[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
SOCIAL SECURITY AND PENSION REFORM: LESSONS FROM OTHER COUNTRIES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SOCIAL SECURITY
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
JULY 31, 2001
__________
Serial No. 107-43
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
75-603 WASHINGTON : 2002
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
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COMMITTEE ON WAYS AND MEANS
BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
E. CLAY SHAW, Jr., Florida FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut ROBERT T. MATSUI, California
AMO HOUGHTON, New York WILLIAM J. COYNE, Pennsylvania
WALLY HERGER, California SANDER M. LEVIN, Michigan
JIM McCRERY, Louisiana BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan JIM McDERMOTT, Washington
JIM RAMSTAD, Minnesota GERALD D. KLECZKA, Wisconsin
JIM NUSSLE, Iowa JOHN LEWIS, Georgia
SAM JOHNSON, Texas RICHARD E. NEAL, Massachusetts
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
MAC COLLINS, Georgia WILLIAM J. JEFFERSON, Louisiana
ROB PORTMAN, Ohio JOHN S. TANNER, Tennessee
PHIL ENGLISH, Pennsylvania XAVIER BECERRA, California
WES WATKINS, Oklahoma KAREN L. THURMAN, Florida
J.D. HAYWORTH, Arizona LLOYD DOGGETT, Texas
JERRY WELLER, Illinois EARL POMEROY, North Dakota
KENNY C. HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
Allison Giles, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Social Security
E. CLAY SHAW, Florida, Chairman
SAM JOHNSON, Texas ROBERT T. MATSUI, California
MAC COLLINS, Georgia LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona BENJAMIN L. CARDIN, Maryland
KENNY C. HULSHOF, Missouri EARL POMEROY, North Dakota
RON LEWIS, Kentucky XAVIER BECERRA, California
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
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
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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
__________
Page
Advisory of July 24, 2001, announcing the hearing................ 2
WITNESSES
Burtless, Gary, Brookings Institution............................ 15
Cato Institute, L. Jacobo Rodriquez.............................. 58
Center for Strategic and International Studies, Paul S. Hewitt... 11
Harris, David O., Watson Wyatt Worldwide......................... 63
Orszag, Peter R., Sebago Associates, Inc......................... 50
Prudential plc, Keith Bedell-Pearce.............................. 26
Swedish National Social Insurance Board, Edward Palmer........... 40
SOCIAL SECURITY AND PENSION REFORM: LESSONS FROM OTHER COUNTRIES
----------
TUESDAY, JULY 31, 2001
House of Representatives,
Committee on Ways and Means,
Subcommittee on Social Security,
Washington, DC.
The Subcommittee met, pursuant to notice, at 10:08 a.m., in
room B-318 Rayburn House Office Building, Hon. E. Clay Shaw,
Jr., (Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SOCIAL SECURITY
Contact: (202) 225-9263
FOR IMMEDIATE RELEASE
July 24, 2001
No. SS-8
Shaw Announces Hearing
on Social Security and Pension Reform: Lessons
from Other Countries
Congressman E. Clay Shaw, Jr., (R-FL), Chairman, Subcommittee on
Social Security of the Committee on Ways and Means, today announced
that the Subcommittee will hold a hearing on Social Security and
pension reform: lessons from other countries. The hearing will take
place on Tuesday, July 31, 2001, in room B-318 Rayburn House Office
Building, beginning at 10:00 a.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Subcommittee and
for inclusion in the printed record of the hearing.
BACKGROUND:
Social insurance systems worldwide have enjoyed enormous success in
reducing poverty among the elderly and the disabled, but, due to long-
term demographic trends, are projected to face financing strains in the
years ahead. In the next 30 years, one in four people in the developed
world will be aged 65 or older, compared with one in seven today.
Several countries, including the United Kingdom, Australia, Sweden, and
Chile have responded to the challenges posed by an aging population by
using individual accounts as part of a package of reforms to reshape
their retirement programs.
President Bush formed a commission to develop recommendations for
restoring fiscal soundness to Social Security. Among the principles
guiding this commission is that ``modernization must include
individually controlled, voluntary personal retirement accounts, which
will augment the Social Security safety net.'' Numerous Social Security
reform proposals introduced by Members of Congress include individual
accounts. As the United States considers options to save Social
Security, lessons can be learned from the experiences of countries that
are implementing or have already implemented personal retirement
accounts as part of their retirement programs.
Several countries have used personal accounts in different ways to
reform their retirement programs. The United States can learn from
their decisions about creating individual accounts and the issues
associated with administering such a system, including centralized
versus decentralized administration, investment choices and risk
protections, pay-out options at retirement, and distribution of the
accounts at marriage, divorce, or death. While these choices are a
reflection of a country's culture, values and previously existing
social insurance system, they also influence the administrative costs,
rates of return workers experience, and the public's acceptance of the
new system.
In announcing the hearing, Chairman Shaw stated: ``The United
States is not alone in struggling to address the financial challenges
of retirement programs while insuring adequate benefits. The graying of
the global population will put tremendous pressure on the public health
and pension systems of industrialized nations. Without reform, the cost
of financing old-age programs will grow at an unsustainable rate and
consume a significant portion of these nations' national budgets. Given
our shared challenges it makes good sense to learn from one another,
particularly as more and more countries are using personal accounts as
part of their strategies to reform their public retirement systems.
Knowing more about their experiences will help us forge our own plan
for strengthening Social Security.''
FOCUS OF THE HEARING:
Witnesses will provide descriptions of other country's (primarily
the United Kingdom, Australia, Sweden, and Chile) retirement systems
after reform, with particular focus on the design of individual
accounts, extent of choice in investments and payout of accounts,
account administration, investment regulation, and consumer education.
Witnesses will also discuss how reforms evolved in their countries and
factors contributing to decisions regarding centralized versus
decentralized administration and the degree of choice in investments
and account payouts. To the degree possible, witnesses will provide
information on administrative costs, rates of return on investments,
and how reforms affected retirement income in their countries.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit six (6) single-
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and hearing date noted on a label, by the close of business, Tuesday,
August 14, 2001, to Allison Giles, 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, by close of business the day before the
hearing.
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Note: All Committee advisories and news releases are available on
the World Wide Web at ``http://waysandmeans.house.gov/''.
The Committee seeks to make its facilities accessible to persons
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call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
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noted above.
Chairman Shaw. This hearing will come to order.
Good morning. Today we focus on the lessons that we can
learn from other countries who have worked to strengthen their
public retirement systems. The challenges presented by an aging
society are not unique to the United States. Throughout the
world, many nations are confronted with seniors collecting
benefits for a longer period of time, as life expectancy
increases, while there are fewer workers supporting each
retiree as birth rates fall.
But before we get to how Social Security might be
strengthened, given the statement of my Democrat colleagues in
response to the President's Commission to Strengthen Social
Security's interim report, I want to revisit the question of
whether Social Security needs to be strengthened at all. Let me
begin by drawing your attention to the placards at the front of
the room, and I quote:
``After the next 15 years--not 37 years--after the next 15
years, increasingly larger amounts of annual interest income
must be used to meet the benefit payments and other
expenditures, and the general fund of the Treasury will be
drawn upon to provide the necessary cash. The accumulation and
subsequent redemption of substantial trust fund assets has
important economic and public policy implications that go well
beyond the operation of the Old Age Survivors and Disability
Insurance, OASDI, program itself.''
Moving on now to the second placard: ``The redemption of a
Treasury security held by a trust fund requires that the
Treasury transfer cash obtained from another revenue source,
such as income taxes or borrowing from the public through the
trust fund.''
These quotes are from the 2000 annual report of the Board
of Trustees, made up of the top economic and pension officials
from the President Clinton administration, namely Lawrence
Summers, Secretary of the Treasury, managing trustee; Alexis
Herman, Secretary of Labor; Kenneth Afpel, Commissioner of
Social Security; and this is among others. Donna Shalala was
one that also signed the report. I was just reading it the
other day.
These trustees conclude precisely the same thing as the
President's Commission, that in approximately 15 years the
system will face cash imbalances that will grow rapidly, and it
is very important that we keep this in mind. It will have cash
imbalances. There will not be enough coming into the trust fund
to pay the benefits, and the trust fund will have to go to the
Treasury and cash in the Treasury bills, and the Treasury will
have to go to the taxpayers or borrow money in order to get the
funds in order to pay off these Treasury bills.
Not only were the conclusions the same, but so were the
explanations. Like other social insurance programs of
industrialized nations, the aging of the population in the
United States will result in fewer workers supporting each
retiree. Many nations examined all the available alternatives,
as we are doing now, and chose to use personal accounts to help
sustain and supplement the benefits that have lifted seniors
out of poverty and kept them out of poverty in this modern era.
For Social Security and the people who depend upon it,
inaction is the greatest enemy. Each time the debate on Social
Security delays progress, the cost and risk to the system
increases. Some Democrats consider any type of personal account
is radical. However, ignoring the system's problems until it
reaches a crisis and faces the prospect of a 38-percent tax
increase on all workers, including working mothers or low-
income families, is what is truly radical and truly reckless.
Other countries are struggling with how to make ends meet,
and their pension systems are in more immediate danger, since
their populations are aging more quickly. Several countries,
including Japan and the United Kingdom, have raised retirement
ages. In addition to increasing taxes or reducing benefits,
more and more nations, such as the United Kingdom, Sweden,
Australia, and Chile, are using personal accounts as an
important part of their retirement program. Even South Africa
is.
Today we will hear from experts, some of whom have traveled
great distances, regarding the similar challenges other
countries have faced and their diverse approaches to
modernizing retirement income security programs and
establishing individual accounts as part of their programs.
Given our shared challenge, and the fact that more and more
countries are using personal accounts as their strategy to
reform their public retirement system, it makes good sense to
learn from one another. Knowing more about their experiences
will help us forge our plan for strengthening Social Security.
Now, if there are some other areas and other ways to meet
the challenge of the cash shortfall that we are going to start
experiencing in 2016, I would like to know about it, because I
do know that personal accounts have become controversial. They
have been attacked by many of my colleagues, perhaps well-
intended. But I think anyone who comes in and attacks these
programs has the obligation to come forward with a plan on how
we are going to take up the cash shortfall that is going to
begin in 2016.
We are obviously going to have Treasury bills, that is the
full faith and credit of the Federal government, that are going
to extend well into the 'thirties, but how are we going to pay
them off beginning in 2016? That is the dilemma that I see as
the challenge before this Subcommittee.
I would now yield to the gentleman from California, Mr.
Matsui, for his opening statement.
[The opening statement of Chairman Shaw follows:]
Opening Statement of the Hon. E. Clay Shaw, Jr., a Representative in
Congress from the State of Florida, and Chairman, Subcommittee on
Social Security
Today we focus on the lessons we can learn from other countries who
have worked to strengthen their public retirement systems. The
challenges presented by an aging society are not unique to the United
States. Throughout the world, many nations are confronted with seniors
collecting benefits for longer periods of time as life expectancy
increases, while there are fewer workers supporting each retiree as
birth rates fall.
But before we get to how Social Security might be strengthened,
given the statements of my Democrat colleagues in response to the
President's Commission to Strengthen Social Security's interim report,
I want to revisit the question of whether Social Security needs to be
strengthened at all. Let me begin by drawing your attention to the
placards at the front of the room, and I quote--
``After the next 15 years, (not 37 years), increasingly larger
amounts of annual interest income must be used to meet the benefit
payments and other expenditures and the general fund of the Treasury
will be drawn upon to provide the necessary cash. The accumulation and
subsequent redemption of substantial trust fund assets has important
economic and public policy implications that go well beyond the
operation of the OASDI program itself.''
Moving on to the second placard . . .
``The redemption of a Treasury security held by a trust fund
requires that the Treasury transfer cash--obtained from another revenue
source, such as income taxes or borrowing from the public--to the trust
fund.''
These quotes are from the 2000 Annual report of the Board of
Trustees, made up of top economic and pension officials from President
Clinton's administration, namely Lawrence Summers--Secretary of the
Treasury and Managing Trustee, Alexis Herman--Secretary of Labor,
Kenneth Apfel--Commissioner of Social Security, among others.
These Trustees concluded precisely the same thing as the
President's Commission--that in approximately fifteen years the system
would face cash imbalances that will grow rapidly.
Not only were the conclusions the same, but so were the
explanations. Like other social insurance programs of industrialized
nations, the aging of the population in the United States will result
in fewer workers supporting each retiree. Many nations examined all the
available alternatives, as we are doing now, and chose to use personal
accounts to help sustain and supplement the benefits that have lifted
seniors out of poverty in the modern era.
For Social Security and the people who depend on it, inaction is
the greatest enemy. Each time the debate on Social Security delays
progress, the cost and the risk to the system increases. Some Democrats
consider any type of personal account `radical.' However, ignoring the
system's problems until it reaches a crisis and faces the prospect of a
38% payroll tax increase on all workers, including working mothers or
low income families, is what is truly radical and reckless.
Other countries are struggling with how to make ends meet, and
their pension systems are in more immediate danger, since their
populations are aging more quickly. Several countries, including Japan,
and the United Kingdom have raised retirement ages. In addition to
increasing taxes or reducing benefits, more and more nations, such as
the United Kingdom, Sweden, Australia, and Chile are using personal
accounts as an important part of their retirement programs.
Today, we will hear from experts, some of whom have traveled great
distances, regarding the similar challenges other countries have faced
and their diverse approaches to modernizing retirement income security
programs and establishing individual accounts as a part of those
programs.
Given our shared challenges and the fact that more and more
countries are using personal accounts as part of their strategy to
reform their public retirement systems, it makes good sense to learn
from one another. Knowing more about their experiences will help us
forge our own plan for strengthening Social Security.
Mr. Matsui. Thank you very much, Mr. Chairman. I appreciate
your remarks, and I want to apologize. My Democratic
colleagues, I think many of them are on the floor at this
particular time. We have the Jordanian trade bill up now, and I
know that Mr. Doggett, Mr. Cardin, and a number of others
wanted to speak on that issue, but I believe that they will be
here shortly.
And I want to also welcome the seven panelists, one of the
first times we have had so many on one particular panel. I
might just mention to the Chairman, because you did suggest
that if anybody has any other ideas about how to fix Social
Security, they ought to come up with them, at this very moment
Mr. Stenholm and Mr. Kolbe in the triangle are having a press
conference on support of their privatization proposal.
As we know, Speaker Hastert, Minority Leader Gephardt, and
Ari Fleischer on behalf of the President yesterday all came out
against Mr. Stenholm and Mr. Kolbe's proposal. And so it is my
hope that the commission comes up with something that might be
a little different, although I don't see how, but perhaps they
will. And anybody who is interested probably should endorse Mr.
Kolbe and Mr. Stenholm's proposal. That might be one way to get
this debate joined, and we can then obviously begin to debate
the real issues, rather than hear from the Chileans and a few
others that have no relevance to the U.S. economy.
I might just point out a few things. In terms of the 2016
date, as I said earlier last week, there is no question that
the commission was attempting to frighten the American people,
and pit young people, those in the work force, against senior
citizens at this particular time. And it is somewhat
unfortunate because on the year 2016 we are going to have $5
trillion worth of payroll taxes that will be sitting in the
Social Security trust fund, undoubtedly will be used, hopefully
to pay down the debt, not spent on other expenditures.
In the meantime we will be accumulating interest on that $5
trillion at the rate of 6.9 percent per annum, and we won't
really draw down on the surplus, the $5 trillion corpus of that
trust fund, until the year 2025. And as we all know, it is not
until the year 2038 that we actually do have a problem where
there will be a benefit shortfall.
The benefit shortfall for the next 75 years is 12 percent,
a fundamental problem and one that we need to address
immediately. And with President Bush in the White House, and
with the Republicans in control of the House, it would be my
hope that they would come up with a proposal, or sit down with
Democrats and Republican Members so that we can work out a
bipartisan compromise.
In fact, I will make that request at this very moment, Mr.
Chairman. Perhaps you and Mr. Thomas and the Republican
leadership can sit down with Mr. Rangel, myself and Mr.
Gephardt, and maybe even bring in the Democratic and Republican
leadership, and see if we can come up with a proposal. I would
welcome that opportunity, because we cannot leave the
uncertainty that we currently have in the market today.
Now, let me just mention a few other things, if I may, and
I will be very brief but I don't want this to go undiscussed.
And I have the greatest respect for Mr. Hewitt. Mr. Hewitt, I
might say that your report is not finalized yet, and I know Mr.
Mondale, the cochair who you will be mentioning in your opening
statement, has significant reservations about privatization
just as I do. And so I would hope that these are your opinions
and not necessarily the organization upon which are you are
talking, because certainly there will be a lot more discussion
about the report when it does become final.
And I might just point out, just by way of discussion here,
in terms of my opening statement, that you mention in your
statement on page 2 that Japan's health and welfare industry
recently estimated that at current birth rates, there will only
be 500 Japanese left in the year 3000. That is a rather
startling statistic. I don't know the relevance of it, but 999
years from now I would be more worried, rather than 500
Japanese being in existence, that the human species would be in
existence, given the fact that no one seems to be concerned
about global warming in the administration, and a few other
significant issues.
But the fact of the matter is that numbers don't really
mean a lot when you talk about 1,000 years from now, maybe even
75 years from now. Seventy-five years ago I think Lindbergh was
flying over the Atlantic, and if he would have been thinking
about supersonic transportation and the kind of Internet
operations we have now, he would probably think he was crazy.
So we don't really know what the birth rate, population, will
be in 75 years.
And let me just conclude by making a couple other
observations. I mentioned Chile, and I didn't mean to pick on
Chile, Mr. Rodriguez, but you know Sweden and Denmark and
Australia, these other countries that we are talking about,
Chile has a population of 20 million and a work force of 10
million. California has a larger population and work force than
that, and I just might say that we wouldn't adopt the Chilean
example.
But I don't know what relevance the population of that has
and the others have when you have 270 million people, 200
million people in the work force. And I just might point out, I
guess London, England is probably the closest thing that we
have today in terms of financial relevance to this hearing and
what our problems are.
But I might just point out there that in terms of the
industrialized countries of the world, this is a shocking
statistic but people ought to know it, the pension, public
pension rate to our senior citizens is the lowest. Canada has
5.2 percent of gross domestic product (GDP) going to their
senior citizens; France, 10.6; Germany, 11.1; Italy, 13.3;
Japan, 6.6. We only give 4.1 percent of GDP to our senior
citizens, the lowest of all these countries except for the U.K.
In the year 2050 it is going to get worse in terms of the U.S.
And I might just point out also that in terms of the
industrialized countries of the world, the United States has
three times the rate of poverty in senior citizens than these
other countries. And so I don't think that we are spending too
much money on our senior citizens. I think, on the contrary,
that perhaps we have a ways to go.
And maybe these other countries have to do something
because they are spending a generous sum on their senior
citizens, but we are not. In fact, if we cut Social Security,
we would put 60 percent of the American senior citizen
population into poverty.
In conclusion, Mr. Chairman, and I really appreciate this
hearing, but I know we are going to have somebody from
Prudential here today, Mr. Bedell-Pearce, and I would like him
to explain some of the issues that perhaps I won't have an
opportunity to ask him, but he should explain this. He calls
it, I guess, mis-selling that occurred in England in the late
'nineties. And I just read here a statement that--if I can find
it--I have it right here. Here it is. This is from the Guardian
of August 10, 1998. I quote:
``Britain's biggest life insurer, the Prudential, was the
center of a new controversy last night after a Guardian
investigation revealed it is continuing to attempt to mis-sell
petitions. When approached by Guardian investigators,
Prudential agents (1) attempted to sell policies that maximized
their earnings for their salespersons and the company; (2)
recommended poorer value pensions; (3) quoted future growth
figures banned by the Financial Services Act; and (4) showed
potential customers deliberately misleading competitors'
statistics.''
And I conclude by making this. Just 2 weeks ago the
statement in a British newspaper stated:
``Ministers are concerned''--that is, the finance ministers
are concerned--``that the financial problems of Equitable Life
Pensioners could deliver a blow to the government stakeholder
pensions.'' That is the second tier pension system. ``About 1
million Equitable policyholders saw the value of their pension
funds cut by 16 percent this week.'' That is the private sector
pension program. ``It certainly will not help us convince
people to save if a big household name is cutting the value of
its funds, but we believe it is an isolated case,'' one
official said.
And perhaps you can comment on that. It is kind of
interesting that we have somebody who benefits from private
pension programs or privatization testifying on behalf of it,
but there is nothing wrong with it, I suppose.
But in any event, I look forward to this hearing, Mr.
Chairman, and look forward to the witnesses, and certainly the
continuing debate on the issue of whether we should carve out
16 percent of Social Security payroll taxes and divert them to
other sources to reduce the senior citizens' pension benefits
and Social Security benefits.
[The following was subsequently received:]
Prudential plc
London, England
On the first point, the congressman referred to pensions mis-
selling that took place in the ``late nineties'' and cited an article
appearing in the UK newspaper ``The Guardian'' in 1998 where it was
alleged that a Prudential representative had offered bad advice in
relation to a pension product and where it was alleged that the
salesman was motivated by potential commission earnings.
The oversight mechanisms introduced by Prudential and the rest of
the industry after 1994 mean that there should not be a reoccurrence of
product mis-selling but the conclusion reached by both the industry and
the Government was that the more satisfactory approach is the regulate
the product itself. With the new Stakeholder pension introduced in
April of this year, the maximum management charge has been restricted
to not more than 1% per annum and there are further rules on the shape
and nature of the product.
As for the Guardian article in question, I am happy to clarify that
Prudential expressed concern about the contents and met the Guardian to
discuss the background. Despite Prudential and the regulator (The
Financial Services Authority) requesting transcripts, the Guardian was
unable to produce any supporting evidence to substantiate the
allegation. Equally importantly, the alleged incident refers, not to a
sale, but to a ``fact finding'' meeting the first stage of the early
process, a process which, since 1995, had been subject to ``second pair
of eyes'' independent oversight. We are confident that no sale would
have been completed in this particular case.
On Equitable Life, the problems of this, the UK's oldest mutual
life company, were truly unique to that company and resulted primarily
from a combination of the issue of guarantees on certain policies which
required reducing payments on non-guaranteed policies because the
financial reserves of the mutual were inadequate. The Equitable case
underlines the dangers of open-ended guarantees and provides an
important warning to both commercial and State providers alike. Far
from diminishing confidence in pensions or the life industry in
general, sales of life products by other life companies have increased
substantially since Equitable's problems emerged.
In short, neither pensions mis-selling nor the problems of
Equitable can be cited as legitimate reasons to avoid the creation of
individual accounts for retirement if the lessons of product regulation
and the inadvisability of guarantees are taken on board. The UK
government has had no hesitation in launching the new generation of
Stakeholder pensions in partnership with the UK insurance industry, a
partnership which is supported by both the public and the trade unions.
Indeed, the Trades Union Congress (the representative body for unions
in the UK) has appointed Prudential as its exclusive provider of
stakeholder pensions for arrangements set-up by its Member unions.
Yours sincerely,
Keith Bedell-Pearce
Executive Director
Chairman Shaw. I would like to just briefly reply, and I
don't want this to be a battle of opening statements, and any
other Members that----
Mr. Matsui. Mr. Chairman, can we go by regular order. I
don't mind that, but then I wish to have an opportunity to
reply. That is fine.
Chairman Shaw. Oh, yes, but I just want to make one point
very clear. Last year Mr. Archer and I did meet with Mr.
Gephardt and Mr. Hastert. We did meet with Mr. Rangel. I don't
recall whether you were in those specific meetings. I think you
were, but maybe I am wrong about that. And I would certainly
accept your challenge to meet again. I think that is a very
good suggestion, and I will be glad to repeat that and meet
again.
Now, if you want to reply----
Mr. Matsui. The only thing I would reply, I was in one of
the meetings, Mr. Chairman, and at that meeting the Archer-Shaw
bill was presented to us as the approach we needed to take. I
recall Mr. Archer saying that this is the way we have to go. It
wasn't really a discussion of negotiations. It was the
discussion of whether we could support that bill.
My problem with your bill was the fact that by 2033 we
would have had to borrow from the general fund, if there was a
general fund surplus, $11.7 trillion, and I didn't think that
that was something that was supportable by your own party. In
fact, Mr. Hastert kind of backed away from it at that time and
the meeting was terminated.
Chairman Shaw. Well, I would say that is totally incorrect.
But in any event, your recollection is totally flawed, and I
will supply you with the numbers of what the Archer-Shaw bill
would have done.
I would like at this time to yield to Mr. Camp for purposes
of introducing one of our panelists this morning.
Mr. Camp. I thank the Chairman for yielding, as I am not a
Member of this Subcommittee. And as the gentleman from
California and I have discussed, I am sure that the person I
would like to introduce will certainly attempt to answer your
concerns later on.
But I just want to say that I attended a seminar with Keith
Bedell-Pearce, who is chairman of Prudential and also
affiliated with Jackson National Life, which brings income
security to many Americans as well as people of the State of
Michigan. And his knowledge of the public-private partnership
in place in the United Kingdom to address retirement security I
think will be of some help to this Subcommittee, and I look
forward to hearing his testimony and to hear his insights on
the pension system in the United Kingdom, so that as we go
forward on this very important debate, that we have at least
the knowledge of experts from around the world on this subject.
And I certainly welcome the entire panel, as well. We have
got a number of distinguished visitors, as well as David
Harris, who I have met before and attended seminars with, as
well. So I look forward to hearing the testimony this morning,
and thank the Chairman for his indulgence.
Chairman Shaw. Thank you, Mr. Camp.
