinera, J. (1996) ``Empowering Workers: The Privatization of Social 
Security in Chile.'' Cato's Letter No. 10. Washington, DC., Cato 


                       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 
    \1\ National financial savings which exclude household dwelling 
    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
                                           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 
    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 
    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 
    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 
    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 
    \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, 
    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 
    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 

    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 
     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.]