And to introduce the other witnesses, some of whom have
already been partially introduced: Paul Hewitt, who is the
director of Global Aging Initiative, the Center for Strategic
and international Studies, welcome; Gary Burtless, who is a
senior fellow at the Brookings Institute; Edward Palmer, who is
the chief, Research and Evaluation, National Social Insurance
Board in Stockholm, Sweden; Peter Orszag, Dr. Peter Orszag--and
if I am mispronouncing your name, you can correct me when it is
your turn--who is the president of the Sebago Associates in
Belmont, California; Mr. Rodriguez, who is assistant director,
Project on Global Economic Liberty at the Cato Institute, and I
might add here at this particular point, I believe Chile had a
Social Security system over 10 years before the United States
did, so they have been very progressive in that area; and Mr.
David Harris, who is a consultant, Watson Wyatt Worldwide, at
Reigate--am I pronouncing that correctly?
Mr. Harris. Reigate.
Chairman Shaw. Reigate, Surrey, United Kingdom.
Welcome, all of you. We have all of your full statements
that will be made a part of the record. You may proceed and
summarize as you see fit. Mr. Hewitt?
STATEMENT OF PAUL S. HEWITT, DIRECTOR, GLOBAL AGING INITIATIVE,
CENTER FOR STRATEGIC AND INTERNATIONAL STUDIES
Mr. Hewitt. Mr. Chairman, in 1999 CSIS undertook a
multiyear research program to assess the economic and financial
consequences of population aging throughout the developed
world. Our work began with the recognition that America is not
the only nation that faces a sharp rise in old-age dependency
over the coming decade.
The whole industrial world is aging, most of it a lot more
rapidly than we are. The transition economies of the former
Soviet bloc are aging faster than we are, and even such key
emerging market countries as China, Korea, Taiwan, Thailand,
Brazil, and Chile can all expect to have older age structures
than we will by mid-century.
Given these trends, it is not surprising to find ourselves
in the midst of a global revolution in pension reform. This
common challenge holds great dangers for the global economy,
not least because financial catastrophe in any one nation could
tip others into crisis. But one advantage it gives us is that
there is a rich record of reform from which we can draw.
Franklin Roosevelt liked to call State governments the
laboratories of democracy, and the same could be said today of
national governments the world over. Our own research effort,
the Global Aging Initiative, is evidence of this cross-national
trend. Overseeing our work is a panel of 86 leading voices from
three continents, reflecting an extraordinary diversity of
political perspectives.
I am proud to note that both you, Mr. Chairman, and
Congressman Matsui serve on the Global Aging Commission,
together with five other Members of Congress from both sides of
the aisle and seven current or former cabinet ministers from
the EU and Japan. Another Member of the commission is also
present on the dias today, Mr. Pomeroy. Thank you for
participating in our project.
Two overarching points can be made about the revolution in
pension reform. First, it is not driven by ideology. In Italy,
pension reform has been spearheaded by the New Democratic Party
of the Left, formerly known as the Italian Communist Party.
Germany's individual account law was recently pushed through
the Bundestag by Gerhard Schroeder's center-left coalition of
Socialists and Greens. These reforms have been nicknamed the
``Riester reforms'' after Labor Minister Walter Riester, the
former deputy national chairman of Germany's largest industrial
union, IG Metall.
Some of the other Social Security reforms to be examined in
this panel today were also championed by parties of the left.
In every case, reform has reflected a pragmatic, non-
ideological response to developments that now threaten
sustainability of retirement systems everywhere.
The second observation that can be made is that retirement
insecurity in the industrial world today stems from social
insurance itself. It doesn't matter whether you are in Austria,
Belgium, Greece, or Japan, public opinion polls reflect the
same overwhelming fear among the young and middle-aged that
social security will not be there for them when they retire.
This is not some international fad that will go away if we
ignore it. By 2030, old age dependency ratios in Japan, Canada,
and the major continental European countries are projected to
roughly double, while in the U.S. this ratio will rise by
somewhere between two-thirds and three-quarters. In every case,
serious funding problems lie ahead.
In order to insure against this new insecurity, governments
are having to work with the private sector. Increased reliance
on funding underlies all of the major Social Security reforms
of the past decade. Funded pensions, essentially retirement
savings plans, have two key advantages over pay-as-you-go
intergenerational transfers.
First, they are not directly affected by changes in the
old-age dependency ratio. Whereas a declining ratio of workers
to retirees immediately signals the need for higher taxes or
reduced benefits, funded systems are only indirectly affected
by population aging through structural changes to the broader
economy.
A second advantage to funded pensions is that cross-border
investment can shield individual retirement security from
adverse national economic trends. This is an important
consideration in countries where labor forces are expected to
decline for the foreseeable future.
America's working-age population is projected to grow by
about 11 percent between now and 2030. Most of this will come
before 2010. But decades of below-replacement birth rate has
left much of Europe and Japan facing substantial declines in
both labor forces and total populations. It was mentioned
earlier that Japan's Health and Welfare Ministry recently
estimated that at current birth rates, there will be just 500
Japanese left by the year 3000. I think that number is around
1,000 by the year 2500. It tails off. But in Italy, Spain,
Bulgaria, a whole series of other countries, birth rates are
even lower. They have been projected to come up for a long
time, for decades now, and they have gone in the other
direction.
Over the next 10 years these demographic trends will begin
to adversely affect our economies. Surging numbers of workers
have accounted for between one-half and two-thirds of the rise
in the developed world's output over the past half century. In
future, declining labor forces are forecast to subtract 1
percent a year or more from the economic growth rates in some
countries.
Pension funding will allow citizens in Europe and Japan to
invest in multinational companies whose operations inevitably
will shift to faster-growing markets abroad. In this way, the
global economy provides an important resource for the aging
nations of this world, but it is only a resource to nations
that fund their pensions.
There is a lot we can learn from the reforms adopted in
other nations. The UK has a voluntary savings scheme that
becomes compulsory once you select it. Australia, Chile,
Sweden, have adopted compulsory savings schemes. Each has its
own contribution levels and unique fiduciary rules,
administrative structures, and contingent guarantees. The
experiences of these and the many other countries that have
moved toward pension funding in recent years should be closely
examined as part of any Social Security reform effort.
Of course, as was mentioned, compared to most other
industrial countries, America is aging less rapidly; our Social
Security benefits are less generous; our private pension system
is more robust; and we continue to be the most favored
destination for capital and talent the world over. Our
situation, though still serious, is less dire, and this gives
America important competitive advantages in the global economy.
But we will squander these advantages if we fail to learn from
other nations whose situation is different from ours only in
degree.
Thank you.
[The prepared statement of Mr. Hewitt follows:]
Statement of Paul S. Hewitt, Director, Global Aging Initiative, Center
for Strategic and International Studies
Mr. Chairman, in 1999, CSIS undertook a multi-year research program
to assess the economic and financial consequences of population aging
in the developed world. Our work began with the recognition that
America is not the only nation that faces a sharp rise in old-age
dependency over the coming decades. The whole industrial world is
aging--most of it, a lot more rapidly than we are. The transition
economies of the former Soviet bloc are aging faster than we are. And
even such key emerging market countries as China, Korea, Taiwan,
Thailand, Brazil and Chile can all expect to have older age structures
than we will by mid-century. Given these trends, it's not surprising to
find ourselves in the midst of a global revolution in pension reform.
This common challenge holds great dangers for the global economy, not
least because fiscal catastrophe in any one nation could tip others
into crisis. But one advantage of global aging is that it has given us
a rich record of reform from which to draw.
Franklin Roosevelt liked to call state governments the laboratories
of democracy. The same could be said today of national governments the
world over.
Our own research effort, the Global Aging Initiative, is evidence
of this cross-national trend. Overseeing our work is a panel of 86
leading voices from three continents, reflecting an extraordinary
diversity of political perspectives. Our co-chairmen are former Vice
President Walter Mondale, former Prime Minister Ryutaro Hashimoto and
former Deutsche Bundesbank President Karl Otto Pohl. In addition to
seven current or former cabinet ministers from Europe and Japan, seven
senior members of Congress--four Democrats and three Republicans--serve
on the Commission on Global Aging. I am proud to note that both you,
Mr. Chairman, and Congressman Matsui, the ranking member of this
subcommittee, are Commission members.
Two overarching points can be made about the revolution in pension
reform. First, it is not driven by ideology. In Italy, pension reform
has been spearheaded by the New Democratic Party of the Left--formerly
known as the Italian Communist Party. Germany's individual account law
was recently pushed through the Bundestag by Gerhard Schroeder's
center-left coalition of Socialists and Greens. These reforms have been
nicknamed the ``Riester reforms'' after Labor Minister Walter Riester,
the former deputy national chairman of Germany's largest industrial
union, IG Metall. Some of the other social security reforms to be
examined in this panel today also were championed by parties of the
left. In every case, reform has reflected a pragmatic, non-ideological
response to developments that now threaten the sustainability of
retirement systems everywhere.
The second observation is that retirement insecurity in the
industrial world today stems from social insurance itself. It doesn't
matter whether you are in Austria, Belgium, Greece or Japan, public
opinion polls reflect the same overwhelming fear among the young and
middle-aged that social security will not be there for them when they
retire. This is not some international fad that will go away if we
ignore it. By 2030, old-age dependency ratios in Japan, Canada and the
major continental European countries are projected to roughly double,
while in the U.S., this ratio will rise by somewhere between two-thirds
and three-quarters. In every case, serious funding problems lie ahead.
In order to insure against this new insecurity, governments are
having to work with the private sector. Increased reliance on funding
underlies all of the major social security reforms of the past decade.
Funded pensions--essentially, retirement saving plans--have two key
advantages over pay-as-you-go intergenerational transfers. First, they
are not directly affected by changes in the old-age dependency ratio.
Whereas a declining ratio of workers to retirees immediately creates
the need for higher taxes or reduced benefits, funded systems are only
indirectly affected by population aging through structural changes in
the broader economy.
A second advantage of funded pensions is that cross-border
investment can shield individual retirement security from adverse
national economic trends. This is an important consideration in
countries where labor forces are expected to decline for the
foreseeable future. America's working-age population is projected to
grow by about 11 percent between now and 2030--most of this coming
before 2010. But decades of below-replacement birthrates has left much
of Europe and Japan facing substantial declines in both labor forces
and total populations. Japan's Health and Welfare ministry recently
estimated that, at current birthrates, there will be just 500 Japanese
left in the year 3000. In Italy, Spain, Greece and several other
nations, birthrates are even lower.
Over the next decade, these demographic trends will begin to
adversely affect our economies. Surging numbers of workers have
accounted for between one-half and two-thirds of the rise in the
developed world's output over the past half century. In the future,
declining labor forces are forecast to subtract one percent a year from
economic growth rates in some countries. Pension funding will allow
citizens in Europe and Japan to invest in multinational companies whose
operations inevitably will shift to faster-growing markets abroad. In
this way, the global economy provides an important resource for the
aging nations of this world. But it is only a resource to nations that
fund their pensions.
There is a lot that we can learn from the reforms adopted in other
nations. Great Britain, Australia, Chile, and Sweden have adopted
compulsory savings schemes, each with their own contribution levels and
unique fiduciary rules, administrative structures, and contingent
guarantees. The experiences of these and the many other countries that
have moved toward pension funding in recent years should be closely
examined as part of any U.S. Social Security reform effort.
Of course, compared to most other industrial countries, America is
aging less rapidly; our social security benefits are less generous; our
private pension system is more robust; and we continue to be the most
favored destination for capital and talent the world over. Our
situation, though still serious, is less dire, and this gives America
important competitive advantages in the global economy. But we will
squander these advantages if we fail to learn from other nations whose
situation is different from ours only in degree.
Information on the Global Aging Initiative can be found at
www.csis.org/gai.
Chairman Shaw. Thank you, Mr. Hewitt.
Mr. Burtless.
STATEMENT OF GARY BURTLESS, SENIOR FELLOW, BROOKINGS INSTITUTE
Mr. Burtless. Thank you very much. I am honored by the
invitation to participate in this hearing. The goal of the
hearing, as I understand it, is to learn what other countries
can teach us about operating a national system of individual
retirement accounts.
My written testimony concludes with an overview of these
issues, and I describe some basic principles about designing
such a system, principles that are based upon experiences
overseas and here in the United States. I have done research in
this area over the past 15 years. I am also guilty of co-
authoring a book on U.S. Social Security reform and another one
on the pension crisis in the five biggest industrial countries.
But my interest in this subject is not just academic. Over
the past decade I have also advised a number of countries on
how they can reform their pension programs to make them more
solvent and protect the retirement incomes of their workers.
Perhaps imprudently, a couple of these countries have even
adopted some of this advice.
My oral statement, however, is not going to focus on the
technical issues connected with how to design a safe and
efficient individual account system. Instead, what I want to do
is talk about a more basic question: Is the decision of other
countries, like Chile or Sweden, Australia or Great Britain, to
adopt an individual account system, really very informative
about whether this would be a good idea for us?
The experiences with their new systems may be helpful in
guiding the design of a similar system here in the United
States, but do they really tell us whether such a system would
be a good idea here? I don't think so. In the next couple of
minutes, what I want to do is mention three key differences
between the United States and countries that have made
individual accounts part of their system. The differences make
individual accounts less compelling for us than they are in
these other countries.
First of all, compared with the situation in other
industrial countries, the funding problem in Social Security is
not particularly severe. One reason is that the American
population is younger and is expected to remain younger than
the populations of the other rich industrialized countries.
This makes the traditional pay-as-you-go financing method more
affordable for the United States than it is elsewhere.
Congress has also been much more cautious about
liberalizing pensions than legislatures in other countries.
Even if we faced the same aging problem as France, Germany, or
Sweden, our financing problem would be smaller because our
basic benefits are less generous and often start at a later
age.
Incidentally, this also distinguishes us from Chile and
other Latin American countries which have adopted individual
accounts. The old pension systems in those countries often
provided unaffordably generous benefits to favored groups in
the population. Imprudent benefit expansions and widespread tax
evasion made the old systems insolvent. The United States,
fortunately, has never faced those problems.
Table 1 in my testimony gives you details about the
demographic outlook and the public pension imbalances in the
seven largest industrial countries. You will notice that the
current U.S. pension system is in much better shape than the
equivalent systems in most of the other G-7 countries, with the
important exception of Great Britain.
A second factor distinguishing our situation from that in
other countries is that we already have a well-developed system
of individual and company pensions. To an extent that people
often forget, the United States has a retirement system built
in part on voluntary contributions by employers and their
workers to company pension plans and to individual pension
plans. More Americans are covered by employer and individual
pension plans than is the case in most of the rest of the
industrialized world.
There are some countries like the Netherlands and
Switzerland where participation is even higher than in the
United States, but we have a very high rate of participation
already. Over half the U.S. work force is covered by an
employer pension plan, and the percentage is higher still if
you restrict your attention to people who are adults in full-
time jobs and who have held their job for at least 1 year.
Thus, the case that our retirement system has a big hole
because we lack a system of private funded pensions completely
misses a big part of our existing system. Employers and
Congress have been busy over the past half century in
developing a private pension system, and then assuring that it
is reasonably safe, that it is transparent, that it is well-
regulated, and that it is nondiscriminatory.
I mentioned earlier that the U.S. has been more cautious
than other countries with regard to liberalizing benefits. This
holds down the cost of our basic system. An unwelcome side
effect is that the United States has a much higher rate of old
age poverty than the other rich countries. This brings up a
third big difference between us and other industrial countries.
The sorry facts are presented in Chart 1 of my testimony.
Among the 15 rich industrial countries where comparable
evidence can be assembled, only Australia has a poverty rate
among the elderly as high as ours. If you take out the United
States and look at the rest of the countries, our rate is more
than three times higher than that of the rest of the
industrialized world.
Now, to me this is relevant to thinking about how we should
fix our Social Security system. I don't think you want to take
out funds from the system that does more than any other program
to hold down the poverty rate among the elderly in the United
States, and put those funds in a system of voluntary pensions.
Anything that diverts funding from the basic pension program is
something that I think in the long term is going to threaten
the well-being of workers who have low or erratic earnings.
Thank you.
[The prepared statement of Mr. Burtless follows:]
Statement of Gary Burtless,* Senior Fellow, Brookings Institution
International Evidence on the Desirability of Individual Retirement
Accounts in Public Pension Systems
Summary
Social Security faces a long-term financing problem. The simplest
and most logical solution to this problem is to trim promised benefits
and increase payroll taxes modestly over the next two decades. These
steps are politically unpopular, however, which explains the growing
interest in supplementing or replacing traditional Social Security with
a new system of worker owned and directed retirement accounts. A number
of countries have already moved in this direction. However, the
introduction of private accounts, by itself, does not solve the long-
term problem facing public pension systems, including the Social
Security system.
---------------------------------------------------------------------------
* The views expressed are solely my own and should not be ascribed
to the staff or trustees of the Brookings Institution.
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Some people who favor individual accounts believe we can learn from
the experience of countries that have adopted such a system. While this
is true, it is more pertinent to ask whether the experience of other
countries sheds any light on the wisdom of replacing traditional Social
Security, in whole or in part, with a system based on individual
retirement accounts. The United States' situation differs significantly
from that of other countries which have recently adopted individual
account systems.
In comparison with most of the industrialized world, the United
States does not face an acute funding crisis in its main public pension
program. The Social Security system is better financed than pay-as-you-
go systems in most other industrialized countries. The U.S. has a
younger population than other developed countries, and the trend toward
a grayer population is proceeding more slowly in the United States than
it is elsewhere. If current immigration and fertility patterns
continue, the fraction of Americans who are past the retirement age
will never reach the levels expected in Japan and most of Western
Europe.
One reason Social Security's financial position is comparatively
healthy is that benefits are relatively low. As a result, the tax
needed to pay for promised benefits after the Baby Boom generation
retires will be lower than the current payroll tax rate needed to pay
for benefits in other countries.
The relatively modest level of Social Security benefits causes the
United States to be different from other countries in one crucial
respect. Our old-age poverty rate is more than three times the poverty
rate in other rich nations. Social Security pensions account for an
overwhelming fraction of the income received by aged Americans who are
at risk of becoming poor. We therefore face a much greater risk than
other wealthy countries of pushing large numbers of the aged into
poverty if we reduce the guaranteed pensions available to low-wage
workers.
The United States also has less need for introducing individual
account pensions. A large percentage of the workforce already
participates in employer-sponsored plans or in voluntary individual
retirement accounts. In comparison with most of the industrialized
world, the assets accumulated in these plans represent an unusually
large percentage of our national wealth. Though it is desirable to
increase the percentage of workers who participate in individual
retirement saving plans, it makes no sense to accomplish this worthy
goal by weakening the retirement income protection and guaranteed
benefits available to workers who have low or intermittent career
earnings.
The crisis in public pension systems
The populations of the United States and other industrial countries
are certain to grow older over the next five decades. By 2050 the ratio
of people past age 64 relative to the number age 20-64 will exceed 45
percent in each of the seven largest industrial countries except the
United States. In Germany, the aged dependency ratio will approach 55
percent; in Italy, it may reach 75 percent. Even though the United
States will not age as fast, the American dependency rate is expected
to be four-fifths higher in 2050 than it is today, rising from 21
percent to 38 percent (see Table 1).
The projected budget cost associated with population aging is so
large that most countries will be forced to make painful changes in
their public pension programs. Policymakers may be tempted to follow
the example of Chile and replace part or all of their national pension
systems with private systems organized around individual retirement
accounts. Advocates of this kind of reform point to Chile's success in
introducing an individual account system to replace its failing pay-as-
you-go system, which the government began to phase out in the early
1980s. So far, Chile's individual account pension system has received
high marks for sound administration, good returns, and broad political
acceptance. The expected surge in public retirement costs in rich
industrialized countries has made policymakers in many countries
receptive to the idea of including individual investment accounts in
their nations' public retirement systems.
A number of countries in Western and Central Europe, in Latin
America, and on the Pacific Rim have enacted major reforms in the past
decade. A partial list includes Sweden, Germany, and Italy in Western
Europe, most of the transition countries in Central Europe, Argentina,
Mexico, and Uruguay in Latin America, as well as Australia, Canada, and
Japan. Some countries decided to introduce voluntary or compulsory
individual retirement accounts as part of their reforms. Others focused
on overhauling the pay-as-you-go component of their existing public
systems. The United States can learn lessons about reform from the
experiences of other countries. The successes and failures of other
countries can guide us in the design and administration of an
individual retirement account system, if we choose to adopt such a
system. But before considering these lessons, it is important to
consider whether the decision of other countries to adopt individual
account systems is really informative about whether that choice is
sensible for the United States.
Differences in the outlook for public pensions. The United States
differs in significant ways from countries that have moved toward
individual retirement systems. Some differences would make it easier to
introduce individual accounts, but many would make it much less
advantageous to do so. In comparison with public retirement systems in
most other rich countries, the U.S. Social Security system places much
smaller burdens on active workers. There are three main reasons for
this.
First, a relatively high birth rate and a high rate of immigration
mean that the American work force will continue to grow far into the
future. This difference with most of the rest of the industrialized
world implies that a pay-as-you-go retirement system can provide
pensions at a lower contribution rate than will be possible in other
rich countries. The working-age population is growing slightly faster
than 1 percent a year in the United States. It is already shrinking in
Japan, and it will soon begin to decline in many other industrialized
countries. The financing problem facing pay-as-you-go pension systems
is thus less serious in the United States than it is in other rich
countries.
Compared with national pension systems in many other countries,
especially developing countries, the U.S. Social Security system is
less costly to administer. Collection of payroll contributions is
closely integrated with collection of the personal and corporation
income tax, making contributions less costly for the government to
collect and for employers to pay. There is a high rate of voluntary
compliance with Social Security contribution requirements, in contrast
with the situation in some other countries where workers and employers
frequently evade contribution requirements, increasing the burden on
employers and workers who honestly pay the required contribution.
Finally, the Social Security Administration is more efficient than
counterpart agencies in many other countries. Only about 1 percent of
American workers' contributions are consumed in the administration of
Social Security, leaving 99 percent of contributions for benefit
payments and investments in pension reserves. Not only is the Social
Security Administration efficient in comparison with public pension
agencies in most other countries, it is remarkably efficient in
comparison with private insurance and pension companies in the United
States that perform similar functions.\1\
---------------------------------------------------------------------------
\1\ Excluding the cost of the disability program, the cost of
administering Social Security is about $10 per person per year. This
estimate is based on 1997 administrative costs of $2.1 billion and
182.6 million participants--145 million workers and 37.6 million
beneficiaries. Peter Diamond estimates that the administrative cost of
the U.S. Social Security system is only one-third to one-twelfth of the
equivalent cost of administering private pension plans. (NBER Working
Paper No. 4510, National Bureau of Economic Research, Cambridge, MA,
1993)
---------------------------------------------------------------------------
A third reason the pension financing problem is less severe in the
United States is that the basic benefits provided by Social Security
are lower in relation to wages than benefits provided by most other
national pension systems. Because benefits are lower relative to
average wages in the United States, the contribution rate needed to pay
for them is also lower. Congress has historically been more cautious in
raising average benefits than legislatures in other industrial
countries. Faced with the prospect of a long-term funding problem in
Social Security, the United States was the first major country to
increase its normal pension age. Congress raised the normal retirement
age from 65 to 67 under the Social Security Amendments passed in 1983.
Around that same year, governments in several West European countries
were revising their pension and unemployment insurance programs to make
it easier for workers between 55 and 64 years old to collect early
pensions. This step was taken to alleviate Europe's worsening
unemployment problem, but it added to the long-term financing problem
faced by their public pension systems.
Table 1 summarizes the demographic outlook and pension fund
challenges facing the seven largest industrial countries. The first
three columns show the U.S. Census Bureau's estimates of old-age
dependency rates in 2000, 2025, and 2050, respectively. High rates of
fertility and immigration give the United States the lowest predicted
dependency rate in 2025 and 2050. The comparatively low dependency rate
combined with a modest level of pensions also give the United States
the lowest level of spending on public pensions, measured as a
percentage of GDP (column 4). Although pension spending will increase
in the future, it will remain substantially lower than spending in the
other G-7 countries, with the notable exception of Great Britain (see
column 5). Revisions of the British pension system enacted in the 1980s
will cause basic pensions to rise more slowly than average wages,
almost guaranteeing that pension outlays will eventually shrink as a
share of national income--assuming the current British system survives
unchanged until 2050. Along with Britain's public pension system, the
American Social Security system has the smallest gross and net
liabilities (columns 6 and 7).
Low benefits and high poverty
The modest basic pension guaranteed by the U.S. system gives rise
to a problem that is unusual in rich industrialized countries--a high
poverty rate among the aged. Chart 1 shows poverty rates among the
elderly in sixteen rich countries. The countries provide micro-census
information to the Luxembourg Income Study in a way that allows
researchers to calculate poverty rates in consistent way. I classify
someone as poor if he or she is a member of a household that receives
less than 40 percent of his or her country's median household
income.\2\ (Household income includes cash and near-cash income, such
as food stamps, but payments for income and payroll taxes are
subtracted. Reported incomes are adjusted to reflect differences in
household size.) Under this definition, the old-age poverty rate in the
United States is 12 percent--more than three times the average rate in
the other 15 countries. Only Australia has an old-age poverty rate that
is as high.
---------------------------------------------------------------------------
\2\ For purposes of comparison, the official U.S. poverty line for
a four-person family was 42 percent of median household income in 1999.
---------------------------------------------------------------------------
A principal goal of national pension systems, including ours, is to
minimize poverty among the retired elderly. In view of the
exceptionally high poverty rate of America's elderly, we should be more
cautious than other countries in reforming our system in a way that
threatens to reduce the guaranteed pensions available to workers who
have low lifetime earnings. About 9 percent of aged Social Security
recipients are poor under the official U.S. poverty definition. The
Social Security Administration estimates that 48 percent of recipients
would be poor if they did not receive Social Security benefits. Social
Security pensions provide about four-fifths of the money income
received by elderly Americans in the bottom 40 percent of the aged
income distribution. For many of these aged Americans, the monthly
benefits provided by Social Security are simply too low to remove them
from the ranks of the poor. Any reform of the U.S. retirement system
should be designed to prevent old-age poverty rates from rising even
further above the rates in the rest of the industrialized world.
Private pensions
The United States differs from many other rich countries in having
a well-developed system of funded private and employer-sponsored
pensions. Slightly more than one-half of all active workers in the
United States, including a large majority of the best paid employees,
are already covered by an employer-sponsored plan.\3\ By law, employer-
sponsored plans are fully funded. In addition, many workers make
voluntary contributions to Keogh plans (for the self-employed), 401(k)
or 403(b) plans (for private company and nonprofit institution
employees), or Individual Retirement Accounts (primarily for employees
not covered by an employer pension plan). Private and employer-
sponsored pension plans now provide at least one-sixth of older
Americans' nonwage incomes, and this fraction is certain to rise as an
increasing share of workers reach retirement after long careers in
pension-covered jobs.
---------------------------------------------------------------------------
\3\ Among working American families in which the head of household
is less than 65 years old, 57 percent of families have at least one
member who participates in an occupational pension plan (EBRI, 2000).
---------------------------------------------------------------------------
Private and employer-sponsored pension plans cover a large
percentage of active U.S. workers. As a result, these plans have
accumulated more assets than private plans in most other industrial
countries (see right-hand column in Table 1). Among the seven largest
industrial countries, only the United Kingdom has accumulated such a
large stock of savings in private pension plans. In comparison with the
situation in most other G-7 countries, the U.S. pension system already
relies to an unusual degree on private pensions funded with the
voluntary contributions from workers and their employers.
Our long experience with funded employer-sponsored and individual
pensions provides a healthy environment for extending individual
pensions to a bigger share of the work force. The rapid expansion of
401(k) and IRA participation after 1980 shows that many American
workers are comfortable with a major role in directing their own
retirement saving. Most large employers offer sound retirement saving
options to workers, and many have developed excellent education
programs to inform their workers of the pros and cons of different
investment options.
In addition, the United States is fortunate in having one of the
world's best developed and most efficient capital markets. It has well
regulated financial securities markets and well established
institutions for providing financial services. Banks, insurance
companies, and mutual fund companies compete intensively for the
opportunity to manage workers' retirement savings. Unlike workers in
much of the rest of the world, Americans can choose among dozens of
firms willing to manage their retirement savings at reasonable cost.
But while the competitive and regulatory environment for individual
pension accounts is healthy, the need for introducing individual
retirement accounts as a component of Social Security is not very
compelling. Compared with the existing Social Security program, a
system of individual accounts would increase the administrative cost of
providing pensions, increase the exposure of workers to financial
market risk, and force many under-prepared workers to make choices
about the allocation of their retirement saving, exposing many to the
risk of making poor investment choices.
An important risk of an individual account system that is financed
with resources diverted from the existing system is that the guaranteed
public pension available to low-income workers would be reduced. This
risk is much greater if individual retirement accounts are established
with funds that have been diverted from the existing system. Most
voters recognize that the future payroll taxes available to finance
Social Security are not high enough to pay for promised future
benefits. To eliminate the difference between future resources and
future obligations, we must increase contributions or reduce benefits.
If we divert part of the current payroll tax to establish new
individual retirement accounts, benefits in the traditional program
will have to be cut even further. Unless the new retirement accounts
produce outstanding returns for low-wage contributors, many of them
will lose more in traditional Social Security pensions than they will
gain in benefits from their new accounts.
Investment risk in individual accounts
A common argument in favor of individual accounts is that they
would permit workers to earn a much better rate of return than they are
likely to achieve on their contributions to traditional Social
Security. I have heard it claimed, for example, that workers will earn
a negative real return on their contributions to Social Security, while
they could earn 8% to 11% on their contributions to an individual
retirement account if it is invested in the U.S. stock market.
This comparison is incorrect and seriously misleading. First, the
claimed return on Social Security contributions is unrealistically low.
Some contributors will earn negative returns on their Social Security
contributions, but on average future returns are expected to be between
1% and 2%, even if taxes are increased or benefits are reduced to
restore long-term solvency.
Second, workers will not have an opportunity to earn the stock
market rate of return on all of their retirement contributions, even if
Congress establishes an individual account system in the near future.
Workers' overall rate of return on their contributions to the
retirement system will be an average of the return obtained on their
contributions to individual accounts and the return earned on their
contributions to whatever remains of the traditional Social Security
system. For an average worker, this overall rate of return will be much
closer to the current return on Social Security contributions than it
is to 8%.
Advocates of individual retirement accounts often overlook the
investment risk inherent in these kinds of accounts. All financial
market investments are subject to risk. Their returns, measured in
constant, inflation-adjusted dollars, are not guaranteed. Over long
periods of time, investments in the U.S. stock market have outperformed
all other types of domestic U.S. financial investments, including
Treasury bills, long-term Treasury bonds, and highly rated corporate
bonds. But stock market returns are highly variable from one year to
the next. In fact, they are substantially more variable over short
periods of time than are the returns on safer assets, like U.S.
Treasury bills.
Some people mistakenly believe the annual ups and downs in stock
market returns average out over time, assuring even the unluckiest
investor of a high return if he or she invests steadily over a 20- or
30-year period. A moment's reflection shows that this cannot be true.
From March 2000 to March 2001 the Standard and Poor's composite stock
market index fell almost 30% after adjusting for changes in the U.S.
price level. The value of stock certificates purchased in March 2000
and earlier lost nearly one-third their value in 12 months. For a
worker who planned on retiring in 2001, the drop in stock market prices
between 2000 and 2001 would have required a major change in consumption
plans if the worker's sole source of retirement income depended on
stock market investments.
I have made calculations of the pensions that workers could expect
under an individual account plan using information about annual stock
market performance, interest rates, and inflation dating back to
1871.\4\ I start with the assumption that workers enter the workforce
at age 22 and work for 40 years until reaching their 62nd birthdays. I
also assume they contribute 2% of their wages each year to their
individual retirement accounts. Workers' earnings typically rise
throughout their careers until they reach their late 40s or early 50s,
when earnings begin to fall. I assume that the age profile of earnings
in a given year matches the age profile of earnings for American men in
1995 (as reported by the Census Bureau using tabulations from the March
1996 Current Population Survey). In addition, I assume that average
earnings in the economy as a whole grow 2% a year, the approximate rate
of the past few years.
---------------------------------------------------------------------------
\4\ Stock market data are taken from Robert J. Shiller, Market
Volatility (Cambridge, MA: MIT Press, 1989), Chapter 26, with the data
updated by Shiller and me.
---------------------------------------------------------------------------
The attached chart shows the replacement rate for workers retiring
at the beginning of successive years from 1911 through 2001. The
hypothetical experiences of 91 workers are displayed in this table. The
worker who entered the workforce in 1871 and retired at the beginning
of 1911, for example, would have accumulated enough savings in his
individual retirement account to buy an annuity that replaced 16% of
his peak lifetime earnings (that is, his average annual earnings
between ages 54 and 58). The worker who entered the workforce in 1961
and retired at the beginning of 2001 could purchase an annuity that
replaced 33% of his peak earnings. The highest replacement rate (39%)
was obtained by the worker who entered the workforce in 1960 and
retired in January 2000. The lowest (6%) was obtained by the worker who
entered work in 1881 and retired in January 1921. Nine-tenths of the
replacement rates shown in the chart fall in the range between 9% and
32%. The average replacement rate is 18%.
To see the impact of recent financial market fluctuations on
pensions, I calculated pension entitlements for workers who retired in
March 2000, when stock market prices reached an all-time peak, and in
March 2001, when stock market prices and bond yields had fallen
sharply. The worker who retired in March 2000 would have received a
pension that replaced 39% of his career high wage; the worker retiring
in March 2001 would have received a pension that replaced 25% of his
peak career wage. In other words, the pension replacement rate fell
more than one-third in just 12 months.
No one denies that a retirement saving account invested in U.S.
stocks offers workers the prospect of good returns on average. However,
a lesson to be drawn from results in Chart 2 is that defined-
contribution retirement accounts offer an uncertain basis for planning
one's retirement. Workers fortunate enough to retire when financial
markets are strong obtain big pensions; workers with the misfortune to
retire when markets are weak can be left with little to retire on. Even
in the four decades since 1960, the experiences of retiring workers
would have differed widely. The biggest pension was 2.7 times the size
of the smallest one. Social Security pensions have been far more
predictable and have varied within a much narrower range. For that
reason, traditional Social Security provides a much more solid basis
for retirement planning and a much more reliable foundation for a
publicly mandated basic pension.
Design lessons from foreign experience
If the nation adopts a system of individual accounts, the
experiences of other countries can help us choose a basic design and
administrative procedures that minimize program costs, assure broad
worker and employer compliance, and offer participating workers the
best possible combination of investment choice, financial safety, and
income protection. I have distilled some of the lessons from past
research in a box at the end of my testimony entitled ``Design
principles for individual account pensions.''
To my knowledge, no other nation has adopted an individual account
system that embodies all of these principles. I believe the design
choices made by policymakers in Chile, Australia, and the United
Kingdom can improved if individual retirement accounts are to play a
central role in U.S. Social Security reform. Whether it makes sense to
include such accounts in a reform of Social Security depends critically
on the level of funding that will remain to pay for the traditional
guaranteed pension. It makes no sense to introduce individual
retirement investment accounts if the accounts are funded with money
that is taken away from guaranteed traditional pensions for low- and
moderate-wage workers.
BOX: Design principles for individual account pensions
If the United States adopts a system of funded individual pension
accounts, Congress should take steps to reduce the administrative costs
of such a system and to increase the protections available to workers
and their survivors. These steps are highly desirable in any compulsory
system of individual accounts. Even if contributions to the new
individual accounts are voluntary, many components of the recommended
system will be needed if workers' contributions to the new system are
taken out of their contributions to the traditional Social Security
program.
First, contributions should be collected centrally,
preferably by the existing Social Security Administration. This
minimizes collection and enforcement costs compared with any
system that relies on decentralized collection and record-
keeping. The U.S. Social Security Administration is extremely
efficient at tax collection, record keeping, and pension
distribution. No private insurance or mutual fund company is
even remotely close. What is more important, its contributions
collection apparatus is already in place. Little modification
is needed for it to collect and keep records on workers'
pension contributions. More important still, every employer in
the nation who complies with the tax laws has already
established the tax collection and earnings record keeping
procedures needed to calculate and send contributions to the
Social Security Administration. This is particularly important
from the point of view of administrative costs, because most
small employers would find it very costly to establish new
contribution-collection procedures in addition to those they
have already established for income and payroll tax
withholding.
Second, the new pension system should offer
contributors a handful of alternative investment options, each
designed to be appropriate for retirement saving. For example,
each worker could choose among (1) Short-term interest-bearing
securities, such as U.S. Treasury bills; (2) Long- and medium-
term U.S. Treasury bonds; (3) Mortgage-backed marketable
securities; (4) Corporate bonds; (5) An index fund of U.S.
corporate stocks; (6) An index fund of European and Asian
corporate stocks; and (7) An index fund of stocks in
corporations that meet certain social standards (no arms
production, no alcohol or tobacco production, no genetically
modified food, etc.). The seventh option should be made
available in order to minimize political controversy around the
first six investment options. The great advantage of offering
workers investment choice is that each worker is permitted to
select a retirement saving portfolio that corresponds with his
or her preferences regarding financial market risk and return.
The enormous advantage of offering only a handful of options is
that it will be much easier to educate workers about the risk
and return characteristics of each option. In fact, when there
are few investment options, newspapers and electronic media
will perform this educational function at least once a year
(and possibly every week).
The Social Security Administration or other government
entity that is responsible for collecting contributions would
also be responsible for collecting and maintaining records
about workers' investment choices. In order to hold down
average administrative costs, workers should be allowed to
change their investment allocation only once every year for
free. They should be charged the full average cost for the
privilege of altering their investment allocation more
frequently than once a year. If the government is not informed
of the worker's investment choice, the portfolio allocation
should reflect an expert's assessment of the optimal allocation
given the worker's age (for example, twenty-year-olds might be
assigned an allocation of 80 percent U.S. corporate stocks and
20 percent corporate or U.S. Treasury bonds; workers near
retirement might be assigned an allocation that contains more
short-term securities and mortgage-backed securities and less
corporate equities). The administrative cost of managing the
system can be collected from workers as a percent of assets
under management or as a percent of workers' annual
contributions.
As soon as pension contributions are collected from
employers or self-employed workers, they should be invested
according to the allocation instructions of contributing
workers. Funds will often come to the government before it has
received investment instructions from contributing workers
(especially newly hired workers). In a centralized system, this
is not an important problem. If there are only seven investment
options, funds flowing in from employers can be allocated
according to historical proportions observed for typical
workers. The investment choices of individual workers have
little effect on that percentage allocation. The advantage of
this system is that contributions begin to earn appropriate
investment returns immediately.
Fifth, the U.S. Treasury should select private fund
managers to handle asset accumulation under each of the
investment options. Managing companies should be selected using
a competitive process that appropriately weighs the
qualifications of the bidding companies as well as the charges
that they propose to charge for managing the assets. Private
sector companies have become extremely efficient at managing
investment funds and deciding how to vote corporate shares in
their investment portfolios. It is hard to believe any entity
of the U.S. government could perform these functions more
effectively and at lower cost (though the U.S. Treasury could
efficiently manage short- and long-term government debt
portfolios that are restricted to U.S. Treasury securities). In
addition to being efficient, the private management of fund
accumulation offers an important political advantage. The
investments would not be directly under the control of a
government entity (although the choice of investment assets is
ultimately determined and regulated by Congress).
Sixth, upon retirement workers should be required to
convert a minimum percentage of their pension accumulation into
a monthly annuity payment. This minimum should be determined by
(1) the amount of traditional Social Security benefits
available to the worker and his or her spouse; and (2) the
amount of monthly income needed to make the worker ineligible
for means-tested Supplemental Security Income benefits. The
goal of this policy is to prevent workers from using up their
pension savings quickly and thereby becoming eligible for
means-tested benefits. If a worker has accumulated too little
savings in her retirement account to purchase an annuity that
renders her ineligible for SSI, the entire balance of the
account should be converted to an annuity upon retirement. If
the worker's traditional Social Security pension, by itself, is
high enough to render the worker ineligible for SSI, then
workers should not be forced to convert any part of it into an
annuity.
Seventh, the Social Security Administration should
handle the distribution of required annuity payments from the
new individual-account system. Compared with private companies,
it enjoys huge economies and vast experience in performing this
function. Equally important, because a single government entity
would be charged with converting pension accumulations into
annuities, it could offer actuarially fair annuities to all
older Americans, something that private insurance companies
cannot do because of the problem of adverse selection and the
requirement that the insurance company earn a market rate of
return on its operations. One important advantage of using the
Social Security Administration to convert pension savings into
annuities is that it is in a much better position than a
private firm to determine the minimum mandatory annuity
conversion that a worker is obliged to accept. As noted above,
workers should convert at least enough of their pension saving
into an annuity to prevent them from becoming eligible for
means-tested old-age benefits. The Social Security
Administration is in the best position to determine how much
annuity conversion is needed, because it has direct access to
information about the worker's traditional Social Security
pension. Another advantage of using a government entity for
annuity conversion is that it will be easier to require that
retired workers purchase annuities indexed to changes in
consumer prices. Private firms that offer such annuities might
go bankrupt or alternatively charge such high prices for
indexed annuities that retired workers are left with very
meager pensions.
Finally, after pension savings have been converted to
annuities by the Social Security Administration, the funds
collected from workers should be turned over to private fund
managers. These fund managers should be selected in the same
way as managers of the pension accumulation funds. However, in
this case the basic portfolio allocation should be selected by
an independent publicly appointed managing trustee. The
selection and tenure of the trustee should be designed to
provide insulation from political pressure and a reasonable
degree of independence. The United States has been quite
successful in protecting the political independence and
integrity of the Federal Reserve Board and its Chairman.
Similar procedures could be used to select and protect trustees
of the annuity reserve fund. The purpose of the fund is to
finance a stream of (indexed) annuity payments to an
identifiable group of workers. The portfolio should not be
selected by the individual workers, because they do not bear
the investment risk. Instead, the portfolio should be chosen by
the government, which ultimately bears the risk of poor
investment performance.
Table 1: Dependency Rates and the Outlook for Pensions in G-7 Countries
Percent
----------------------------------------------------------------------------------------------------------------
Aged dependency ratio [1] Public pension Private
--------------------------- expenditures/GDP Gross pension
[2] pension Net pension fund
Country ------------------ liabilities/ liabilities/ assets/
2000 2025 2050 GDP in 1994 GDP in 1994 GDP
1995 2050 [3] [4] 1994
[5]
----------------------------------------------------------------------------------------------------------------
Canada........................ 21 36 46 5.2 8.7 204 101 34
France........................ 27 40 51 10.6 14.4 318 102 4
Germany....................... 26 40 54 11.1 17.5 348 62 6
Italy......................... 29 43 75 13.3 20.3 401 60 2
Japan......................... 27 50 69 6.6 16.5 299 70 6
U.K........................... 27 37 50 4.5 4.1 142 24 68
U.S.A......................... 21 34 38 4.1 7.0 163 23 67
----------------------------------------------------------------------------------------------------------------
[1] The aged dependency ratio is the ratio of persons aged 65 and over to those who are 20-64. Source: U.S.
Census Bureau.
[2] Source: Roseveare et al. (1996). ``Ageing Populations, Pension Systems and Government Budgets: Simulations
for 20 OECD Countries.'' Economics Department Working Paper No. 168 (Paris: OECD).
[3] Gross pension liabilities are the discounted present value of future public pension payments. Source:
Roseveare et al. (1996).
[4] Net pension liabilities are calculated by subtracting the present value of future contributions from
discounted gross liabilities. Source: Roseveare et al. (1996).
[5] Source: E. Philip Davis (1997). ``Can Pension Systems Cope? Population Ageing and Retirement Income
Provision in the European Union.'' Special paper (London: Royal Institute of International Affairs).
[GRAPHIC] [TIFF OMITTED] T5603A.000
[GRAPHIC] [TIFF OMITTED] T5603A.001
Chairman Shaw. Thank you. Mr. Bedell-Pearce?
STATEMENT OF KEITH BEDELL-PEARCE, EXECUTIVE DIRECTOR,
PRUDENTIAL PLC, LONDON, ENGLAND
Mr. Bedell-Pearce. Mr. Chairman, just by way of
introduction, the Prudential is one of the largest U.K.
financial institutions. We have in the region of $70 billion of
pensions assets under management, which I suspect pales into
insignificance compared with, say, CALPERS, but it is about
twice the total assets under management in Chile under their
private arrangement. About 20 percent of the working population
of the United Kingdom in defined contribution schemes are
Members of Prudential's pensions arrangements, and about one in
four of the personal pensions in existence in the U.K. are with
the Prudential.
I should also explain that we are no relation of Prudential
Insurance Company of America. That company was set up in the
1870s, and the Prudential's board at that time gave Prudential
Insurance use of the Prudential name in America, unfortunately
for nothing, and we do now know how the Russians feel about
selling Alaska to the United States.
In 1952, Her Majesty the Queen sent out 255 telegrams.
These were to people reaching their 100th birthday. In 1998,
the year for which I last have figures, the number was 5,958.
And I suspect in terms of the Queen's telegram bill it is only
going to get worse, and the same applies as far as the cost of
Social Security.
The impending explosion of the demographic time bomb has
come as something of a surprise to some of the governments in
continental Europe. It shouldn't have done, because the shape
of population is one of the very few things that we can predict
with some certainty 50 years out.
The problem in terms of making adequate provision for
retirement is largely one of political time horizons. Our
former Prime Minister, Harold Wilson, said that a week is a
long time in politics. Well, if that is the case, 20 years is
an eternity. To change Social Security and pensions requires a
degree, a high degree of political consensus, and we have
perhaps been fortunate, either by accident or design, to have
that political consensus in the United Kingdom.
Bearing in mind that politics is the art of the possible, I
have given some thought, based on lessons of the past, as to
the shape of future U.K. pension systems going forward, and I
would like to just spend a couple of minutes outlining what
reforms I would make to the U.K. system, in the hope that there
may be some parallels that you may be able to draw from these
views.
Starting with the basic State pension, this is currently
unfunded, on a pay-as-you-go system linked to general inflation
rather than wage inflation. It therefore follows that the
relative value of the basic State pension is diminishing over
time, and in 20 years will be of very small value indeed.
Indeed, at this point it is roughly about 20 percent of
national average earnings, for an individual retiree, about
$100 a week.
I would migrate this basic State pension over time to a
funded system, with the funds vested and managed by an
independent board of trustees, with asset management contracted
out according to investment guidelines established for the
national pension fund. And I pretty much have these guidelines
in line with those set out in Gary Burtless' written testimony,
which I found extremely interesting.
I would vest ownership in this basic State pension very
clearly in the potential beneficiaries by following the Chilean
model, at least in providing them with what I understand is a
little red book which shows them their entitlement, because it
is very clear from Chile that pride in ownership has been a
very significant part in reinforcing the popularity of the
Chilean system.
Second, I would have an earnings-related layer, and as at
present in the U.K. this would be compulsory, and it would be
either in the form of a State scheme--and at the moment this is
unfunded--or with an opt-out to approve private schemes which
are funded. I would change the State scheme from unfunded to
funded, but still allow opt-out, and I would increase the
compulsory contribution rate from about 4.9 percent at the
moment to around 10 percent, which is slightly in excess of
what prevails in Australia at this stage. The private sector
provision: I would cap the annual management charge at 1
percent, the rate that currently prevails in the U.K. for what
we call stakeholder pensions.
The third layer would be a voluntary private-funded
provision with tax incentives, but limited to the relief on
contributions at the basic rate of tax. And this is a
substantial change, because at the moment tax relief is
provided at the highest rate. This favors the savings classes,
the people who would save in any event.
And I think that I would remove the earnings cap that we
have at the moment but put a contributions' cap of 5 percent of
earnings for the tax-privileged third layer. Contributions in
excess of 5 percent could be made, but with no tax relief. Tax
gains by the Treasury could be used to defray the cost of
moving to a funded State system.
The final element, often forgotten, is income streaming
from retirement through to death. In the U.K. there is a
requirement to purchase an income stream annuity from an
authorized provider on retirement, although there are some
income draw-down facilities. I would strongly support
continuation of this arrangement, rather than creating a
generation of transient lottery winners with the opportunity to
blow 40 years of savings, or even worse, leaving them on the
on-deposit while making them easy prey to rapacious boiler
house salesmen.
None of the changes I have suggested are without
difficulty, but all fall within my test of the art of the
possible. I believe there are close parallels in what I think
is right for the U.K. with what might work in the U.S.A.
I would like to conclude at this point, but just add that I
am very much looking forward to receiving my telegram in 45
years time from King Charles the Third, although I suspect it
will be an e-mail by then, and almost certainly sponsored by
Pfizer. Thank you.
[The prepared statement of Mr. Bedell-Pearce follows:]
Statement of Keith Bedell-Pearce \1\ Executive Director, Prudential
plc, London, England
Pensions: a British Success Story
Pensions provision has been one of the major success stories of
post-war Great Britain. It is the result of successive Governments of
both left and right aiming to achieve a proper balance between state
and private sector provision, with the state providing a basic pension
for everyone reaching retirement age (currently 60 for women and 65 for
men) and encouraging additional provision by employers and individuals
through a range of incentives, principally tax breaks.
---------------------------------------------------------------------------
\1\ Prudential plc is a leading international financial services
group (not related to the U.S. company with a similar name) and has
been a key player in UK pension provision for more than 70 years.
---------------------------------------------------------------------------
The reason for this success is primarily the result of a continuing
partnership between the State and private sector, originally
established for pragmatic reasons of affordability and more lately
maintained as the result of a policy endorsed by all political parties
that beyond the basic State pension, retirement provision is primarily
the responsibility of the individual.
Whilst pensions provision excites vigorous debate both inside and
outside Parliament (the debate, in itself, being an important element
in developing awareness of the need for adequate retirement provision),
the area has avoided becoming a political football. There is, I
suspect, something of an unspoken compact on this within the political
arena, with a recognition that continuity and security of pensions
provision is important to whichever party is in power, with those who
are not in residence in Downing Street expecting to inherit what is in
place in due course. Change, therefore, is a matter of evolution rather
than revolution and is thereby more acceptable to the electorate. This
is in sharp contrast with the position in most of the major continental
European economies which, as a result of post-war ``social contracts'',
rely predominantly on State run pay-as-you-go systems which are
becoming progressively unaffordable as a growing retired population has
to be supported by a diminishing workforce.
In Britain, however, it has not been all sweetness and light.
Despite generous tax breaks, many people who can afford to provide for
themselves fail to do so adequately and personal provision remains a
significant problem for those on lower incomes.
One of the penalties of an evolutionary approach is that complexity
is layered on complexity and this in itself becomes a disincentive for
individuals to do anything for themselves.
Over the past 15 years, some fundamental structural weaknesses have
been exposed such as in governance arrangements for occupational
schemes (the so-called Maxwell scandal) and in the selling of personal
pensions to those who would have been better off remaining in, or
joining, their occupational schemes.
But despite these and other problems, confidence in the system in
the UK remains high, perhaps because of the combination of continuing
commitment of successive governments to make the system work and
vigorous competition between providers in the private sector.
In this testimony, I will endeavour to do the following:
outline the basic structure of pension provision in
the UK
identify where problems have arisen and how these have
been addressed
briefly review the challenges for the future and
suggest how they might be met.
1. The basic structure of pensions provision in the UK.
The basic structure can be regarded as something of a layer cake.
Starting at the bottom, we have the Basic State Pension. This is
covered with a layer of icing for those for whom the Basic State
Pension is their only income. This supplement makes up the difference
between the Basic State Pension and what is known as the ``Minimum
Income Guarantee''and is essentially a means tested welfare payment.
The second layer of the cake proper is made up of earnings based
pensions. These can take three forms:
state provided arrangements
private provision
a combination of state and private provision.
The technical details of these arrangements can be found in
Appendix A to this paper but it is sufficient to note here that
individuals can substitute this part of their state arrangements with
approved alternative private arrangements and are encouraged by
financial incentives to do so.
The private element of the layer cake is made up of a number of
components but the main division is between occupational schemes
(equivalent to ERISA type arrangements) and personal pensions
(equivalent to IRAs and 401(k)s).
Private arrangements fall into two broad categories:
defined benefit
defined contribution.
A ``defined benefit'' scheme is one where the employee on
retirement receives a pension which is a percentage of his or her
pensionable earnings, the percentage usually being related to length of
employment. Defined benefit schemes are limited in practice to large
occupational schemes where the employer has the size to take on what is
effectively an open-ended guarantee of pension liabilities related to
earnings levels many years into the future. Because of this commitment
and related costs, there are now virtually no new defined benefit
schemes being created and many employers are closing existing schemes
to new employees. Defined benefit schemes always involve employer
contributions and usually (but not always) employee contributions.
The alternative to defined benefit is ``defined contribution'',
where payments are made into a scheme to build a pot of assets which on
retirement is used to generate an income stream from retirement to
death.
Defined contribution schemes can be occupational (employer
sponsored) or private or a combination of both.
In all defined contribution schemes, the level of pension paid on
retirement is a function of the size of the asset pot which is used to
purchase a pension (an ``annuity'', a term which is somewhat different
in meaning in the UK context than the US--see Appendix A for details)
which is supplied by an insurance company on terms which are determined
primarily by medium term interest rates and the actuarially assessed
life expectancy of the individual concerned.
Pension funds enjoy complete freedom as to the asset classes in
which they may be invested. Restrictions are a matter of actuarial
prudence, not regulatory intervention. As a result, most funds have
historically been invested predominantly in equities, in some cases in
excess of 80%. Property (real estate) and fixed interest have tended to
make up the balance at around 10% each. For a variety of financial and
actuarial reasons, we have seen a move away from equities in the recent
past but this asset class still makes up the majority of investments in
most cases. Larger funds tend to make direct investments with the
remainder investing on a pooled (mutual fund) or insured basis.
With personal pensions (and the new Stakeholder pension as
explained below), investment has to be via an approved vehicle, in
practice a mutual fund or insured scheme. Insured arrangements dominate
in this area with two distinct arrangements on offer: unit linked (a
mutual fund with an insurance wrapper) and with-profits (a managed fund
where returns are smoothed over time).
Historically, this investment freedom within a regime of actuarial
prudence and links to approved investment vehicles has proved to be
very beneficial to both scheme sponsors and scheme members. Tax
incentives apply to all private arrangements, with the rate of the tax
break from the individual's perspective being at the highest rate paid
by the individual. The shape of the tax breaks is shown by the
following chart:
------------------------------------------------------------------------
Money In Asset Build Up Pension Paid
------------------------------------------------------------------------
Full tax relief................. Exempt from income Fully taxed
and capital taxes. (except for tax
free lump sums in
some cases)
------------------------------------------------------------------------
There are limits which vary by age to the amount of contributions
that quality for tax relief. These limits are a percentage of
qualifying earnings and for schemes entered into after 1988, there is a
cap on qualifying earnings of circa $150,000.
The UK has gone further than most countries in moving the balance
for pension liabilities from the private to the public sector. For an
individual retiring recently, their average income can be broken down
as follows:
Sources of Pensioner Incomes 1995/6--UK
Disability benefits........ 5%
State Sources Means-tested benefits...... 10% ...........................
51% Basic pension*............. 33% Sources of pension split
Earnings-related pension*.. 3% 36% State 24% Private
<5-ln }>or otherwise
expressed
Occupational pensions*..... 24% in proportion 60/40.
------------------------------------------
Private Sources Investment income.......... 16%
49% Earnings................... 8%
Other...................... <1%
Source: ``We all need pensions--the prospects for pension provision'': An independent report to the UK
Department of Social Security by the specially formed Pension Provision Group, June 1998.
If we focus on pensions alone (highlighted with an asterisk), these
figures demonstrate that 60 per cent of the total ``pension'' provision
currently comes from the State whilst only 40 per cent comes from the
private sector.
Personal pensions, introduced by the Conservative Government in
1988, are an investment vehicle for individuals which can be used as a
partial substitute for State pension provision. However, such
substitution was only relevant for those more than 10 years from
retirement and therefore this trend has yet to show through in the
incomes of new pensioners. The Labour Government, elected in 1997, soon
announced its intention to develop policy measures to help move this
ratio from 60/40 to 40/60 by the year 2050.
The British pension system is already in a much stronger fiscal
position than that of most other countries. In marked contrast to
nearly all other OECD countries, State-funded old-age spending in
Britain, as a proportion of GDP, is forecast to decrease from 4.5 per
cent of GDP in 2000 to 4.1 per cent in 2050. In comparison, spending in
the U.S. is projected to increase from 4.2 to 7.0 per cent. The
difference between the British experience and that of other countries
stems in part from more favourable demographic trends, but more
significantly from reductions in the State pensions programme and the
use of funded private pensions as an alternative to at least part of
the unfunded public pension.
In its Green Paper (Government policy discussion document) in 1998,
the current UK Government proposed the principle that the public and
private sectors should work in partnership to ensure that, wherever
possible, people are insured against foreseeable risks and make
provision for their retirement. This was a continuation of a policy
started as far back as 1978 when the Government first introduced
rebates to allow part of the State Earnings Related Pension (SERPS) to
be substituted by private defined benefit occupational pension
provision. Contracting out was extended to defined contribution
vehicles including personal pensions in 1988. The proposed success
measures for this partnership principle are that:
at the end of the process of reform, there should be a
guarantee of a decent income in retirement for all,
there should be an increase in the amount of money
going towards retirement savings and insurance, but without
increasing the proportion borne by the State,
there should be an extension of high-quality private
pension provision to a greater proportion of the working
population (with the definition of ``work'' being extended to
include carers), and
there should be an increase in public confidence in
the quality and regulation of private sector savings, pensions
and insurance products.
The Conservative Government established personal pensions as a way
of encouraging wider voluntary pension provision. They were also
developed as a vehicle to facilitate individuals contracting out of the
SERPS and into a private pension on a defined contribution basis. At
retirement, a pension had to be purchased to provide for a basic level
of post-retirement inflation protection, with the State still providing
protection against higher rates of inflation thereafter. This
protection was removed in 1997.
SERPS, or the corresponding rebates, represent a compulsory element
of the State system that has been the subject to continuing change. The
proposed change from an earnings related basis to a flatter rate of
benefit is expected to take place sometime after 2006. The level of
compulsion, and the benefits that it will provide, is designed to try
to reduce the amount of means-testing necessary. We expect the policy
of compulsion to be reviewed again by the Government in 2003.
The ``Stakeholder pension'' (see Appendix A) is not a fundamentally
distinct concept from its predecessors since it is either an
occupational or a personal pension. The key feature, however, is that
product regulation has been introduced so that underlying assets and
charging levels are pre-specified by Government. The system is being
changed through a combination of self-assessment, regulatory pressure
and Government regulation. The Government intends to build popular
confidence in pension savings by introducing Stakeholder pensions as a
new, more accessible and cheaper vehicle, designed to appeal to those
on low to moderate incomes. It is hoped that Stakeholder pensions may
eventually become as familiar to the UK consumer as 401(k)s are in the
US.
2. Problems in the UK pension market
The evolutionary nature of pensions development has inevitably
given rise to problems, and whilst hindsight is a wonderful thing, the
commitment to the overall system from Government, providers, scheme
sponsors and above all, the population as a whole means that the
lessons learned have been applied. Some of the issues are now discussed
in more detail below.
Advice to contract out: Advice is an important issue. If there is a
public policy intention that individuals should be encouraged to switch
from public to private pension funding, then that incentive should be
tangible and clearly advantageous. It is unproductive to create a
regime in which consideration of an individual's age, future salary,
likely future voluntary contributions or attitude to risk is necessary
before it is possible to judge whether contracting out is attractive.
The original rebates offered an incentive, whereas the current rebates
mean that the most obvious choice for someone within SERPS is to stay
there. We understand that when SERPS changes to the new Second State
Pension, in or after 2006, there may be a disincentive for higher paid
employees to remain within the State scheme.
The decision to contract out, and the associated advice, applies on
a year by year basis. There is no question of making a decision for
life. There is also no question of switching accrued SERPS benefits to
a private scheme - principally because accrued SERPS benefits are
unfunded and such a policy would be expensive for the State. Moreover,
the current Government has no policy intention of allowing switching
from the basic state pension to private pensions, although that was a
feature of Conservative policy during the recent UK election.
Advice to make additional contributions: The original expectation
was that once an individual had set up their own personal pension to
accept rebates, then they would make further voluntary contributions on
top. This proved not to be the case. In general, data show that fewer
than 50 per cent of employees enrolled in personal accounts make any
voluntary contributions. Appendix A includes an outline of the
alternative investment products which might provide a better form of
saving in the UK than does a pension, even for retirement needs. This
complicates the choice and highlights the need for advice.
This problem also arises with the new Stakeholder pension. Although
this new arrangement gives easy access to a pension scheme and
deduction of pension contributions from salary, the need for advice
remains. The limitation of charges to 1 per cent of the fund makes no
provision for advice. This may be charged for separately. However,
experience in the UK suggests that people do not want to pay a fee for
advice--although it is probable that at least part of the market will
go that way, the lower paid are unlikely to want to pay an additional
flat fee. The commission structure that these fees have replaced
offered some form of redistribution since commissions were proportional
to contributions.
The problem of providing advice to low earners is even more
relevant when we recognise that some low paid workers will lose state
entitlements under the Minimum Income Guarantee (the absolute state
safety net designed to ensure a minimum standard of living in
retirement) if they make voluntary pension contributions. At present,
State benefit may be lost for for any private
income. The dilemma of whether or not to save at all is being reduced
by the proposed introduction of a so-called ``pension credit'' which
will ensure that the entitlement is not lost 1 for
1 of weekly income from a private pension but only
0.40 per 1.
Charges: Whilst the charges for a basic personal pension receiving
only the SERPS rebate were kept low, the costs of personal pensions
generally have been much higher, including the extra costs of
commission. Indeed, since the charging structure seeks to recover the
full cost of the initial expenses even if the policy is terminated
after only a few years, charges on early termination may be as much as
50 per cent of the premiums paid. For a pure rebate policy the
administration of the contribution is as simple as possible with
electronic transfer of rebates. Similarly with few initial expenses,
these problems on early termination do not apply to these policies.
However, personal pension administration costs have historically
been high. The regulatory practice has been to quote an annual
reduction in yield, equivalent to an average fund charge (see Appendix
B). Although such figures might seem low at between 1% and 3% of the
fund, expressed as a percentage of the fund's value after 25 years,
even a 1% annual charge on a single premium represents more than 22 per
cent of the fund's value over 25 years.
But these criticisms are set to become a thing of the past. The
introduction of Stakeholder pensions is now causing the UK pensions
market to reduce charges significantly. Indeed, the charges on new
pension contracts were reduced in preparation for the introduction of
Stakeholder pensions, whilst even the charges for existing contracts
have now, generally, been reduced to Stakeholder levels. Changes have
had to be made in sales, marketing and administration to reduce
expenses commensurately. This is leading to a reduction in individual
advice resulting in more workplace direct offer sales with no personal
advice.
It should be noted that the maximum 1% charge on Stakeholder
pensions is low even by comparison with equivalent products in the US.
Whilst it may be difficult to compare like with like, a fact-finding
visit to the US in 1999 by a group of pension specialists reached the
conclusion that the equivalent charge in the U.S. was between 1.4% and
1.7% depending on the level of technology support, in practice this
being internet access and self-service.
The fact that with Stakeholder pensions there is only a low fund
charge and no transfer charge means that the criticisms of high charges
in comparison with premiums on early termination will disappear.
Pensions Mis-selling: Publicity overseas about the UK personal
pensions market is often dominated by mention of what is described as
pensions mis-selling. For the sake of clarity, it should be emphasised
that these examples of inappropriate advice did not relate to the
decision as to whether to contract out of SERPS and to invest the
rebate in a personal pension. Indeed, the regulator commissioned a
review of this and confirmed that in view of the incentives built in to
the level of rebate, contracting out during the first few years of
personal pensions was reasonable advice.
Pensions mis-selling occurred largely in relation to incorrect or
no advice on the most appropriate scheme for voluntary contributions in
addition to the rebate and on whether to transfer from another scheme.
Despite the fact that the introduction of personal pensions was
designed to coincide with the new regulation of the conduct of business
under new sales and marketing rules introduced as a result of the
Financial Services Act in 1988, mis-selling arose because of a
systematic industry-wide misunderstanding across almost the whole of
the retail financial services market about the implications of that
complex piece of legislation.
The introduction of personal pensions in 1988 also coincided with a
relaxation of Social Security legislation which prevented employers
from making membership of their pension scheme an absolute condition of
service, despite the fact that the presence of an employer contribution
almost invariably makes membership of the scheme better than a personal
pensions alternative. This fact was, sadly, often not communicated to
those who had chosen not to join their occupational pension scheme.
Although membership of an occupational pension scheme was not regarded
as a regulated investment under the legislation, the regulator later in
the 1990s decided that any salesman who had recommended a personal
pension to someone who had not joined their employer's scheme was
likely to have been guilty of mis-selling.
As regards advice to transfer the value of deferred rights in an
occupational pension scheme to a personal pension, the problem was the
result of inadequate transfer values from the occupational scheme. Here
the problem stemmed less from the decision to transfer, but more from
the fact that the amount of the transfer value was often unlikely to
reproduce as much as the deferred benefit, under any reasonable
investment strategy. Although transfer values were required to be
``fair'', this was measured by comparison with other scheme members
rather than the absolute amount of the transfer value. Hence if a
scheme was underfunded it was unlikely to offer a sufficient enough
transfer value for the purposes of the standards effectively set by the
Financial Services Act when judging whether such a transfer was good
advice. It was also a feature of many schemes that their transfer
values made no allowance for discretionary increases once the pension
would have started. Eventually, in about 1993, in advance of any action
by the regulator, personal pension providers introduced systems to
analyse the transfer value.
A thorough case by case review by providers of transfers, opt-outs
and non-joiners is seeking to ensure that no-one has lost out as a
result of bad or inappropriate advice. Indeed, the review has gone
further and has also effectively compensated many people for the
fundamental change in economic conditions that has occurred over the
last 10 years. As personal pensions are defined contribution and
occupational pensions are most likely to have been defined benefit, the
policyholders are, in effect, also being compensated for any adverse
effect of the additional investment risk that they assumed.
Investment performance: The UK Government has recently announced a
review into the UK markets for medium and long-term savings products
purchased by retail customers. The stated purpose is to identify the
competitive forces and incentives that drive the industries concerned,
in particular in relation to their approaches to investment, and where
necessary, to suggest policy responses to ensure that consumers are
well served. A similar review relating to occupational pensions
proposed a set of the principles of investment and the retail review
will look at their applicability in the retail markets.
The review will examine such important influences as:
the drivers underlying competition,
information flows to consumers, and consumers'
understanding of them,
the nature and quality of consumer advice,
advisers' incentives and skills,
charging structures for products,
the principles of governance within the relevant
products.
A significant proportion of personal pensions invest in ``with-
profits'' funds in the UK, and that class should be considered
separately, although there should be little if any difference in the
underlying fund performance, other than that such funds are likely to
remove any innate conservatism that exposed investors may feel.
With-profits: Contributions which are paid into a with-profits fund
are pooled with those of other policyholders and invested in a wide
range of assets. Depending upon the size of the capital base supporting
the with-profits fund, a large proportion of the fund will be invested
in equities, although to reduce the possible risks there will be
diversification into both overseas equities and property. Over the long
term, real assets are not only the most likely to provide the best
long-term returns but also provide protection against inflation.
Bonuses are set annually to give each with-profits policyholder a
return on the contributions paid which reflects the earnings of the
underlying investments whilst smoothing out the peaks and troughs in
investment performance. The importance of such an approach is clear for
personal pensions (and indeed any defined contribution pension
arrangement) where the individual is taking the risk of volatility in
the market close to retirement. Such smoothing also takes into account
the expected future trends in underlying investment performance.
If we look at the Prudential with-profits fund over the last 5
years, depending on when the premium was invested in 1995, the 5 year
growth rate for with-profits ranged between 80 per cent and 84 per
cent, whereas for an equivalent discretionary fund, the range would
have been between 61 per cent and 96 per cent. In order to operate a
with-profits fund, a company needs to hold a substantial amount of
capital in order to provide the benefits of smoothing and guarantees
whilst investing a high proportion of the fund in real assets. This was
one of the problems for Equitable Life, where, largely because that
institution was a mutual with no ability to call on shareholder funds
for support, the capital base was inadequate to carry the costs
associated with current market conditions. We will return to this
below.
Over time, the fund will pay policyholders their fair shares
reflecting the long-term performance of the fund less the costs of any
smoothing and guarantees supported by the capital. The balance of the
fund that is not expected to be paid out to the current generation of
with-profits policyholders is the working capital of the fund. It is
sometimes called the ``inherited estate'' or ``orphan assets'' and
provides some of the solvency capital that the regulator requires
companies to hold.
Equitable: Bad news spreads quickly and the US investor may have
heard about the demise of this, the oldest of UK life insurers.
Equitable offered defined contribution pensions on a with-profits
basis. It is important to point out that the situation at Equitable is
specific to the approach adopted by that particular company and not a
symptom of any more general problems in the UK pensions market, or in
the concept of with-profits itself.
A number of factors conspired to work against this policyholder-
owned company, thus causing it to need to ask its policyholders (other
than those with guarantees) to meet the costs of liabilities that the
directors had not anticipated. With-profits policyholders in a
policyholder-owned company participate in the overall profits and
losses of the company, and in this case the losses were quite
substantial. Operating on the basis of distributing as much of its
investment return as possible to policyholders it held very low
reserves. When the recent changes in economic conditions, resulting in
lower interest rates, triggered relatively generous interest rate
guarantees the company had expected to call on those policyholders with
the guarantees to share the costs. However, the costs were not only
substantial but also had to be shared by all the policyholders, without
any orphan assets to call upon.
The lesson from the Equitable experience is that guarantees are
both expensive and potentially risky. Hence, in the context of
providing a private alternative to a scheme where a benefit is
``guaranteed'' by public finance, whilst it might be tempting to insist
that guarantees be built in, the costs would be self-defeating. It is
possible that a Government may be in a better position to provide such
guarantees itself, although it is worth noting that public pension
``promises'' can be changed. What private scheme would be allowed to
defer maturity by 5 years and in so-doing require increased
contributions and payment over a shorter period of time, as has
happened recently in the UK with the change in female State retirement
age from 60 to 65? Interestingly, the change was made with little or no
adverse public comment. Similar changes elsewhere in Europe have
brought protestors onto the streets.
Adverse selection in the Annuity Market: We should not just focus
on the fund build-up prior to retirement. In the UK, strict rules
govern the retirement benefit which has led to a substantial annuity
market. The annual market for the purchase of annuities at retirement
currently stands at approximately 9bn in the UK--
approximately 6bn in guaranteed annuities backed by bonds
(broadly equivalent to a fixed benefit annuity in the US),
1bn in with-profit annuities backed by equities (broadly
equivalent to a variable annuity in the US), and 2bn left
in a fund with regular income drawn down periodically.
There is an often-repeated allegation that annuities offer many
retirees a poor investment. This is primarily a problem of perception
rather than fact. First, when setting annuity rates, companies make
assumptions about mortality which have recently underestimated the
anticipated average lifespan--this represents an unexpected bonus for
average retirees. Second, although annuity rates have fallen over the
last 10 years this is due to both the increase in life expectancy and
the fall in interest rates. Third, there is criticism that for some
people who die early their return is very poor--this is a feature of
any form of insurance where those who do not have a claim pay part of
the benefit for those that do. In the case of an annuity, insurance is
against living longer than expected, where the underpayment to those
who die early is used to meet the costs of the long-lived.
A legitimate criticism relates to adverse rate setting against
lower income groups. Based on the assumption that on average lower
income groups have a shorter life expectancy than the better off, then
companies should, in theory, offer them better annuity rates.
Governance: The development of the occupational pensions success
story in the UK has also reflected the need for any regime to evolve.
The most recent example is the introduction of the Pensions Act 1995
which followed the Maxwell Affair and the subsequent Pension Law
Review's recommendations to improve the governance of occupational
pension schemes.
The death of Mr Robert Maxwell in a boating accident led to the
revelation of misuse of pension scheme assets in some companies in the
Maxwell business empire. In response, the UK House of Commons Select
Committee on Social Security identified weaknesses in the regulatory
framework and made a number of recommendations--these included the
establishment of a committee to carry out a thorough review of the
regulation of occupational pensions.
As a result, the Secretary of State for Social Security established
the Pension Law Review Committee. Its over-riding recommendation was to
clarify the roles and responsibilities of sponsoring employers,
trustees and their advisers, and the establishment of a regulator to
whom ``the whistle could be blown in the event of wrong-doing''.
If ``whistle-blowing'' were to have any impact, it is important to
have a regulator to respond. The Occupational Pensions Regulatory
Authority (OPRA) was set up in 1997 with the following
responsibilities:
Scheme trusteeship.
Minimum funding requirements.
Modifications to trust deeds and scheme rules in
appropriate circumstances.
Scheme wind-up and breaches of the requirements for
the use of surplus in such circumstances.
Transfer payments.
Breach of pension scheme regulations.
Contravention of scheme requirements.
Contravention of the requirement to pay the
regulator's levy.
These important issues remain under ongoing review. However, we
regard the ability to review such matters periodically and implement
appropriate changes as a strength not a weakness of the occupational
pensions regime in the UK.
3. Challenges for the future
Retirement provision for the low paid: The obvious difficulty is
that the low-paid have insufficient funds to save. The UK Government
accepts that it has a role in providing a safety net and will use the
public pensions and benefits regime to provide a minimum income in
retirement.
Some of the issues that need to be resolved are:
Should the low paid be encouraged to save?
Are pensions the best savings vehicle for their
retirement?
How much more generous can the State safety net become
before it acts as a disincentive for average earners?
Increasing the level of compulsion: The current social security
regime in the UK includes an element of compulsion.\2\ Other countries
have introduced compulsion in pensions provision at an even higher
level. Some believe that the extension of compulsion will need to be a
significant part of the solution in the UK.
---------------------------------------------------------------------------
\2\ In the UK, at present, employees pay contribution of 10% of
their salary between 87 and 575 per week and
employers pay 11.9% on all earnings above 87 per week. This
entitles the employee to sickness, maternity, disability, unemployment
and pension benefits.
---------------------------------------------------------------------------
Some of the issues that need to be resolved are:
Is it appropriate to compel pension contributions from
those who cannot afford it?
Is it appropriate to compel pension contributions when
accessible shorter term savings would be better advice?
Should employers be compelled to make pension
contributions or will that simply represent unwanted salary
sacrifice?
Operating within a 1% market: The historical criticisms of the high
charges in the UK pensions market have led to a very strict 1% charge
cap for the new regime of Stakeholder pensions. The challenge for the
whole industry is the extent to which radical changes will be necessary
to operate within that environment.
Some of the issues that need to be resolved are:
Is there sufficient capacity within the UK market to
operate at that level?
Will there be pressure to further reduce the 1%
maximum limit as funds grow?
Does a 1% charge cap necessarily produce a better
overall return for the customer?
The future of advice: The interaction in the UK market between
pensions and other savings products with different advantages will
continue to make advice important. This is further aggravated by the
State safety net which may not only act as a disincentive to save but
may be used as a reason to claim mis-selling in future if that safety
net continues to be improved.
Some of the issues that need to be resolved are:
Can ``best advice'' be expected in future?
Are decision trees an adequate alternative to personal
advice?
Should individuals be allowed to claim if they lose
future means tested benefits through having saved?
Financial Education: Most pensions markets accept the need for
simplification both of their administration systems and of the choice
presented to customers. At the same time it is recognised that greater
resources need to be put behind a campaign to increase general
financial education.
Some of the issues that need to be resolved are:
Can general financial education be expected to cover
anything more than a superficial understanding of the need to
save?
Will a financially literate population simply seek to
maximise their State entitlements from the Welfare system or
tax relief?
Does financial literacy help an individual to manage
their own financial risk?
APPENDIX A
The UK Pension System
The British pension system consists of two tiers, a flat-rate
pension provided by the State called the Basic State Pension and a
second tier consisting of supplementary pensions provided by either the
state (SERPS), the employer, or through individual accounts
Basic State Pension (BSP): The BSP is indexed to inflation rather
than to real wage growth and has therefore declined over time relative
to average earnings, falling from approximately 20 per cent of average
earnings in 1977-78 to 15 per cent in 1996-97. Prior to 1980, BSP
benefits were indexed to earnings; the change to a price index allows
for significant cost savings, estimated to be two per cent per year.
The normal retirement age is 65 for men and will increase from age 60
to age 65 for women in small steps between 2010 and 2020. Workers are
entitled to the full BSP if they have contributed for 44 or more years
for men and 39 years for women. While the majority of workers have
additional pensions to supplement the BSP, about 12 per cent of workers
have only BSP alone and do not participate in one of the second tier
programmes. However, the BSP benefit is currently below the Minimum
Income Guarantee (MIG) provided by the State. Thus, for those with no
second tier pension benefits, the income floor is the amount legislated
through the welfare system and not that obtained from the pension
system. Furthermore, because MIG is indexed to earnings the gap is
expected to increase over time. Average earnings in the UK are
currently around $35,000.
Earnings based pensions
The second tier of the British pension system offers three options
for workers all of which base benefits either directly on earnings
(i.e. defined benefit or ``DB'' plans) or on earnings-based
contributions to a retirement fund (i.e. defined contribution or ``DC''
plans).
State Earnings-Related Pension Scheme (SERPS): The first option is
participation in a public programme called the State Earnings-Related
Pension Scheme (SERPS) which began in 1978. This programme is the
default for workers who do not opt out of the public system and into an
employer-based or personal pension. It is financed on a pay as you go
basis. Benefits are a function of average ``reckonable earnings,''
(i.e. earnings between a lower and upper limit, currently approximately
15 per cent and 110 per cent respectively of national average
earnings). Lifetime earnings are adjusted for earnings growth when
determining initial benefits, although after retirement SERPS benefits
are adjusted for price inflation rather than earnings.
The self-employed are not members of SERPS.
Pension reforms in the 1980s gave workers the opportunity to
participate in private pension plans in lieu of SERPS; this was known
as ``contracting out'' (a term not to be confused with the generally
unwise practice of ``opting out'' of a scheme sponsored with employer
contributions and taking out a personal pension instead--this was part
of the well-publicised Pensions Mis-selling). Contracting out applies
to SERPS only and not to the BSP. It also only applies to future
benefits and not those already accrued. About one-half of those who
were members of SERPS in 1985 have since contracted out. Workers who
contract out and choose a private plan receive a rebate on
contributions. In 1996-97 about 30 per cent of workers were contracted
into SERPS (about 26 per cent in SERPS alone and 4 per cent in both
SERPS and an employer-sponsored occupational scheme). The data shows
that workers enrolled in SERPS are more likely to be female than
workers opting out, and they are disproportionately low-income
workers--this is both because in the UK females are more likely to be
on low incomes and because of an inconsistency in the rates of rebate
for males at some ages.
On-top voluntary contributions cannot be made to SERPS.
Occupational pension schemes: As an alternative to SERPS, workers
can participate in employer provided pensions (occupational pensions)
and approximately 33 per cent do so (as noted above, an additional 4
per cent have both occupational pensions and SERPS). Most such plans
are defined benefit plans (where it is the benefit that is earnings
linked) but as in the U.S. there is a trend towards defined
contribution plans (where it is only the contribution that is earnings
linked). By law the minimum benefit available from an employer provided
pension must approximately equal the benefit from SERPS, but benefits
are typically more generous. For a worker with 40 years of employment,
defined benefit pension plans provide up to two-thirds of their final
salary. While pension contributions are made pre-tax, eventual benefits
are subject to tax. There is, however, a one-time option at retirement
to make a tax-free lump sum withdrawal of up to 150 per cent of final
salary or 25 per cent of the value of the plan, thus reducing the
future pension in payment by that equivalent amount. Retirement
benefits must now be indexed to inflation up to an annual inflation
rate of 5 percent.
As in the US, a drawback of these defined benefit pensions is that
workers can appear to lose substantial pension wealth from changing
jobs but recent reforms have sought to improve the portability. In the
UK, the final salary on leaving employment must be indexed to inflation
up to an annual inflation rate of 5 per cent when calculating the
pension payable at retirement.
Voluntary contributions (up to a specified limit of overall
employee annual contribution) can be paid into a defined benefit plan,
although these normally purchase benefits on a separate money purchase
basis rather than by purchasing so-called ``added years'' (i.e.
effectively increasing the notional period of employment on which the
overall defined benefit is based).
Personal Pensions: A second alternative to SERPS is a personal
pension. These instruments are similar to IRAs. Investments in personal
pensions are composed of the rebate the worker receives for opting out
of the SERPS plan along with any additional voluntary contributions the
worker makes subject to a specified limit--that limit is at least
3600 gross of tax relief (about 15 per cent of national
average earnings) although age related contribution rates increase that
limit for many. In 1996-97 of the approximately 25 per cent of
employees enrolled in personal accounts, about three-fifths made no
voluntary contributions. The rebate is calculated by the Government
Actuary so that on realistic assumptions it will provide approximately
the same as the SERPS benefit foregone, although estimates are that for
young workers even this low level of contributions will yield a larger
pension benefit than SERPS. These personal pension plans have the
advantage of being fully portable with respect to job changes but, as
with any defined contribution pension, at the cost of letting the
worker assume all of the investment risk.
Stakeholder Pensions: Recent reforms introduced in April 2001, now
require any employer with more than 4 employees to make access
available to a defined contribution scheme known as a Stakeholder
Pension, or to a suitable alternative pension scheme. The Stakeholder
scheme may be either an occupational scheme or a personal pension,
either in a scheme operated by trustees or a Stakeholder manager. The
key feature that Stakeholder pensions introduced is that, although no
employer contribution is required, the scheme is subject to a form of
product regulation not previously seen in the pensions market in the
UK. They have minimum standards for charges (a maximum charge of 1 per
cent of the fund), low minimum contributions (schemes have to accept
one-off payments as low as 20 (i.e. only about $30), and
transfers must be allowed to another pension scheme without charge. In
general, contributions will be by deduction directly from salary rather
than by direct debit from the bank and this may make it easier for
individuals to maintain their commitment to voluntary contributions
once they begin. These schemes are expected to improve the
opportunities for those who do not have the option of occupational
pensions. It should be noted, however, that they also extend access to
children (there is no lower age limit), to those without income (the
personal pension limits apply with a minimum of 3600 per
annum for anyone) so anyone can make a pension contribution of
3600 gross of tax relief (effectively offering the
advantages of tax relief to those not required to pay tax), and
existing pensioners up to age 75. Although it is much too early to
tell, there is some anecdotal evidence that these schemes might be
being used by some as a way of gaining even more tax relief rather than
by the lower paid target market.
Outcomes
The overall impact of the UK pension system is that the average
income of the elderly has risen substantially since SERPS benefits were
introduced. The after tax income of ``pensioner units'' (single
pensioner or couple) increased by 64 per cent in real terms from 1979
to 1996/1997 compared to an increase of 38 per cent in earnings over
the same period. However, the upper portion of the income distribution
has fared substantially better than the lower. Gains in real income
varied from 28 per cent for single pensioners in the bottom fifth of
the distribution to approximately 80 per cent for married couples in
the highest fifth. This difference is due to the growth in occupational
pensions (up 162 per cent in real terms between 1979 and 1996/97) and
investment income (up 110 per cent). Furthermore, those elderly who
receive only the BSP have seen a deterioration in their relative
incomes as the BSP benefit has remained approximately constant in real
terms despite growth in earnings.
Major Reforms over the last 20 years to reduce the future cost of BSP
and SERPS
Reforms of the 1980s and 1990s centred on reductions in the
generosity of the public pension system and incentives for firms to
offer private pensions and for workers to choose such plans or to
invest in personal savings plans. The major changes included:
Indexing State pensions to prices rather than wages.
Plans to gradually raise the retirement age for women
from 60 to 65 in monthly steps from 2010 to 2020.
Reductions in SERPS benefits of approximately two-
thirds by changing the benefit formula from 25 per cent of
``reckoned earnings'' to 20 per cent, increasing the number of
years of employment used in the calculation from the best 20
years to an average of all years, cutting spousal benefits for
widow(er)s from 100 per cent to 50 per cent, and reducing wage
indexing.
An important aspect of these reforms was the decrease in the
generosity of public pensions. The changes were possible politically
for several reasons. First, the SERPS regime was relatively new, having
begun in 1978, and therefore had few pensioners drawing benefits.
Second, its complexity made it difficult for people to understand the
changes. Third, many of the changes were phased in gradually and the
impact was not apparent. For example, the change to inflation indexing
rather than wage indexing for benefits will save a substantial sum but
will not result in a noticeable difference in benefits for several
years. Fourth, the possibility of opting out of the government
programme is likely to have decreased opposition to the cuts. Finally,
some argue that the most important factor was that public pensions
account for a much smaller fraction of retirement income in Britain
than in other countries, making decreases in benefits more tolerable.
Although each of those reforms reduced both the future cost and the
value of public pensions, from 1988 to 1993, the rebate into a personal
pension included an incentive to induce workers to contract out of
SERPS. Personal pension schemes were launched as providing greater
choice to individuals and with increased portability, being initially
developed under the name portable pensions. More recently, the greater
flexibility of withdrawals on retirement from personal accounts has
increased their attractiveness.
The current government has focused reforms on low-income workers:
Introducing a minimum income guarantee (MIG) separate
from the BSP beginning in 1999, at a level above the BSP, with
that gap set to rise since MIG will increase at least in line
with earnings whilst BSP increases with earnings.
Replacing SERPS in April 2002 with a new State Second
Pension (S2P) that eventually (possibly as early as 2006/7)
pays a flat rate benefit although contributions are expected to
remain earnings based. The goals of the S2P are to get more
middle income workers out of SERPS and into private plans (once
Stakeholder pensions have become established) and to provide
more retirement benefits to low income workers. S2P ensures a
higher minimum pension for workers with incomplete earnings
histories than SERPS and covers the disabled and those who
provided childcare.
Other tax advantaged schemes
Any summary of the UK pension system should be set within a wider
context. In most countries a key feature of the pension system is that
they are tax advantaged (in the UK that means tax relief on
contributions and gross roll up on investment, but with the exception
of up to about 25 per cent of the fund being able to be taken as a tax
free cash sum the pension in payment is subject to income tax). Unlike
in some other countries, there is no provision to access those funds
before retirement (which itself cannot be before age 50)--although a
transfer value may be taken (for example on a change in employment)
that is only payable to another pension scheme and not directly to the
individual.
The locked-in nature of a pension, means that other tax advantaged
savings schemes offered in the UK may appear more attractive in meeting
individual needs in planning their savings regime, including saving for
their retirement. Not only is the pension taxed in payment, it also has
to be taken as a regular and fairly inflexible stream of income--it
cannot for example be used up before age (say) 75 at which point an
individual might believe that their income needs will have reduced.
This makes non-pensions products potentially attractive even for
retirement planning.
In the UK, individual savings accounts, national savings schemes
and employee share option schemes offer tax relieved alternatives to
more conventional pension savings. These arrangements may allow
immediate access, can be taken after a term unrelated to any pre-set
retirement age (the Government has suggested that it is inclined to
increase the minimum age at which a private pension can be taken from
50 to 55), and do not involve benefits as a stream of income. In some
cases the benefit may be subject to a tax on capital gains, so they may
be a tax advantage in spreading the benefit over a small number of
years. The flexibility of these contracts mean that pensions may not be
the automatic natural basic block of retirement provision that they are
in other countries. This has advice implications, and possibly leads to
an expectation that someone should be directing the consumer towards
the most appropriate purchase.
Annuities
We should not just focus on the fund build-up prior to retirement.
In the UK, strict rules govern the retirement benefit which has led to
a substantial annuity market. For example, the fund accumulated from
the SERPS rebates cannot be taken in cash at all. The whole of the fund
has to be taken as an income, from age 60 at the earliest, providing an
escalating pension linked to inflation subject to a maximum of 5 per
cent on the basis of the individual and their assumed spouse on a
unisex basis. Such unisex and unistatus provision is otherwise
virtually unknown in the UK market, although the absence of choice at
retirement (other than to defer it) reduces the risks associated with
such an approach.
An ``annuity'' in the UK means the provision of an income stream on
pre-agreed terms either for a defined period or until death. This is
quite distinct from the fixed and variable annuity products sold in the
USA.
For defined contribution schemes, the benefits are generally
provided by an annuity purchased in the competitive UK insurance
market. Since these annuities are purchased outright at retirement, the
investment mix in the accumulating pension fund is changed from
equities to gilts or corporate bonds close to retirement in order to
reduce the volatility of the benefit to be purchased. An alternative
approach, known as ``income drawdown'', is possible whereby the fund
remains invested (probably in equities) and regular benefits are drawn
out of the fund, broadly in line with the benefits that would otherwise
have been purchased under an equivalent annuity. In any case an annuity
must be purchased by age 75.
The fund accumulated from the voluntary contributions can have 25
per cent of it taken as a tax free cash sum at retirement from age 50
at the earliest, and the balance must be used to purchase an annuity in
the form selected by the individual. Rates are gender-based, and some
addition may be allowed if the individual can demonstrate a shorter
expected lifespan (for example, as a result of a smoking addiction).
Again, an income drawdown approach is possible, although the same
requirement exists to purchase an annuity by age 75.
APPENDIX B
Personal Pension Charges
If the Subcommittee is looking at the flat fund charge equivalent
of the charging structure used on monthly and stand alone premiums of
various terms on personal pensions, the following tables show the
industry average and the effect of the advent of Stakeholder.
Naturally, we would expect these charges to reduce substantially for
equivalent products in the future as they are moved down ever closer to
1%.
Monthly Premiums of 200 per month
----------------------------------------------------------------------------------------------------------------
Term 5 years 10 years 15 years 20 years 25 years
----------------------------------------------------------------------------------------------------------------
2000 Survey.................................... 3.3872 2.0632 1.6113 1.3728 1.2341
1997 Survey.................................... 4.8782 2.7415 2.0064 1.657 1.4406
----------------------------------------------------------------------------------------------------------------
One Stand Alone SP of 10,000
----------------------------------------------------------------------------------------------------------------
Term 5 years 10 years 15 years 20 years 25 years
----------------------------------------------------------------------------------------------------------------
2000 Survey.................................... 1.934 1.4547 1.2777 1.1902 1.1248
1997 Survey.................................... 2.3031 1.5955 1.3161 1.1827 1.1065
----------------------------------------------------------------------------------------------------------------
Source: Money Management surveys October 1997 and October 2000, covering personal pensions only showing the
position as at 1 July 1997 and 2000 respectively.
1. Prudential plc is a leading interantional financial services group (not related to the U.S. company with a
similar name) and has been a key player in UK pension provision for more than 70 years.
2. In the UK, at present, employees pay contribution of 10% of their salary between 87 and 575 per week and employers pay 11.9% on all earnings above 87 per week. This entitles the
employee to sickness, maternity, disability, unemployment and pension benefits.
Chairman Shaw. Thank you. Mr. Palmer.
STATEMENT OF EDWARD PALMER, PROFESSOR, SOCIAL INSURANCE
ECONOMICS, UPPSALA UNIVERSITY IN SWEDEN, AND CHIEF OF RESEARCH
AND EVALUATION, SWEDISH NATIONAL SOCIAL INSURANCE BOARD,
STOCKHOLM, SWEDEN
Mr. Palmer. Thank you, Mr. Chairman. I would like to begin
with a brief overview of Sweden's new pension system.
During a series of steps in the 1990s, Sweden converted a
two-tier defined benefit system dating from 1960 into a
combination of notional defined contribution (NDC), pay-as-you-
go accounts, and financial defined contribution schemes. Reform
was driven by the threat of future large contribution rate
increases, redistributional unfairness in the design of the old
system, and a goal of providing a framework that would promote
mandatory saving through the pension system but with privately
managed assets.
The overall contribution for the two schemes together is
18.5 percent of earnings, with a split of 16/2.5 percent
between the notional and the financial account systems. The
annuity in both schemes is based on lifetime account values and
life expectancy at retirement. The accounts in the NDC system
earn an economic rate of return, whereas the accounts in the
financial system earn of course a market rate of return.
The main goal, I think, in the Swedish reform was to create
financial stability, and this has been the overriding goal, the
idea that commitments in the future should be met but people
today should be able to realize that this is the underlying
goal of both the pay-as-you-go and the financial account
systems. In addition, the NDC and financial account system
shift the costs of early exit from the labor force to the
individual, and this has been a very important part of the
reform in Sweden.
I might also add that there was a political consensus
behind this reform. Eighty-five percent of the parliament, five
of the at that time seven political parties, and certainly the
five main political parties in Sweden, got together and were
all behind this reform, and still are.
I am going to turn now to the financial account system. The
driving forces behind the construction of the Swedish financial
account scheme were desire to hold down costs while enabling
people to choose among a large number of financial portfolio
opportunities. In order to do this, a separate agency, the PPM,
Premiepensionsmydigheten, which stands for Premium Pension
Authority, was created within the social insurance
administration, and they are in charge to manage the financial
account system. The PPM is a clearinghouse for fund
transactions. It keeps individual accounts, and it will be the
sole provider of annuities in the financial account system.
Let me briefly summarize the flows of money and information
in this system. Contributions to the financial scheme are
collected annually, together with all other social insurance
contributions and taxes in general, by the national tax
authority. Information on payments is transferred on an
individual basis to the National Social Insurance Board, and
from them to the PPM. Money from new contributions is
transferred through the National Debt Office, which administers
all financial transactions in Sweden, to the participating
funds, following the receipt of an order from the PPM.
The idea behind the system is really to eliminate the
problem of having the high pressure salesmen beating on your
doors, and to this end the PPM has been set up as a
clearinghouse for all fund transactions. You might regard it as
a sort of a broker for all of Sweden. Orders to buy and sell
fund shares together are executed jointly on each transaction
day by the PPM. The PPM is the sole provider of annuity
products in this scheme, also.
Participants can choose between single and joint life
annuities, and annuities can be fixed or variable rate. I
should mention that lump sum payments or phased withdrawals
over shorter periods than a full life are not among the
products offered.
A few words about participation criteria for fund managers,
fund choices, and administrative costs. All funds licensed to
operate as investment funds in Sweden and/or the European Union
are allowed to participate in the system. In addition, funds
must conclude an agreement with the PPM, agree to provide
information to the PPM upon request, agree not to charge
withdrawal fees, and provide a periodic report of
administration charges.
Funds are required to compute share values and report them
electronically to the PPM on a daily basis. Since the PPM
invests assets on behalf of participants, it is the sole client
for any given fund.
Part of the agreement concluded with the PPM includes
accepting a system of rebates established by the PPM. What this
means in practice is that the fund can levy normal charges
minus a possible rebate. The rebate depends on the amount of
PPM assets held by the fund in question.
Individuals bear the costs of their own fund choices. I
might choose a fund which has cost of 0.4 percent, somebody
else, 1.5 percent. It is up to me.
The first fund choices were staggered throughout the
country in September-October 2000. There were 460 registered
funds to choose from. People were given a month to choose, and
the money of non-choosers, about 30 percent of all
participants, went to a public-managed non-chooser fund which
has a distribution of assets 80/20 between equities and bonds.
Participants chose, on average, 3.4 funds, which gave a
total of over 11.5 million fund choices. Over 72 percent of
those making a choice chose an equity fund. The market fund
getting the largest share of total assets got 4 percent. The 10
largest funds got 23 percent of all assets. The conclusion,
then, is that the assets were fairly well distributed among
very many funds.
Administration costs, let me conclude with these. The costs
actually depend on individual choices, since I can chose a fund
which could cost 0.4 or 1.5 percent of assets held. The average
for choices made in the year 2000 was 0.65. The PPM can charge
a rate of 0.3, which gives for 2000 an average administration
cost of 0.95 of total asset holdings.
Finally, I should mention that unless individuals make new
fund choices, contributions are distributed in accordance with
their last fund choices. Information on fund values is
available daily through the major newspapers, and by Internet,
through the administration.
How have people reacted? I think, according to the mass
media response, which has been very positive, and the high rate
of participation, it seems as if this has been very well
accepted by the Swedish public.
Thank you.
[The prepared statement of Mr. Palmer follows:]
Statement of Edward Palmer, Professor, Social Insurance Economics,
Uppsala University in Sweden, and Chief of Research and Evaluation,
Swedish National Social Insurance Board,\1\ Stockholm, Sweden
Sweden's New Pension System \2\
An Overview of Sweden's New Pension System
In a series of steps in the 1990s, Sweden converted a two-tier
defined benefit scheme from 1960 into a combination of notional defined
contribution (NDC) pay-as-you-go and financial defined contribution
(FDC) schemes. The reform was driven by the threat of future large
contribution rate increases, redistributional unfairness in the design
of the old system and a goal of providing a framework that would
promote mandatory saving through the pension system--but with privately
managed assets.
---------------------------------------------------------------------------
\1\ E-mail: [email protected]
\2\ The reader interested in learning more about the Swedish
pension reform is recommended to visit the administration's web sites
at www.pension.nu and www.ppm.nu.
---------------------------------------------------------------------------
The overall contribution rate for the two schemes together is 18.5%
of earnings, with a split of 16/2.5 between the notional and financial
account schemes. The annuity in both schemes is based on lifetime
account values and life expectancy at retirement. Accounts in the NDC
system earn an economic rate of return, whereas accounts in the FDC
scheme earn a financial rate.
About 90 per cent of the Swedish labor market is also covered by
contractual pension arrangements that top off the public pension. This
was also a consideration in establishing the parameters for coverage in
the new public system. During the 1990s, contractual schemes for
private sector blue-collar and municipal government employees
(generally, persons working with health care, education, social
assistance, other public services provided locally, and local public
administration) have converted to financial defined contribution
following the reform of the public system. Blue-collar workers have a
contractual supplement of an additional 3% on earnings, and municipal
workers can have a supplement of up to 4.5%, depending on regional
arrangements. (See Palmer 2000, 2001a and b.) Consequently, the pension
portfolio for over half of Swedish employees contains a large total
mandatory/quasi-mandatory FDC component, in which participants choose
their own investment portfolios. Presently, private white-collar
workers are mostly covered by advance funded defined benefit schemes,
and can also make their own fund choices within this framework. There
is also discussion on converting private white-collar contractual
schemes into defined contribution schemes, in line with the reform of
the public system.
Appendix 2 provides an illustration of replacement rates for a
person born in 1975, with the present life expectancy forecast for this
cohort. This individual begins working at age 22 and the table
illustrates replacement rates for different ages of retirement for ages
from 61 through 70. In the illustration, the contractual benefit is
based on a contribution rate of 3.5%, on top of the 16% (NDC) and 2.5%
(FDC) contribution rates in the public system. This means that 27% of
total contributions go to the financial account systems and that the
outcome will depend on the market rate of return for this 27% of
contributions. If we look at the replacement rate for an individual
retiring at age 65, a real market rate of return of 2% would yield an
overall replacement rate of 54%, while a return of 6% would yield a
replacement rate of 70%.
Lastly, it is important to note that the reform creates mandatory
insurance without redistribution--other than over the individual's own
lifetime, and the redistribution from men to women embodies in the
unisexual life expectancy factor used to compute annuities.
Redistribution is financed through general revenues, instead of through
the insurance system, with the most important example being a new
guarantee benefit for low-income pensioners. Also, all non-contributory
credits are financed with general revenues, and money is transferred to
the NDC and FDC schemes to support these credits. As a part of the
reform, a separate deduction for pensioners was abolished putting all
forms of pension income and earnings on the same tax status. (A
detailed summary of the Swedish reform is provided in Appendix 1.)
The Process of Legislation and Implementation
The concept for the reform was published in the autumn of 1992. It
was passed by Parliament in 1994 with a majority vote of about 85%,
supported by both the governing liberal-conservative block and the
Social Democratic opposition. Ownership from a broad political spectrum
was viewed from the beginning as being an important condition for the
long-run stability of the reform.
Since 1994, representatives of the political parties responsible
for the reform have constituted an implementation group with the
purpose of working through all the legislative details. Most of the
necessary legislation was passed in 1998, although at the time of this
writing, some legislation still remains.
The first step in implementation was to set off contributions to
start individual financial accounts. Beginning in 1995, contributions
were paid into a blocked, interest-bearing account at the National Debt
Office. In following years, new contributions were paid in and held in
the blocked account in the interim until the individual accounts and
the administrative apparatus had been created. The interim account is
still used to hold new contributions, with interest, until tax forms of
all participants have been processed and approved through the standard
tax procedures.
Sweden has had computerized individual accounts since the 1970s.
Nevertheless, the systems were dated and did not satisfy the
requirements of the new schemes--or for that matter those of a modern
administration. In addition much new information had to be created, in
some cases retroactively from 1960. As a result, it took some time to
create the accounts needed for the new system.
The technical conversion of old-system accounts from 1960 into NDC
accounts was completed in December 1998. At the same time, individual
financial accounts were created for the contributions that had been
paid since 1995. The first individual account statements were sent out
in the spring of 1999, with an extensive mass medial campaign and
ensuing discussion and renewed debate. Since 1999, account statements
are sent out to all participants in the spring of each year. Owing to a
delay in the development of IT support for fund choices and accounting,
the debut for individual fund choices in the financial account scheme
was postponed from the early autumn of 1999 to the same time in 2000.
Joint account statements for the NDC and FDC schemes are sent to
participants in the spring of each year. In addition to general
information, statements include personal ``forecasts,'' assuming
individual earnings follow the most recent outcome, 2% real average
wage growth in the future and a real rate of return in the financial
market of 6%. The former is close to the long-run (100 year) rate of
growth in productivity and the latter corresponds to a bond and equity
fund with real rates of return similar to those experienced over the
past half century, with a bond/equity mix of around 40/60. Not
surprisingly, these assumptions have been criticized as being both too
optimistic and too pessimistic. On the other hand, the debate itself
has served to focus public attention on the new system.
The implementation of the new pension system also provided a much-
needed impetus for the National Social Insurance Board to focus on
developing modern information services for participants. In addition to
the yearly statements and other information available at local offices,
people can access information on their accounts not only through their
local offices, but using the internet. In fact, there is an internet
program for calculating your own pension. The user provides his/her own
assumptions about personal earnings growth, non-contributory periods,
alternative rates of return, and ages for and degrees of (partial or
full) retirement. The latter is especially useful for older individuals
who want to examine different exit alternatives.
The PPM is the Clearing House for Fund Transactions, Keeps Individual
Accounts and will be the Monopoly Annuity Provider in the FDC
Scheme
The PPM (Premipensionsmyndigheten)--or Premium Pension Authority in
English--is the agency within the social insurance administration that
administers the financial account scheme. The focus of development of
the administration has been on holding back administrative costs. The
principal responsibilities of the PPM are to enter into contracts with
funds applying to participate in the system, execute purchases of fund
shares on behalf of the participants, collect and make available
information on fund shares, keep the individual accounts of the system
and provide the insurance products specified by the law.
The flow of funds and information in the administration of the
financial accounts can be summarized as follows:
Contributions for the financial account scheme are
collected together with all other social insurance
contributions (and taxes in general)--by the National Tax
Authority. Information on payments is transferred on an
individual basis to the National Social Insurance Board (NSIB),
which also keeps all the social insurance accounts. Money from
new contributions is transferred through the National Debt
Office, which administers all the financial transactions of the
Swedish State, to the participating funds, following the
receipt of an order from the PPM.
The PPM is a clearinghouse for all fund transactions.
Choices for new entrants and requests to buy and sell fund
shares for all other participants are grouped together and
executed jointly on each transaction day by the PPM.
Participating funds are required to report fund values to the
PPM electronically and on a daily basis. The PPM keeps the
individual accounts of fund shares and values are computed for
all trading days.
The PPM is the sole provider of annuity products.
Participants can choose between single and joint life
annuities. Annuities can be fixed or variable rate annuities.
(Lump-sum payments or phased withdrawals over shorter periods
than a life are not among the available alternatives.) A fixed
annuity is ``purchased'' from the PPM and entails moving fund
assets to the PPM. Alternatively, the participant can leave
his/her money in market funds and accept a recalculated annuity
on an annual basis.
FDC Fund Participation Criteria and Fund Administration Costs
All funds licensed to operate as investment funds in Sweden and/or
the European Union, are allowed to participate in the system. In
addition, funds must conclude an agreement with the PPM, agree to
provide information to the PPM upon request, agree not to charge
withdrawal fees and provide a periodic report of administration costs
charged. Funds are required to compute share values and report them
electronically to the PPM on a daily basis. The PPM invests assets on
behalf of participants, and is the sole client for any given fund. Part
of the agreement concluded with the PPM includes accepting a system of
rebates established by the PPM. What this means in practice is that the
fund can levy its normal charge minus a possible rebate to the PPM,
depending on the normal charge and the amount of PPM assets held. (See
Appendix 3.) Individuals bear the costs of their own fund choices.
As a result of individual fund choices in December 2000 about 70%
of total assets were allocated to private market funds and 30% to the
public fund for non-choosers. Private fund choices resulted in the
distribution of costs shown in Table 1, with an average cost of 0.72%
of PPM assets. The publicly managed fund for non-choosers charges a fee
of 0.48% of assets.
For both systems together, the average cost for fund
administration, given the distribution of individual choices in 2000,
was 0.65%. By regulation the PPM is allowed to charge up to 0.3%,
annually, of total PPM assets, to cover the costs of both its
clearinghouse and insurance functions. These costs are to be
distributed proportionately among the insured. This gives total
administration costs of 0.95% of total assets, based on the year 2000
distribution of choices and actual fund charges.
Table 1. Distribution of assets among market funds by fee category
Percent of
Cost category (Percent of PPM fund assets) Number of total
funds capital
-0.24......................................... 6 3
0.25-0.49..................................... 92 48
0.5-0.74...................................... 63 7
0.75-0.99..................................... 51 2
1-1.24........................................ 125 28
1.25-1.49..................................... 81 11
1.5-1.74...................................... 32 1
1.75-7 0......................................
FDC Fund Choices
Around 4.4 million participants were given the opportunity to make
their first fund choice(s) beginning September 11, 2000. To avoid
administrative overload, information was sent out to six separate
regions of the country at intervals of one week, ending October 26.
People were given a month to respond and after this deadline non-
choosers were allocated to the public fund for non-choosers.
To help participants make informed choices, a brochure listing all
registered funds, their investment profile, historical performance,
degree of risk and administrative charges were sent to all
participants. As it turned out, some funds had no or only a short
record of operation and thus little or no performance information could
be provided. The PPM spent the equivalent of around 7 million dollars
on a mass media campaign. In addition, large insurance companies and
other large fund managers advertised heavily especially in the radio
and TV media immediately prior to and during the first choice period.
About 3 million persons--or 67 per cent of all participants--made
an active choice from among the 460 funds registered with the PPM at
the time. Slightly more women (68%) than men (66%) made active choices,
and this was true for all age groups and throughout most of the
country. Younger persons were slightly less active: Active fund choices
were made by around 58% of participants in the age group18-22 and 63%
of participants age 23-27.
Participants chose on average 3.4 funds, which gave a total of over
11.5 million fund choices. The number of active fund choices was a
little over 10 million. Around 1.4 million participants were ``non-
choosers.'' Over 72% of those making active choices chose funds holding
only equities, and another approximate 25% chose either mixed bond-
equity or generation funds that enable the individual to adjust his/her
risk profile to remaining years to planned retirement.
About 30% of available funds ended up in the publicly managed non-
chooser fund. This fund presently has a portfolio with a split of
around 80/20 between equities and bonds. The private fund getting the
largest share of total assets (of 56 billion Swedish kronor--or around
5.6 billion dollars) held 4% of the PPM assets in December 2000. The
top 10 funds together attracted 23% of all assets. Among these was only
one foreign owned fund, and this fund was number 9 in terms of assets
held in the ranking of the top 10 private funds.
Unless individuals actively make new fund choices, all new
contributions are distributed to their existing fund choices in
accordance with the portfolio shares they made at the time of their
last choice. Information on fund values is available daily in major
Swedish newspapers and through the internet link to the administration.
Summary Remarks
Prior to the introduction of the financial account system nearly
half of all Swedes had some personal experience with financial market
funds, and there was, in addition, opposition from important quarters.
Most noteworthy in this respect is that, although they were initially
opposed to the advance funded component of the public system, the
central blue-collar union changed its mind and negotiated a shift from
its own defined benefit supplement to a defined contribution supplement
that closely resembled the new public FDC component! Both the blue-
collar union (LO) and the Confederation of Employers (SAF) supported
the move towards NDC. Blue-collar workers, who usually have long, but
flat earnings profiles--compared to managers and professionals--could
easily see the advantages in fairness to their members in introducing
notional and financial account schemes in social insurance. For
employers there was a clear advantage to a system with a contribution
rate that, in principle, will be fixed forever.
How have people in general reacted? With the reform, all
participants were provided the opportunity to choose the construction
of their own portfolios in the public scheme, and 67% made an active
choice. There was widespread mass medial coverage of the events
surrounding the first opportunity to make fund choices, and the whole
process appeared to go very smoothly--judging by the lack of negative
press coverage. In short, it appears that the Swedish people have
accepted the reform and with it a paradigm change in the provision of
social security.
Appendix 1. Summary of the New Swedish Pension System
1. Individual accounts--contributions
Persons born prior to 1938 are outside the new system.
Generally, participants born 1938 and after have two accounts
in the new system: one Notional Defined Contribution (NDC) and
one Financial Defined Contribution (FDC).
Contributions are paid on earnings above the minimum
level at which income must be declared for tax purposes
(presently about 900 dollars per year) and up to a ceiling of
about 29 000 dollars, using an exchange rate of 10 kronor per
dollar. (The Swedish krona has fluctuated between 5.5 and 11.0
kronor per dollar since 1995 and is presently close to its
lowest level.)
The transition rule is that persons born in 1938 will
receive 4/20 of their benefit from the new system and 16/20
from the old system; persons born in 1939 5/20 and 15/20 etc.
Persons born in 1954 and later are completely in the new
system. (The new system proportions are also used to determine
payments for the transition cohorts to the FDC scheme.)
The contribution rate is 18.5% on earnings.
(Eventually to be split equally between the employee and
employer.)
A 16% contribution rate goes to the pay-as-you-go
system and is noted on the individual's NDC account.
A 2.5% contribution rate goes to the individual's
financial account. Individuals choose one to five registered
funds. Funds of non-choosers go to a publicly managed default
fund. There is no limit when or how often participants can
switch funds and (presently) no individual charge on switching
funds.
2. Non-contributory rights and rights for periods of sickness,
disability and unemployment covered by social insurance
Non-contributory rights in conjunction with child
birth, higher education and (conscripted) military service are
financed by general revenues and money is transferred from the
general state budget to the NDC and FDC social insurance
schemes to cover these.
Childbirth credits are given for a maximum of four
years per child, although only one credit can be earned at any
given time (two children born two years apart give 6 credit
years in total). The credit can be claimed by either parent,
but to date is usually claimed by the mother. Claimants are
entitled to the most advantageous of: 1) contributions based on
75% of average earnings for all covered persons; 2)
contributions based on 80% of the individual's own earnings the
year prior to child birth: or 3) a supplement consisting of a
fixed amount, indexed over time to the (covered) per capita
wage.
Periods of sickness, disability and unemployment
covered by social insurance provide financed rights in both the
NDC and FDC schemes. Benefits for sickness and unemployment are
treated as earnings in computing contributions. An imputation
of future earnings is performed for disability (the rules
remain to be legislated in the autumn of 2001), and
contributions are transferred from the disability scheme to
finance these rights. The sickness and unemployment schemes pay
for the employer share of the contribution for sickness and
unemployment. A disability benefit is converted into an old-age
benefit at latest at age 65.
3. Account values
Accounts in both the NDC and FDC schemes grow with:
New contributions and transfers to the system for non-
contributory rights
A rate of return based on the growth in the average
wage rate in the NDC scheme and the return on the individual's
fund(s) in the FDC scheme
Inheritance gains. Inheritance gains derive from the
accounts of persons who die prior to the retirement age. They
are distributed among survivors in the same birth cohort as the
deceased.
4. Calculation of a benefit
A full or partial (25%, 50%, 75%) benefit can be
claimed from the NDC and/or FDC scheme separately or together
at any age from age 61. There is no upper age limit. A benefit
can be combined with continued work. Contributions paid on
earnings from work always yield enhanced account values. A
person who claims a partial benefit and/or combines a benefit
with work will have the benefit recalculated, based on new
account values, upon permanent retirement.
The annuity is calculated as:
Annuity = Account value/unisexual life expectancy from
retirement and
-- in the NDC scheme assuming a real annual return of 1.6%
during retirement
--in the financial account system taking into account the
return on the funds of annuity recipients.
In the NDC scheme permanent life expectancy factor is
determined for a cohort in the year in which its members turn
65, even for individuals who claim a benefit before or after
this age.
The annuity in the NDC system is indexed to the CPI,
however a yearly adjustment (up or down) is made for trend
divergence of real per capita contribution growth from the
growth norm of 1.6% used in calculating the original annuity
value.
Even benefits of pensioners born 1937 and earlier are
indexed from 2002 with inflation plus the difference between
1.6% and the actual outcome.
In the financial account system the participant can
choose either a fixed or variable life annuity. In the latter
case he/she chooses the investment fund and the annuity is
recalculated annually. A joint life annuity is also offered. A
survivor benefit can also be subscribed to during working
years.
Although early retirement is possible for persons born
in 1938 in 2001, most persons born in 1938 are expected to
claim benefits in 2003, which has been a ``normal'' retirement
age for over two and a half decades, in part owing to
contractual arrangements covering about 90 per cent of
employees. In addition, a guarantee supplement cannot be
claimed until the age of 65, which for persons born in 1938 is
in the year 2003.
5. The guarantee benefit
The guarantee benefit is available from age 65. It is
an inflation-indexed supplement (with a specified maximum) to
the total benefit provided by the NDC and FDC earnings-related
schemes.
The guarantee is financed with general revenues.
Together with a means-tested housing allowance, it will usually
be sufficient to meet the subsistence norm established by the
National Welfare Board. Since it is prorated with regard to
years of residence, with 40 years needed for a full amount, it
is possible that late-working-life immigrants may nevertheless
fall under the subsistence norm and be in need of social
assistance, provided by local authorities.
The initial level of the guarantee was set at a high
enough gross value to align it after-tax with the commensurate
benefit in the old system.
6. Taxation
Individual earnings and pension benefits have the same
income tax status. The reform eliminated a separate tax
deduction for pensioners.
7. Administration
The tax authority collects contributions (together
with other taxes).
NDC accounts are kept by the National Social Insurance
Board. The Board also keeps track of all contributions for and
pays NDC, FDC and guarantee benefits together.
The FDC accounts are managed by a state monopoly--the
PPM. The PPM places one daily order per fund, aggregating all
orders to buy and sell. The PPM is the single provider of FDC
annuities.
8. Reserve funds in the NDC scheme
The NDC system has a buffer fund that arises due to
fluctuations in the sizes of birth cohorts, but which will also
pick up remaining imperfections in the practical design of the
scheme. Reserves, accumulated within the framework of the old
system, were approximately 450 billion kronor at the end of the
year 2000. (GDP was around 2100 billion kronor.) These reserves
will help in financing the transition period--when the large
cohorts born in the 1940s are only partially within the new
system.
9. Financial stability of the NDC system
Two main sources of potential financial instability
remain. The first source of instability arises because life
expectancy is calculated from the known life courses of
contemporaneous cohorts at the age when the retiring cohort has
reached age 65. Neither of the two more stable alternatives--
continuous adjustment after retirement or basing the factor on
a cohort-specific projection--was chosen. The second source of
instability is the choice of using the growth in the average
wage for indexation, whereas it is well known that the growth
of the contribution base (which also takes into account the
size of the contributing labor force) must be used to guarantee
financial stability--a fixed contribution rate. To counter
these a balance index has been constructed.
The balance index: An evaluation of the present value
of assets and liabilities is made, based on current
information, to construct a balance index. When the valuation
of assets falls short of the valuation of liabilities, the
index falls under unity and both account values and benefits
are deflated by the index. Positive indexation occurs in a
recovery until the balance index reaches unity again. (See
Settergren, 2001)
Appendix 2. Replacement Rates
The following tables provide an illustration of how the system
works and the replacement rates an individual born 1975 with earnings
from age 22 can expect based on different market rates of and present
life expectancy estimates for a person in the 1975 cohort. The tables
are from Palmer (2000) and Palmer (2001b), which also explains the
characteristics and logic of the new system in greater detail. Note
that benefits are affected by three factors. The first is additional
contributions. The second is indexation and market returns on account
values not converted into benefits. The third is unisexual life
expectancy from the time of retirement. For the older worker, the
latter two are generally more important.
[GRAPHIC] [TIFF OMITTED] T5603A.002
One of the advantages that can be claimed for the combination of
NDC and financial account schemes is that workers can combine work
(full or part-time) with a partial or full benefit from either or both
of the social insurance schemes. See Palmer (1999).
[GRAPHIC] [TIFF OMITTED] T5603A.003
Appendix 3. Fee Schedule for administrative costs for private asset
managers participating in the FDC scheme
The authority administering the financial account system, the PPM,
is the sole client for the system. The PPM has at most one (net of
purchases and sales) transaction in fund shares per day vis a vis any
specific fund manager--and normally the transaction amount will be very
small relative to the amount of total assets managed on behalf of the
PPM. On the other hand, a large amount of money will be transferred on
an annual basis, in conjunction with the transfer of new contributions
covering a whole year.
The fund manager's cost of administrating PPM assets should be very
low under these circumstances. For this reason, the PPM uses a fee
schedule designed to keep asset management costs low for participants,
and fund managers must agree to use the fee schedule to participate in
the scheme. The way it works is that managers are allowed to charge
what they normally charge in the way of administration fees, but will
pay a rebate to the PPM if their administration fees exceed a specified
amount, determined by a formula. The following table (Palmer 2000)
illustrates how the rebate schedule works in practice. Generally
speaking, the larger the stock of PPM assets held by the fund, the less
it is allowed to charge for administration.
Fund Manager Charges
Normal Administrative
Administrative Flat rebate Incremental Rebate cost after
cost, % of rate, of Rebate payable of rebate, % of
fund's PPM fund's PPM factor fund's PPM fund's PPM
assets assets assets assets
1. Managers holding less than 70 million SEK in PPM Funds
1.5 0.4 0.25 0.275 1.225
1.0 0.4 0.25 0.15 0.85
0.5 0.4 0.25 0.025 0.475
0.12 0.4 0.25 0 0.12
2. Managers holding 70 to 300 million SEK in PPM Funds
1.5 0.35 0.65 0.7475 0.7525
1.0 0.35 0.65 0.4225 0.5775
0.5 0.35 0.65 0.0975 0.4025
0.12 0.35 0.65 0 0.12
3. Managers holding 300 million to 500 million SEK in PPM Funds
1.5 0.3 0.85 1.02 0.48
1.0 0.3 0.85 0.595 0.405
0.5 0.3 0.85 0.17 0.33
0.12 0.3 0.85 0 0.12
4. Managers holding 500 million to 3000 million SEK in PPM Funds
1.5 0.25 0.95 1.1875 0.3125
1.0 0.25 0.95 0.7125 0.2875
0.5 0.25 0.95 0.2375 0.2625
0.12 0.25 0.95 0 0.12
5. Managers holding 3000 to 7000 million SEK in PPM Funds
1.5 0.15 0.95 1.2825 0.2175
1.0 0.15 0.95 0.8075 0.1925
0.5 0.15 0.95 0.3325 0.1675
0.12 0.15 0.95 0 0.12
6. Managers holding more than 7000 million SEK in PPM Funds
1.5 0.12 0.96 1.3248 0.1752
1.0 0.12 0.96 0.8448 0.1552
0.5 0.12 0.96 0.3648 0.1352
0.12 0.12 0.96 0 0.12
References
Palmer, Edward, 1999. ``Exit from the Labor Force for Older
Workers: Can the NDC System Help?'' The Geneva Papers on Risk and
Insurance, Vol. 24(4), Geneva: Blackwell Publishers.
Palmer, Edward, 2000. ``The Swedish Pension Reform--Framework and
Issues,'' World Bank Pension Primer, Washington D.C.
Palmer, Edward, 2001a. ``The Evolution of Public and Private
Insurance in Sweden in the 1990s'' in (ed. X. Scheil-Adlung) Building
Social Security: The Challenge of Privatization, The International
Social Security Association's International Social Security Series,
Vol. 6, Transaction Publishers, New Brunswick (USA).
Palmer, Edward, 2001b. ``Swedish Pension Reform--How Did It Evolve
and What Does It mean for the Future?'' in M. Feldstein and H. Siebert
(eds.) Coping with the Pension Crisis: Where Does Europe Stand?
Chicago: University of Chicago Press (forthcoming).
Settergren, Ole 2001. ``The Automatic Balancing Mechanism of the
Swedish Pension System--a non-technical introduction,''
Wirtschaftspolitische Blatter 4/2001.
Chairman Shaw. Thank you. Dr. Orszag.
STATEMENT OF PETER R. ORSZAG, PH.D., PRESIDENT, SEBAGO
ASSOCIATES, INC., BELMONT, CALIFORNIA
Dr. Orszag. Mr. Chairman and Members of the Subcommittee,
thank you for inviting me to testify. My testimony this morning
will focus on the United Kingdom, and I want to underscore the
importance of looking to the U.K. for lessons on voluntary
individual accounts.
Unlike many other countries that involved in adopting
individual accounts, the U.K. is an industrialized economy like
we are. It shares many of our traditions, our language, and it
is more similar to us than many of the other countries to which
we often look for insight into individual accounts.
But, more importantly, the U.K. is the only industrialized
economy that has adopted a voluntary system of individual
accounts, in which individuals can partially opt out of the
State-run system and into an individual account. As you know,
President Bush has endorsed such a voluntary approach to
individual accounts in the United States. Other OECD,
Organization of Economic Cooperation and Development, countries
have adopted individual accounts, but they have been mandatory.
The U.K. is the only advanced economy that has made them
voluntary, and therefore it is particularly telling to see what
we can learn from the U.K. experience.
Now, voluntary accounts probably sound innocuous at worst
and quite promising at best when you first hear about them.
After all, how can you be opposed to something if participation
is voluntary? What I want to emphasize is that the U.K.
experience underscores many of the problems associated with
voluntary accounts, and I want to focus on five issues
associated with the U.K. experience.
First, one crucial challenge in a voluntary system is how
to provide advice to workers about whether to opt into the
individual accounts. In the United Kingdom, as already was
mentioned, in what has become known as the mis-selling scandal,
individuals were deceived as to the benefits of individual
accounts by financial firms. High pressure sales tactics were
used to persuade workers to switch out of occupational funds
and into unsuitable individual account plans. Financial firms
are now being forced to repay amounts estimated at more than
$15 billion to the individuals who were misled.
Second, to offset the incentive of younger workers to
disproportionately opt into individual accounts, the U.K. has
adopted an age-related rebate scheme. The government places a
rebate into your individual account, but the amount of the
rebate depends on how old you are. And you need to do that in
order to offset the inherent tendency of younger workers to
disproportionately opt into individual accounts relative to
older workers, basically because the power of compound interest
operates for more years for younger workers than older workers.
In any case, age-related rebates have not entered the U.S.
debate at all. They are very confusing to many workers, but if
you don't implement such a system, younger workers have a much
stronger incentive to opt into individual accounts than older
workers.
Third, in designing a system of voluntary accounts, you
have to worry about the incentives to opt into the individual
accounts by earnings level. Higher income taxpayers generally
get a less good deal under Social Security than lower earners,
and therefore would have a stronger incentive to opt into
individual accounts. This is exactly what we find in the U.K.
The partial withdrawal of higher income workers has left behind
a pool of disproportionately lower earners in the State-run
system in the U.K.
Issue number four is annuitization, that is, converting
upon retirement the accumulated balance in your account to a
payment per month or per year that lasts as long as your
lifetime. In the U.K., the balance that you build up from the
tax rebates funded by the government in an individual account,
the so-called protected rights, must be converted into an
annuity upon retirement, and that annuity is restricted so that
it ends with the life of the annuitant or the spouse, leaving
nothing for heirs after annuitization.
A final and crucial issue associated with the U.K.
experience involves administrative costs. Along with two
colleagues, I recently completed an exhaustive World Bank study
of administrative costs in the United Kingdom. We concluded
that over a working career, fees would reduce account balances
for the typical worker by 43 percent relative to the balances
that would accrue in the absence of administrative costs. Other
studies by actuaries and financial analysts in the United
Kingdom have reached similar conclusions.
This 43-percent estimate includes the cost of converting
the account balance to an annuity upon retirement. Without such
annuitization costs, the administrative costs in the U.K.
system would reduce account balances for the typical worker by
36 percent. These high administrative costs dramatically reduce
the retirement income from individual accounts. They also
indicate that competition alone is not sufficient, or at least
was not sufficient in the U.K., to reduce fees to reasonable
levels.
Indeed, in response to the high charges imposed on
individual account holders, the U.K. government has recently
adopted reforms to cap the fees that can be charged by
individual account providers. The political viability of such
caps--their fees are now capped at 1 percent per year--in the
United States is unclear.
In conclusion, although they may initially sound
attractive, voluntary individual accounts involve a variety of
very difficult administrative issues. The experience in the
United Kingdom should serve as a particularly forceful
indicator of the potential problems associated with such
voluntary accounts.
The U.K. has witnessed a scandal in which vulnerable
members of society were given misleading advice regarding the
benefits of individual accounts, and has suffered from high
administrative costs that sharply reduce the retirement
benefits associated with such accounts. The government has
recently been forced to impose a cap on the fees that can be
charged on individual accounts by financial firms. In summary,
although voluntary accounts may sound innocuous, the experience
in the U.K. suggests that they may not be that at all.
Thank you, Mr. Chairman.
[The prepared statement of Dr. Orszag follows:]
Statement of Peter R. Orszag,\1\ Ph.D., President, Sebago Associates,
Inc., Belmont, California
``Voluntary Individual Accounts: The Lessons from the U.K. Experience''
Mr. Chairman and Members of the Subcommittee, my name is Peter
Orszag. I am currently the president of an economic consulting firm,
and will join the Brookings Institution next week as a Senior Fellow in
Economic Studies. It is an honor to appear before the Subcommittee to
discuss Social Security reform and the lessons that we may be able to
draw from experiences in countries that have adopted personal
retirement accounts.
---------------------------------------------------------------------------
\1\ Dr. Peter Orszag is the President of Sebago Associates, Inc.,
an economic policy consulting firm. He will join the Brookings
Institution as a Senior Fellow in Economic Studies in August 2001. In
the current or previous two fiscal years, Sebago Associates has held
contracts on Social Security issues with the Social Security
Administration (through the Center for Retirement Research at Boston
College), the Securities and Exchange Commission, and the Office of
Policy Development in the Executive Office of the President. None of
these contracts addressed international Social Security issues and
therefore are not relevant to the subject matter of, or my
representational capacity at, this hearing. In his appearance before
the Subcommittee, Dr. Orszag does not represent any organizations,
clients, or entities. A curriculum vitae for Dr. Orszag has been
provided in a separate document.
---------------------------------------------------------------------------
My testimony this morning will focus on the United Kingdom, which
has had a system of voluntary individual accounts for more than a
decade. The U.K. offers two important advantages in providing lessons
for the Social Security debate in the United States.
First, although cross-country comparisons are fraught with
difficulties, the U.K. is similar in many ways to the United States. In
addition to our shared language and traditions, both the U.K. and the
U.S. are advanced industrialized economies. Many of the other countries
cited in the debate over individual accounts are developing economies,
which face substantially different challenges than we do. Drawing
lessons for the United States from the experiences of these developing
economies is particularly difficult.
Second, the U.K. is the only industrialized nation of which I am
aware that allows individuals to opt out of its state-run Social
Security system and into an individual account. Other industrialized
countries have adopted individual accounts, but have made them
mandatory. The U.K. thus provides an important case study on the
operation of voluntary individual accounts.
As you know, the Bush Administration has endorsed such voluntary
accounts. One of its guiding principles for Social Security reform is
that ``Modernization must include individually controlled, voluntary
personal retirement accounts, which will augment Social Security.'' \2\
I hope that the experience with voluntary accounts in the U.K. will
prove helpful to you in evaluating the potential costs and benefits of
such accounts here.
---------------------------------------------------------------------------
\2\ President Bush has also recently appointed a commission to
examine how to design and implement voluntary individual accounts (see
http://www.commtostrengthensocsec.gov). Former Senator Daniel Patrick
Moynihan is one of the co-chairs of that commission. Senator Moynihan
previously sponsored legislation in 1998 (S. 1792) that included
voluntary individual accounts.
---------------------------------------------------------------------------
Voluntary individual accounts likely seem innocuous at worst, and
quite promising at best, to many who first hear about them. After all,
how can anyone be opposed to such accounts if participation is
voluntary? Unfortunately, as I hope to illustrate through the
experience in the U.K., the reality is more complicated.
I. Background on the U.K. pension system
The pension system in the United Kingdom is complicated.\3\ It
consists of two tiers: a flat-rate basic state pension, and an
earnings-related pension. The government provides the first tier, which
is not related to earnings. The second tier, which can be managed by an
individual, his or her employer, or the government, depends on an
individual's earnings history.
---------------------------------------------------------------------------
\3\ For more detailed discussion on the features of the U.K.
pension system, see Lillian Liu, ``Retirement Income Security in the
United Kingdom.'' ORES Working Paper 79, Social Security
Administration, 1998; and Mamta Murthi, J. Michael Orszag, and Peter R.
Orszag, ``Administrative Costs under a Decentralized Approach to
Individual Accounts: Lessons from the United Kingdom,'' in Robert
Holzmann and Joseph E. Stiglitz, eds., New Ideas about Old Age Security
(The World Bank, 2001).
---------------------------------------------------------------------------
Basic State Pension
The first tier of the U.K. pension program is called the basic
state retirement pension (BSP). The BSP is a pay-as-you-go system.
Under the BSP, a portion of the National Insurance Contribution (NIC)
payroll tax finances a flat-rate benefit for retirees. In other words,
once a worker qualifies by working for a sufficient number of years,
this basic benefit does not vary with the worker's earnings level. The
full benefit payments amount to about 70 (or about $100)
per week per person. Currently, about 11 million pensioners, or
virtually the entire population of retirees, receive a basic state
pension. Such pensions currently provide about one-third of total
income for retirees.
The State Earnings-Related Pension Scheme and Opting Out
The second tier of the U.K. system offers three different
alternatives to workers. Roughly one-quarter of full-time British
workers currently choose the most basic option, the State Earnings-
Related Pension Scheme (SERPS). SERPS is similar in some senses to our
Social Security system: It is run by the government and provides an
earnings-related defined benefit pension. When it was first introduced
in 1978, SERPS was relatively generous. Over time, a series of reforms
made the program less attractive to middle- and upper-income
workers.\4\ Beginning in April 2002, SERPS will be replaced by the
State Second Pension, which will provide substantially improved
benefits for lower- and moderate-earners.
---------------------------------------------------------------------------
\4\ For a description of the reforms, many of which were designed
to encourage movement to either employer- or individual-based pension
systems, see Lillian Liu, ``Retirement Income Security in the United
Kingdom,'' ORES Working Paper 79, Social Security Administration, 1998.
---------------------------------------------------------------------------
Workers who opt out of SERPS receive a NIC tax rebate and, as a
result, do not accrue SERPS benefits. Since their subsequent pensions
are in effect not financed out of NIC taxes, the government provides a
payroll tax rebate to reflect reduced future SERPS payments. The tax
rebate then finances an employer-provided pension or an individual
account. The two opt-out options are:
Individual Accounts. Since 1988, one way to opt out of
SERPS has been through an individual account. About 25 percent
of workers in the United Kingdom are currently enrolled in
individual accounts. The government's payroll tax rebate
finances contributions into individual accounts that are
roughly equivalent to three percent of average annual earnings
for American workers covered by the U.S. Social Security
system. Roughly half of those who have these accounts
contribute an additional amount on top of the government
rebate.
Employer-Based Pensions. About half of all workers
participate in an employer-sponsored pension plan (often
referred to as an ``occupational pension''). Occupational
pensions can be either defined benefit or defined contribution
plans.
To summarize, roughly one-quarter of workers belong to the state-
run program (SERPS). One-quarter opt out of SERPS and into individual
accounts, and one-half opt out of SERPS and into employer-based
pensions.
II. Design of Voluntary Individual Accounts
The individual accounts adopted in the U.K. illustrate many of the
difficult implementation issues that any system of voluntary accounts
in the United States would face:
Consumer protection and financial advice
One crucial challenge in a voluntary system is how to ensure that
workers make good decisions about whether to opt into the individual
accounts. This concern is particularly relevant to the U.K. experience.
In the United Kingdom, in what has become known as the ``mis-
selling'' scandal, individuals were deceived as to the benefits of
individual accounts. High-pressure sales tactics were used to persuade
workers to switch into unsuitable individual account plans. Sales
agents had often sought too little information from potential clients
to provide proper advice.
The U.K. regulatory authorities began an investigation of this mis-
selling phenomenon after the problem became apparent in the early- to
mid-1990s. As a result of this investigation, financial firms are being
forced to repay amounts estimated at more than $15 billion to the
individuals who were given misleading advice. In addition, regulators
have adopted a more aggressive enforcement stance for the advice
offered to individuals.
If voluntary individual accounts were adopted in the United States,
careful attention would have to be given to ensuring that individuals
were given responsible advice regarding whether they should opt for
such accounts. Two issues arise with regard to such advice and
financial education. First, an important question involves who should
provide the advice: independent analysts, the government, the financial
firms offering the accounts, or some combination thereof. The U.K.
experience suggests that allowing advice to be provided by the
financial firms themselves may cause significant problems, even in the
presence of comprehensive and good-faith regulation. Second, the costs
of providing the advice should not be under-estimated. Even in the
United States, financial literacy levels are surprisingly low. For
example, according to the Securities and Exchange Commission, more than
half of all Americans do not know the difference between a stock and a
bond; only 12 percent know the difference between a load and no-load
mutual fund; only 16 percent say they have a clear understanding of
what an Individual Retirement Account is; and only 8 percent say they
completely understand the expenses that their mutual funds charge.\5\
---------------------------------------------------------------------------
\5\ Arthur Levitt, Speech at the John F. Kennedy School of
Government, Harvard University, October 19, 1998.
---------------------------------------------------------------------------
Temporary or permanent opt-out choices
If workers are allowed to partially opt out of Social Security, is
the choice a permanent one? Or would an individual be allowed to opt
out in some years and opt back in others? Either approach has potential
problems. Making the choice irrevocable could strand some workers who
realize they made a mistake in opting out. But allowing workers to move
back and forth between the two systems could increase the opportunities
for gaming both systems, as well as increase the administrative burdens
and costs for the Social Security Administration, which would have to
track the choices that workers made each year regarding whether to
divert payroll contributions to individual accounts or to remain within
the pure Social Security system.
The U.K. has chosen to allow workers to switch back and forth
between the state-run system and individual accounts. This policy
decision means that workers must decide on an ongoing basis whether to
opt into individual accounts, and has raised the costs associated with
providing advice to workers on the best option available to them. The
data on switching are unfortunately limited because of the complexity
of the system, but it appears that switching among the options is more
likely when workers change jobs.
Age-related incentives to opt into individual accounts
If participation in a system of individual accounts is voluntary,
and if workers can switch back and forth between the individual account
and the state-run system, workers will typically find it more
attractive to opt into the individual account when young and then into
the state-run system when old.
For example, consider two workers earning $25,000 a year. One
worker is aged 60 and intends to retire in five years. The other worker
is aged 25 and intends to retire in 40 years. Both are given the option
to put two percent of their wages into an individual account. If the
older worker puts two percent ($500) of her wages into an individual
account and earns five percent per year (after inflation) on the
balance in the account, her account will accumulate to $638 (in
inflation-adjusted dollars) upon retirement. However, if the younger
worker puts two percent ($500) into an individual account and earns the
same rate of return per year as the older worker, the $500 will
accumulate to more than $3,500 upon retirement because interest will
compound for a much longer number of years. If both workers would
receive $750 more in lifetime Social Security benefits if they did not
opt to contribute the $500 to the individual account, the older worker
should choose not to contribute to the account (since $638 is less than
$750) while the younger worker should choose to do so (since $3,500 is
more than $750). If switching back and forth between the two systems is
allowed, a worker would likely find it advantageous to opt into
individual accounts when young and then back into the state-run system
when old.
To offset the incentive of younger workers to disproportionately
opt into individual accounts, the U.K. has adopted an age-related tax
rebate scheme. Workers who opt into an individual account obtain a
rebate on their payroll taxes, which is used to fund the individual
account contribution. But the rebate rate is larger for older workers
and smaller for younger workers. The purpose of these age-related
rebates is to offset the impact of age on the incentives to opt into
individual accounts. The age-related rebates, however, further
complicate the administration of the system and are confusing to many
workers.
Disproportionate incentives for higher earners to opt into individual
accounts
In designing a system of voluntary accounts, one must also consider
how the incentives to opt into individual accounts vary by earnings
level. For example, the existing Social Security system in the United
States is progressive: higher-income workers receive lower rates of
return than lower-income workers, even after taking into account the
longer life expectancies of higher earners. Higher-income taxpayers
would therefore generally have a stronger incentive to partially opt
out of the Social Security system than lower-income taxpayers, since
Social Security represents a less attractive deal for higher earners
than lower earners.
The tendency of higher earners to find individual accounts more
attractive is precisely what has occurred in the U.K.: Higher earners
have disproportionately opted out of the state-run system. Indeed, the
majority of Britons who remain enrolled in SERPS today earn less than
10,000 annually. It may be possible to design voluntary
individual accounts that would provide stronger incentives for lower
earners to opt into them, but the challenges in doing so are
substantial. In any case, the U.K. has not pursued that path.
The partial withdrawal of higher-income workers under a voluntary
system of individual accounts leaves behind a pool of
disproportionately lower-income workers. The partial withdrawal of
higher-income workers from Social Security consequently would weaken
the system's ability to accomplish redistribution toward such lower-
income workers. As Harvard economist David Cutler has emphasized:
``We typically think that giving people choice is optimal
since people can decide what is best for them. Thus, the
economic bias is to believe that, if people want to opt out of
social security, they should be allowed to do so. In the
context of social security privatization, however, this
analysis is not right. Allowing people to opt out of social
security to avoid adverse redistribution is not efficient; it
just destroys what society was trying to accomplish. . . . An
analogy may be helpful. Suppose that contributions to national
defense are made voluntary. Probably, few people would choose
to contribute; why pay when you can get the public good for
free? Realizing this, we make payments for national defense
mandatory. The same is true of redistribution. Redistribution
is a public good just as much as national defense; no one wants
to do it, but everyone benefits from it. As a result, making
contributions to redistribution voluntary will be just as bad
as making contributions to national defense voluntary. We need
to make redistribution mandatory, or no one will pay for it.''
\6\
---------------------------------------------------------------------------
\6\ David Cutler, ``Comment on Gustman and Steinmeier, `Privatizing
Social Security: Effects of a Voluntary System,' '' in Martin
Feldstein, editor, Privatizing Social Security (University of Chicago
Press: Chicago, 1998), page 358.
---------------------------------------------------------------------------
Such factors suggest that voluntary individual accounts pose unique
challenges, which is why most proponents of individual accounts would
make them mandatory. But other features of the U.K. system highlight
some of the issues that must be addressed in any system of individual
accounts, including mandatory ones. Such issues include:
Choice of providers and investments
The U.K. has a decentralized system of individual accounts,
somewhat similar to the rules governing Individual Retirement Accounts
in the United States. The individual accounts in the U.K. can be held
at a wide number of financial institutions. The assets in the
individual accounts can be held in a variety of different forms, and
are not restricted to broad market index funds. An alternative would
mimic the more centralized approach of the Thrift Savings Plan, by
restricting where the accounts could be held and the types of assets
they could hold.
This choice involves a difficult tradeoff: Decentralized systems,
such as the one in the U.K., typically involve substantially higher
administrative costs than more centralized systems.\7\ They also expose
individuals to the possibility of making particularly poor investment
choices, and therefore require even more aggressive financial education
efforts than centralized plans.
---------------------------------------------------------------------------
\7\ Estelle James, James Smalhout, and Dimitri Vittas,
``Administrative Costs and the Organization of Individual Account
Systems: A Comparative Perspective,'' in Robert Holzmann and Joseph E.
Stiglitz, eds., New Ideas about Old Age Security (The World Bank,
2001).
---------------------------------------------------------------------------
Although centralized systems of individual accounts are preferable
to decentralized systems because they reduce administrative costs and
ensure diversified portfolios, such centralized systems tend to
generate less political enthusiasm. They also raise many of the same
political issues (such as the choice of which firms are included in the
index funds) that would be involved in allowing the government to
invest directly in private assets.
Fee regulations
As explained below, administrative costs on individual accounts in
the U.K. have proven to be extremely high. The government has recently
adopted a series of reforms to cap the fees that financial providers
can impose on a new type of individual accounts, called Stakeholder
Pensions. The previous experience with individual accounts in the
absence of fee regulations suggests that competition alone is
insufficient to reduce fees to reasonable levels (see below).
Annuitization
The SERPS program in the United Kingdom automatically provides an
inflation-adjusted annuity to beneficiaries. Systems of individual
accounts often mandate that accounts be converted into an annuity upon
retirement (in other words, the account value is exchanged for a
monthly or annual payment that is made as long as the retiree or the
retiree's spouse is alive) to ensure that individuals avoid outliving
their savings. The regulations governing when an annuity must be
purchased in the United Kingdom are complicated. They require that the
portion of an individual account funded by tax rebates (as opposed to
any additional contributions) must be fully annuitized. The annuity
must be purchased at some point between age 60 and age 75. The portion
of an individual account funded by additional contributions (beyond the
tax rebate) does not have to be entirely annuitized. In particular, up
to 25 percent of the accumulated balance from this component of the
individual account can be withdrawn tax-free in a lump sum. If workers
die before annuitizing their account, the balance of the account enters
their estate.
Many supporters of individual accounts highlight the potential of
such accounts to provide payments to heirs. It is crucial to realize,
however, that providing a payment to heirs requires that a retiree
receive a lower monthly annuity payment and have less to live on in old
age. The iron laws of finance demand such an outcome, since the same
dollars can be used for only one purpose. Thus, each dollar that a
pensioner can bequeath to heirs means a dollar less to support
retirement income, because the pool of funds available to finance
retirement benefits is reduced. This iron law holds for all pensions--
Social Security, private pensions, and individual accounts.
Annuities in the U.K. illustrate this tradeoff. To ensure adequate
retirement income, individual accounts accumulated from tax rebates
must be annuitized using a basic annuity, under which the payments end
with the death of the annuitant. In other words, following
annuitization, heirs receive nothing from the individual accounts that
had been accumulated from tax rebates.
For those who made additional contributions to their accounts
(beyond the tax rebates), other options are available. For example,
more complicated annuities offer a guaranteed payment period. Under
these annuities, the heirs receive some payment if the annuitant dies
before the end of the guaranteed period. In the U.K. market, for
example, a 65-year-old single man who had accumulated a
100,000 account could turn that balance into an annuity
payment of about 9,000 per year for as long as he lived.\8\
That would, however, leave nothing for his heirs. To obtain a 10-year
guaranteed payment period, he would have to accept a lower annuity
payment per year. In the U.K. market, the cost involved would reduce
his annuity per year by about 550, or roughly 6 percent.\9\
And that would provide a payment to his heirs only if he died before
age 75. If he died after age 75, the annuity payments would end with
his death and the heirs would receive nothing. The U.K. market data
highlight the unavoidable tradeoff between the provision of retirement
income and the provision of a bequest to heirs.
---------------------------------------------------------------------------
\8\ See http://www.annuity-bureau.co.uk/rates.html.
\9\ See http://www.annuity-bureau.co.uk/annuity-optional.html
---------------------------------------------------------------------------
III. Administrative costs
A final and crucial lesson to be learned from the U.K. experience
with voluntary accounts involves administrative costs. Operating
individual accounts entails various costs that reduce the account
balances. The level of administrative costs in a system of individual
accounts would depend on a number of factors, including: how
centralized the system of accounts was and how limited the investment
choices were; the level of service provided (e.g., whether individuals
enjoyed unlimited telephone calls to account representatives, frequent
account balance statements, and other services); the size of the
accounts; and the rules and regulations governing the accounts. The
higher the administrative cost, the lower the ultimate benefit a worker
would receive (all else being equal), since more of the funds in the
accounts would be consumed by administrative costs and less would be
left to pay retirement benefits.
Administrative costs for voluntary accounts are likely to be
substantially higher than for mandatory accounts, since voluntary
accounts involve administrative complexities not present in a mandatory
system. For example, voluntary systems require tracking which workers
have opted into the individual account system; a mandatory system can
instead rely on comprehensive worker records. Voluntary systems also
require the provision of more advice to beneficiaries, since
beneficiaries need to decide whether to opt into individual accounts
(and to opt partially out of Social Security). Evidence from the United
Kingdom shows that the voluntary individual account system there has
produced significantly higher administrative costs than under mandatory
individual account systems in other countries.
Along with two colleagues, I recently completed a World Bank study
of administrative costs in the United Kingdom.\10\ We focused on the
system of individual accounts before the new type of individual
accounts, with capped fees, were introduced.
---------------------------------------------------------------------------
\10\ Mamta Murthi, J. Michael Orszag, and Peter R. Orszag,
``Administrative Costs under a Decentralized Approach to Individual
Accounts: Lessons from the United Kingdom,'' in Robert Holzmann and
Joseph E. Stiglitz, eds., New Ideas about Old Age Security (The World
Bank, 2001). For a summary, see Peter Orszag, ``Administrative Costs in
Individual Accounts In The United Kingdom,'' Center on Budget and
Policy Priorities, March 1999, available at http://www.cbpp.org.
---------------------------------------------------------------------------
We concluded that over a working career, the historical fees in the
U.K. would have reduced account balances for the typical worker by 43
percent relative to the balances that would accrue in the absence of
administrative costs. Other studies by actuaries and financial analysts
in the United Kingdom have reached similar conclusions.\11\ (The 43
percent estimate includes the cost of converting the account balance to
an annuity upon retirement. Without such annuitization costs, the
historical administrative costs in the U.K. system would have reduced
account balances for the typical worker by 36 percent.) These high
administrative costs dramatically reduce the retirement income from
individual accounts.
---------------------------------------------------------------------------
\11\ See John L. Shuttleworth, ``Operating costs of different forms
of pension provision in the U.K.,'' Coopers & Lybrand, June 27, 1997,
and John Chapman, ``Pension plans made easy,'' Money Management,
November 1998.
---------------------------------------------------------------------------
These charges indicate that competition alone is not sufficient, or
at least was not sufficient in the U.K., to reduce fees to reasonable
levels. Indeed, in response to the high charges imposed on individual
account holders, the U.K. government has recently adopted reforms to
cap the fees that can be charged by individual account providers. The
political viability of such regulations in the United States is
unclear.
Conclusion
Although they may sound attractive, voluntary individual accounts
involve a variety of very difficult administrative issues. The
experience in the United Kingdom should serve as a particularly
forceful indicator of the potential problems associated with voluntary
individual accounts. The United Kingdom has witnessed a scandal in
which vulnerable members of society were given misleading advice
regarding the benefits of individual accounts and also has suffered
from high administrative costs under its voluntary individual account
system that sharply reduce the retirement benefits those with such
accounts eventually receive. The government has recently been forced to
impose a cap on the fees that can be charged on individual accounts by
financial firms.
Finally, it is important to remember that voluntary individual
accounts do nothing in and of themselves to improve Social Security's
financial condition. To the extent that they divert current revenue
away from Social Security, they could exacerbate the Social Security
shortfall. Individual account contributions equal to two percent of
taxable payroll, in and of themselves, would increase the 75-year long-
term deficit within Social Security from 1.9 percent of taxable payroll
to 3.9 percent of taxable payroll. Policy-makers considering a system
of voluntary individual accounts in the United States should carefully
examine the potential costs involved. The fact that the accounts are
voluntary does not mean they are not harmful.
Chairman Shaw. Thank you.
Mr. Rodriguez.
STATEMENT OF L. JACOBO RODRIGUEZ, ASSISTANT DIRECTOR, PROJECT
ON GLOBAL ECONOMIC LIBERTY, CATO INSTITUTE
Mr. Rodriguez. Thank you, Mr. Chairman, distinguished
Members of the Subcommittee.
In 1981 Chile replaced its bankrupt pay-as-you-go
retirement system with a fully funded system of individual
retirement accounts managed by the private sector. That
revolutionary reform defused a fiscal time bomb that is ticking
for countries with pay-as-you-go systems, under which fewer and
fewer workers have to pay for the retirement benefits of more
and more retirees. More important, Chile created a retirement
system that, by giving workers clearly defined property rights
in their pension contributions, offers proper work and
investment incentives; acts as an engine of, not an impediment
to, economic growth; and enhances personal freedom and dignity.
Since the Chilean system was implemented, labor force
participation, pension fund assets, and benefits have all
grown. Today, more than 95 percent of Chilean workers have
voluntarily joined the system; the pension funds have
accumulated $36 billion in assets, a figure that is equivalent
to about 35, 40 percent of Chilean GDP; and the average real
rate of return has been 10.9 percent per year.
If imitation is the sincerest form of flattery, the Chilean
system should be blushing from the accolades that it has
received. Since 1993, eight other Latin American nations have
implemented pension reforms modeled after Chile's. In March
1999, Poland became the first country in Eastern Europe to
implement a partial privatization reform based on the Chilean
model. In short, the Chilean system has clearly become the
point of reference for countries interested in finding an
enduring solution to the problem of paying for the retirement
benefits of aging populations.
Although the basic story of Chile is well known, it is
worth recapping briefly. Every month, workers deposit 10
percent of the first $22,000 of earned income in their own
individual pension savings accounts, which are managed by the
specialized pension fund administration company of their
choice. Those companies invest workers' savings in a portfolio
of bonds and stocks, subject to government regulations on the
specific type of investment and the overall mix of the
portfolio. Contrary to a common misconception, fund managers
are under no obligation, nor have they ever been, to buy
government securities, a requirement that would not be
consistent with the notion of pension privatization.
At retirement, workers use the funds accumulated in their
accounts to purchase annuities from insurance companies.
Alternatively, workers can make programmed withdrawals from
their accounts. The amount of those withdrawals depends on the
worker's life expectancy and those of his dependents.
The government provides a safety net for those workers who,
at retirement, do not have funds in their accounts to provide a
minimum pension. But because the new system is much more
efficient than the old government-run system, and because to
qualify for the minimum pension under the new system, a worker
must have contributed at least 20 years, the cost to the
taxpayer of providing a minimum pension funded from general
government revenues has so far been very close to zero. Of
course, that cost is not new. The government also provided a
safety net under the old program.
The bottom line is that workers are retiring with better,
more secure pensions and increasingly at an early age. For
instance, since the early retirement option was introduced in
1988, the average monthly pensions for workers retiring early
have ranged from $258 to $318. By comparison, during the period
1988 to 1998, the representative worker in the United States
retiring at age 62 under Social Security is getting monthly
benefits that range from $506 to $780.
That is an indication of the efficiency of the private
system in Chile, not just in comparison with the old Chilean
government-run system but also in comparison with the
government-run system here in the United States, a country
where per capita income is more than five times higher than in
Chile. Chilean workers who retire at 65 are also getting
benefits that are higher relative to per capita income than the
benefits U.S. workers get under Social Security.
Through their pension accounts, Chilean workers have become
owners of the means of production in Chile, and increasingly of
the means of production of other Latin American countries, and
consequently have grown much more attached to the free market
and to a free society. This has had the effect of reducing
class conflicts, which in turn has promoted political stability
and helped to depoliticize the Chilean economy. Pensions today
do not depend on the government's ability to tax future
generations of workers, nor are they a source of election-time
demagoguery. To the contrary, pensions depend on a worker's own
efforts and thereby afford workers satisfaction and dignity.
Critics of the Chilean system, however, often point to high
administrative costs, lack of portfolio choice, and the high
number of transfers from one fund to another, as evidence that
the system is inherently flawed and inappropriate for other
countries, including the United States and the industrialized
countries of Europe. Some of those criticisms are misinformed.
For example, administrative costs are about 1 percent of
assets under management, a figure similar to management costs
in the U.S. mutual fund industry. To the extent the criticisms
are valid, they result from a single problem, excessive
government regulation. And I would be happy to discuss during
the Q and A how government regulation creates distortions and
how those distortions could be eliminated.
All the ingredients for the system's success--individual
choice, clearly defined property rights and contributions, and
private administration of accounts--have been present since
1981. If Chilean authorities address some of the remaining
shortcomings with boldness, we should expect Chile's private
pension system to be even more successful in the years to come
than it has been in the first 20 years. And unlike a pay-as-
you-go system, a fully funded individual capitalization system
can anticipate fewer problems as it matures.
Thank you very much.
[The prepared statement of Mr. Rodriguez follows:]
Statement of L. Jacobo Rodriguez, Assistant Director, Project on Global
Economic Liberty, CATO Institute
My name is L. Jacobo Rodriguez and I am the assistant director the
Project on Global Economic Liberty at the Cato Institute. I would like
to thank Chairman Shaw for inviting me to testify. In the interest of
transparency, let me point out that neither the Cato Institute nor I
receive government money of any kind.
In 1981 Chile replaced its bankrupt pay-as-you-go retirement system
with a fully funded system of individual retirement accounts managed by
the private sector.\1\ That revolutionary reform defused the fiscal
time bomb that is ticking for countries with pay-as-you-go systems
under which fewer and fewer workers have to pay for the retirement
benefits of more and more retirees. More important, Chile created a
retirement system that, by giving workers clearly defined property
rights in their pension contributions, offers proper work and
investment incentives; acts as an engine of, not an impediment to,
economic growth; and enhances personal freedom and dignity.
---------------------------------------------------------------------------
\1\ A lengthier treatment of the Chilean reform can be found in L.
Jacobo Rodriguez ``Chile's Private Pension System at 18: Its Current
State and Future Challenges System at 18: Its Current State and Future
Challenges.'' Cato Institute, Social Security Paper no. 17, July 30,
1999 http://www.socialsecurity.org/pubs/ssps/ssp-17es.html.
---------------------------------------------------------------------------
Since the Chilean system was implemented, labor force
participation, pension fund assets, and benefits have all grown. Today,
more than 95 percent of Chilean workers have joined the system; the
pension funds have accumulated $36 billion in assets; and the average
real rate of return has been 10.9 percent per year.\2\
---------------------------------------------------------------------------
\2\ For more statistical information on the Chilean system, see the
official website of the Superintendencia de AFPs, the Chilean
government regulator of the private pension system, at http://
www.safp.cl.
---------------------------------------------------------------------------
If imitation is the sincerest form of flattery, the Chilean system
should be blushing from the accolades it has received. Since 1993 eight
other Latin American nations have implemented pension reforms modeled
after Chile's. In March of 1999 Poland became the first country in
Eastern Europe to implement a partial privatization reform based on the
Chilean model. In short, the Chilean system has clearly become the
point of reference for countries interested in finding an enduring
solution to the problem of paying for the retirement benefits of aging
populations.
Although the basic story is well known, it is worth recapping
briefly. Every month workers deposit 10 percent of the first $22,000 of
earned income in their own individual pension savings accounts, which
are managed by the specialized pension fund administration company of
their choice. Those companies invest workers' savings in a portfolio of
bonds and stocks, subject to government regulations on the specific
types of instruments and the overall mix of the portfolio. Contrary to
a common misconception, fund managers are under no obligation to buy
government securities, a requirement that would not be consistent with
the notion of pension privatization. At retirement, workers use the
funds accumulated in their accounts to purchase annuities from
insurance companies. Alternatively, workers make programmed withdrawals
from their accounts; the amount of those withdrawals depends on the
worker's life expectancy and those of his dependents. The government
provides a safety net for those workers who, at retirement, do not have
enough funds in their accounts to provide a minimum pension. But
because the new system is much more efficient than the old government-
run system and because, to qualify for the minimum pension under the
new system, a worker must have at least 20 years of contributions, the
cost to the taxpayer of providing a minimum pension funded from general
government revenues has so far been very close to zero. (Of course,
that cost is not new; the government also provided a safety net under
the old program.)
The bottom line is that workers are retiring with better, more
secure pensions and, increasingly, at an early age. For instance, since
the early-retirement option was introduced in 1988, the average monthly
pensions for workers retiring early have ranged from $258 (in 1989) to
$318 (in 1994). By comparison, the representative worker in the United
States retiring at age 62 is getting monthly benefits that range from
$506 to $780 under Social Security.\3\ That is an indication of the
efficiency of the private system in Chile, not just in comparison with
the old Chilean government-run social security system, but also in
comparison with the government-run system in the United States, a
country where per capita income is more than five times higher than in
Chile. Chilean workers who retire at 65 are also getting benefits that
are higher relative to per capita income than the benefits U.S. workers
get under Social Security.
---------------------------------------------------------------------------
\3\ Information taken from the Office of the Chief Actuary, Social
Security Administration, http://www.ssa.gov/OACT/COLA/IllusAvg.html.
---------------------------------------------------------------------------
Through their pension accounts, Chilean workers have become owners
of the means of production in Chile and, consequently, have grown much
more attached to the free market and to a free society. This has had
the effect of reducing class conflicts, which in turn has promoted
political stability and helped to depoliticize the Chilean economy.
Pensions today do not depend on the government's ability to tax future
generations of workers, nor are they a source of election-time
demagoguery. To the contrary, pensions depend on a worker's own efforts
and thereby afford workers satisfaction and dignity.
Critics of the Chilean system, however, often point to high
administrative costs, lack of portfolio choice and the high number of
transfers from one fund to another as evidence that the system is
inherently flawed and inappropriate for other countries, including the
United States and European countries. Some of those criticisms are
misinformed. For example, administrative costs are about 1 percent of
assets under management, a figure similar to management costs in the
U.S. mutual fund industry. To the extent the criticisms are valid, they
result from a single problem: excessive government regulation.
In Chile pension fund managers compete with each other for workers'
savings by offering lower prices, products of a higher quality, better
service or a combination of the three. The prices or commissions
workers pay the managers are heavily regulated by the government. For
example, commissions must be a certain percentage of contributions
regardless of a worker's income. As a result, fund managers are
prevented from adjusting the quality of their service to the ability
(or willingness) of each segment of the population to pay for that
service. That rigidity also explains why the fund managers have an
incentive to capture the accounts of high-income workers, since the
profit margins on those accounts are much higher than on the accounts
of low-income workers.
The product that the managers provide--that is, return on
investment--is subject to a government-mandated minimum return
guarantee (a fund's return cannot be more than 2 percentage points
below the industry's average real return in the last 12 months). That
regulation forces the funds to make very similar investments and,
consequently, have very similar portfolios and returns.
Thus, the easiest way for a pension fund company to differentiate
itself from the competition is by offering better customer service,
which explains why marketing costs and sales representatives are such
an integral part of the fund managers' overall strategy and why workers
often switch from one company to another.
Government restrictions on fees and returns have probably created
distortions in the optimal mix of price, quality and service each fund
manager would offer his customers under a more liberalized regime. As a
result of those restrictions, fund managers emphasize the one variable
over which they have the most discretionary power: quality of the
service. (Before the airline industry was deregulated in the United
States, airlines competed on service, rather than on price. That
service might be thought of as the equivalent of ``wasteful
administration costs'' in the absence of price competition. Similarly,
banks in the United States competed on service before deregulation of
the banking industry allowed them to engage in other forms of
competition, such as offering better interest rates or lower fees.)
Although, in the eyes of the Chilean reformers, restrictions made
sense at the beginning of the system in a country with little
experience in the private management of long-term savings, it is clear
that such regulations have become outdated and may negatively affect
the future performance of the system. Thus, in addressing the
challenges of the system as it reaches adulthood, Chilean authorities
should act with the same boldness and vision they exhibited 21 years
ago. They should take specific steps:
Liberalize the commission structure to allow fund
managers to offer discounts and different combinations of price
and quality of service, which would introduce greater price
competition and possibly reduce administrative costs to the
benefit of all workers.
Let other financial institutions, such as banks or
regular mutual funds, enter the industry. If financial
institutions were allowed to establish one-stop financial
supermarkets, where consumers could obtain all their financial
services if they so chose, the duplication of commercial and
operational infrastructure could be eliminated and
administrative costs could be reduced.
Eliminate the minimum return guarantee or, at the very
least, lengthen the investment period over which it is
computed.
Further liberalize the investment rules, so that
workers with different tolerances for risk can choose funds
that are optimal for them.
Let pension fund management companies manage more than
one variable-income fund. (At present, and since the spring of
2000, AFPs have been able to manage a second fund made up
completely of fixed-income instruments. Consumer demand for
that type of fund has been to date negligible.) One simple way
to do this would be to allow those companies to offer a short
menu of funds that range from very low risk to high risk. That
could reduce administrative costs if workers were allowed to
invest in more than one fund within the same company. This
adjustment would also allow workers to make prudent changes to
the risk profile of their portfolios as they get older. For
instance, they could invest all the mandatory savings in a low-
risk fund and any voluntary savings in a riskier fund. Or they
could invest in higher risk funds in their early working years
and then transfer their savings to a more conservative fund as
they approached retirement.
As Latin American markets become more integrated,
expand consumer sovereignty by allowing workers to choose among
the systems in Latin America that have been privatized, which
would put an immediate (and very effective) check on excessive
regulations.
Give workers the option of personally managing their
accounts. Thanks to the emergence of the World Wide Web as an
investment tool, individuals could gain greater control over
their retirement savings if they decided to administer their
accounts themselves.
Reduce the moral hazard created by the government
safety net by linking the minimum pension to the number of
years (or months) workers contribute.
Adjust contribution rates in such a way that workers
have to contribute only that percentage of their income that
will allow them to purchase an annuity equal to the minimum
pension. In other words, if a high-income worker can obtain an
annuity equal to the minimum pension by contributing only 1
percent of his income, he should be able to do so and decide
for himself how to allocate the rest of his income between
present and future consumption.
Those adjustments would be consistent with the spirit of the
reform, which has been to relax regulations as the system has matured
and as the fund managers have gained experience. All the ingredients
for the system's success--individual choice, clearly defined property
rights in contributions, and private administration of accounts--have
been present since 1981. If Chilean authorities address some of the
remaining shortcomings with boldness, then we should expect Chile's
private pension system to be even more successful in its adulthood than
it has been during its infancy and adolescence. And unlike a pay-as-
you-go system, a fully funded individual capitalization system can
anticipate fewer problems as it matures.
[Attachments are being retained in the Committee files.]
Chairman Shaw. Thank you, Mr. Rodriguez.
Mr. Harris.
STATEMENT OF DAVID O. HARRIS, RESEARCH ASSOCIATE AND 1996 AMP
CHURCHILL FELLOW, WATSON WYATT WORLDWIDE, REIGATE, SURRY,
UNITED KINGDOM
Mr. Harris. Mr. Chairman, Members of the Committee, I am
pleased to have the opportunity to discuss the Social Security
reform experiences of Australia.
For many countries, the need for Social Security reform is
becoming more chronic as populations rapidly age. Moreover,
through generous promises linked with Social Security programs
in many developed nations, major economic and social reforms
will likely have to be implemented against the backdrop of
either cutting benefits or increasing associated contributions
to Social Security programs like that found in the United
States.
It should be stressed from the outset that I do not think
that one particular country has provided solutions to all the
challenges of executing successfully Social Security reform.
Moreover, I believe international experiences provide a
composite of important emulations or experiences that the
United States can take on board.
Thus, in the case of Australia, many cultural links and
social behaviors are shared in common, which can help smooth or
translate important features into the American context. Both
countries, for example, experienced a sharp baby boom in the
middle part of the 20th century. In effect, both countries'
demographic profiles are very similar.
I will now turn to the current Australian retirement
system. The old age pension in Australia is seen by many as
providing both a foundation and an important source of income
for those retirees who have limited resources to sustain
themselves in retirement. In effect, it is a non-earmarked pay-
as-you-go system. Its origins date back to 1909, where a flat
rate benefit was provided to individuals upon reaching a
prescribed retirement age. Policy planners during this period
in Australia turned their back on the notion of an earmarked
pay-as-you-go model that Bismarck had used to forge a single
Germanic state.
A common perception in the past by many workers with regard
to their old age pension was that they were entitled to an old
age pension after paying taxes throughout their working lives.
Largely, this view was encouraged by many governments, but in
the eighties increasingly the commonwealth treasury and the
Federal government expressed concerns over the direction of
expenditure for providing for the first pillar in Australia's
retirement framework. Increasingly, expenditures in providing
the first pillar were linked to a greater concern that the
population of Australia was rapidly aging. Today these benefits
are means tested and equate to a maximum of 20 percent of male
total average weekly earnings.
Clearly, to engineer or make such a significant shift in
the overall retirement structure of any country requires a
strong political resolve, a basis of consensus between
political parties, and a vision for the future of the nation's
citizens. In Australia's case, more through coincidence and
luck, a popular Federal Government, through trade union
support, was able to convey to the nation the impending problem
that Australia would confront if it did nothing about
addressing its aging population.
I want to stress to you today, it was a social democratic,
trade union supported political party, like the Democratic
Party of the United States, that continues to support the need
for ongoing retirement reforms. For trade unions, which had
strongly supported the election of a Federal Labor government
in 1993, increasing superannuation coverage was seen as a major
priority.
Before the introduction of mandated second pillar
superannuation accounts, the extent of coverage of
superannuation was limited only roughly to 40 percent of the
work force. Typically, employees who were covered by
superannuation were middle class, white collar jobs that
usually denied benefits of coverage to women and people from
minority groups.
By 1986, circumstances were ideal for change. A compulsory
3-percent employer contribution was generated through
centralized wage-fixing. Such an approach proved difficult to
administer, and did gain increases in the levels of
contributions. Again, the time was ripe for change, and by 1992
the Superannuation Guarantee Charge Act implemented, saw
employees required to contribute up to 9 percent of their
salary by July 1, 2002, into a retirement or individual
retirement account. Additionally, Mr. Chairman, it should be
noted that on average, average contributions to individual
accounts on a voluntary basis equate to 4 percent on top of the
compulsory level.
Another method by which the Federal Government was able to
engineer significant change was through a comprehensive public
education campaign in 1994-1995. The Australian Government
spent $11 million educating the people on the value of their
individual retirement accounts.
I would like to speak just briefly with regard to the
taxation of superannuation in Australia. Australia has pursued
a course which is quite unique, and which on the whole I cannot
agree with, in terms of the design and the overall rate of
taxation applied. Australia has adopted a tax-tax-tax approach
to its retirement, taxing the contributions at 15 percent,
taxing the return at 15 percent, and taxing the contribution at
over 15 percent. While this is quite unique, increasing
criticism and increasing debate centers on whether this
approach will continue.
The profile of the second pillar of Australia's retirement
system depicts both a diversity and an adequacy of return that
reflects strong and vigorous competition amongst financial
services participants. I would like to now turn briefly to the
mechanics associated with selling, distribution, and withdrawal
of benefits from superannuation accounts.
As a former insurance regulator, I can suggest one of the
reasons why Australia has been so successful in keeping
administrative costs low and also avoiding problems associated
with mis-selling is through an effective, cost efficient system
of regulation. Strict rules govern how superannuation policies
are sold.
It should be also noted that today individuals have between
five to seven investment choices associated with their
superannuation accounts, on average. This intense competition
between market participants has led to, in part, returns being
maximized and administrative fees being minimized. The success
of consumer policy and integrated distribution platforms has
meant that large scale consumer detriment has been minimized in
Australia.
I would like to now just briefly turn to some of the
statistical and demographic highlights. By March 2001, the
Australian superannuation system had $497.1 billion invested,
or $253 billion U.S. dollars. For just over 9 million workers,
this level of retirement savings is considered to be quite
significant, with the level of coverage of the population being
91 percent. It is important to know that 19.8 percent of these
assets are invested internationally. It is also worth noting
that out of these assets, 42 percent is invested into equities.
Like the United States, Australia has a demographic profile
that depicts a significant baby boomer population, and this is
depicted in Appendix 1.
Just moving on, administrative costs continue to be a
sensitive issue within the Australian political and financial
services environment. These costs can vary widely between the
types of superannuation funds found in Australia. Through an
authoritative survey conducted by the Association of
Superannuation Funds of Australia, an average estimate of $1.28
Australian or 65 cents U.S. per member per week was made for
overall administrative costs. It should be noted that this
figure has declined significantly in the last two years.
Expressed in another way, cost as a percentage of assets in
June 2000 was calculated to be 1.29 percent. It is anticipated
that the levels of costs as a percentage of assets will decline
as the system matures.
It should be noted for the record, as an aside, that in
respect to the administrative data presented by Dr. Orszag from
the United Kingdom, I must concur with the reservations
expressed by Edward Whitehouse of Axia Economics in his paper,
1999, that criticizes the associated analysis and assumptions.
My conclusions are, for the United States, the challenges
of Social Security reform may seem immense if not impossible
from initial observations. Yet what countries like Australia
demonstrate is the ability for a nation to give its people a
greater ability to craft out a sufficient and appropriate level
of retirement wealth to meet expected future needs and demands.
Certainly no one country's experience with regard to Social
Security reform can be easily translated to another. Yet what
countries like Australia can demonstrate to public policy
planners in the United States is the strong propensity that the
individual is ideally placed to determine his or her own
retirement needs.
Having worked, finally, in the United States and as a
member of the Social Security Trust Fund, I look forward to the
progress of Social Security reform in this country that I
admire greatly. Thank you.
[The prepared statement of Mr. Harris follows:]
Statement of David O. Harris,* Research Associate and 1996 AMP
Churchill Fellow, Watson Wyatt Worldwide, Reigate, Surrey, England
Mr. Chairman, I am pleased to appear before the House Ways and
Means Subcommittee on Social Security to discuss the social security
reform experiences in Australia. For many countries, the need for
social security reform is becoming more pressing as populations rapidly
age. Moreover through generous promises linked with social security
programs in many developed nations, chronic economic and social reforms
will likely have to be implemented against the backdrop of either
cutting benefits or increasing associated contributions. The ongoing
success of the Australian retirement model is clear proof that
successful pension reforms can be achieved in developed nations that
benefit the entire nation as a whole. Women, minority groups and ``blue
collar'' workers have seen significant benefits flow to them in having
the ability to efficiently craft out their own retirement savings
structures.
---------------------------------------------------------------------------
* The views in this statement are those of the author and do not
necessarily reflect the views of Watson Wyatt Worldwide or any of its
other associates.
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For the United States great economic progress was nurtured through
the ability of the economy to generate efficient forms of capital
through individual saving in the last century. In the twenty first
century the crucial dilemma confronting most Americans will be to
generate sufficient retirement savings and what financial instruments
will be best placed to satisfy this function. While Roosevelt in 1934
envisaged a strong and vibrant social security program for all
Americans, nobody during this point in history could have anticipated
the rapid aging of populations throughout the world. Simply put
countries like Australia, Chile, Sweden and the United Kingdom have
moved towards encouraging individuals to save on an individual
retirement basis so offsetting the rapid aging of each corresponding
population.
Political Economy Linked with Pension Reform
When comparing globally the approach of many countries towards the
reform of their mandated retirement provision; Australia, Chile, Sweden
and the United Kingdom stand out as countries who have grasp the
``thorny nettle'' of considering and implementing significant
retirement reforms. Although all three have signaled, through pension
reforms their intentions to move towards a more fully funded, defined
contribution system, distinctions exist between the three countries'
approaches to reform in terms of the structure of political
institutions, role of organized labor and business. These three
important factors or vested interests individually or combined can both
encourage and discourage reform of retirement systems from occurring.
``Only three countries rely heavily on private mandatory saving
policies for retirement, these include Australia, Switzerland and
Chile.''\1\ Australia's experience to date with the initial reforms of
its retirement system in 1987 and subsequently in 1992 have generally
been viewed as positive. In 1983 the Australian Labor Party (social
democratic) led by Mr. Bob Hawke MHR came to power. The ALP was
determined to deregulate Australia's economy so as to compete more
effectively on a world level. A vital ingredient in achieving this goal
was seen to be significant reductions in wages growth. With this as a
backdrop, the need for change in the retirement policy of Australia was
also sharply defined by the Labor Government in 1983. Like its
counterpart in the United Kingdom, the Australian Labor Party is
fundamentally a social democratic party based on largely collectivist
principles. It had and still remains strongly linked with the trade
union or organized labor movement, through its peak body, the
Australian Council of Trade Unions (ACTU). Superannuation during this
time was provided through traditional employer sponsored plans on a
voluntary basis. Surprisingly for some in the United States, it was the
Australian Labor Party, a social democratic political party who, with
trade union (organized labor) support began to generate the momentum
for change of Australia's retirement system. In the first instance the
newly elected Federal Government began the process of ensuring the
long-term viability of the Old Age Pension at its current level.
Maximum payments per fortnight by the mid 1980s were now determined
through the interaction of a comparatively stringent income and asset
tests.
---------------------------------------------------------------------------
\1\ Hazel Bateman and John Piggott: ``Mandating Retirement
Provision: The Australian Experience'', The Geneva Papers on Risk and
Insurance (Oxford, United Kingdom: The International Association for
the Study of Insurance Economics, January 1999), Vol. 24 No. 1, p. 95.
---------------------------------------------------------------------------
The Old Age Pension in Australia is seen by many as providing both
a foundation and an important source of income for those retirees who
have limited resources to sustain themselves in retirement. Many older
Australians who are or have retired in the past often have not built up
sufficient retirement savings. A common perception in the past by many
workers was that they were entitled to an old age pension after paying
taxes all their working life. Largely this view was encouraged by many
governments but in the 1980s increasingly, the Commonwealth Treasury
and the Federal Government expressed concerns over the direction of
expenditure for providing the first pillar of Australia's retirement
framework. Increasingly expenditures in providing the first pillar were
also linked to a concern over the demographic position of Australia in
the next century.
``For Australia the percentage of the population aged over 65
is expected to rise from 15% of the population, 2.9 million, to
23% by 2030, that is, 5 million people. The percentage aged
over 85 is expected to more than double from around 2% to more
than 5% amounting to 650,000 Australians over 85.'' \2\
---------------------------------------------------------------------------
\2\ Susan Ryan, ``Quality of Life as It Relates to Australia's
Aging Population or Living to 100 in a Civilized Society'', Association
of Superannuation Funds of Australia, Speech, 1997.
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The full pension payment under this pillar represents approximately
26% of male total average weekly earnings. Maximum payments per
fortnight are calculated on a flat basis and are reduced accordingly,
based on income and asset tests.
Clearly to engineer or make such a significant shift in the overall
retirement structure of any country requires a strong political resolve
and vision for the future of a nation's citizens. In Australia's case,
more through coincidence and luck a popular Federal Government, through
trade union support was able to convey to the nation the impending
problems Australia would confront, if it did nothing about addressing
its aging population. This theme of the realization and admittance of a
future retirement hurdle was best summarized in the Better Incomes:
Retirement into the Next Century statement which expressed a commitment
to:
``maintain the age pension as an adequate base level of
income for older people'' but went on to state that persons
retiring in the future would require a standard of living
consistent with that experienced whilst in the workforce.'' \3\
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\3\ Senate Select Committee on Superannuation: ``Safeguarding
Super'', June 1992, p. 7, Canberra, Australia.
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For trade unions, which had strongly supported the election of a
Federal Labor government in 1983, increasing superannuation coverage
was seen as a major priority. Before the introduction of mandated,
second pillar, superannuation accounts, the extent of coverage of
superannuation was limited to roughly 40 percent of the workforce.
Typically employees who were covered by superannuation were employed in
middle class, ``white collar'' jobs where usually women and people from
minority groups were under-represented. Brandishing this as a major
bargaining tool, the trade union movement set about convincing the
Federal Government that the level of superannuation coverage needed to
be extended, via compulsory contributions into individual accounts. As
early as the 1970s, the trade union movement in Australia had expressed
reservations in how the retirement framework of Australia excluded
certain workers based on income and profession. Many of the younger
trade union officials argued for a more comprehensive system of
retirement provision that in effect required all workers to be
proactive in contributing and managing their own retirement needs. Some
had noted the successes of the national provident funds, as seen in
Malaysia and Singapore. Significant dissatisfaction also existed
amongst the labor movement over the extent and coverage of non-
management or ``blue collar'' workers. Moreover the union movement also
realized that comprehensive wage increases were becoming increasingly
difficult to successfully negotiate and that deferred savings benefits
may be an alternative to simply striving for an increase in workers net
pay. Initially the union movement's policies was effectively to
increase employee coverage of superannuation but by the mid 1980s the
union movement had shifted its stance whereby it would play a more
direct and active role in the day to day operations of superannuation,
via industry funds. These industry funds, grouped around a particular
economic sector of the Australian economy saw union and employer
representatives come together as trustees to manage the administration
and investment of many thousands of individual retirement accounts. The
increasing involvement by the union movement in superannuation matters
challenged some industry participant's views that effective
administration and investment decisions would be distorted in favor of
policies that stressed mutuality rather than economic reality.
Notwithstanding the active policy position taken by trade unions in
Australia regarding superannuation for employees, a more pragmatic view
of such support is linked with the steady decline in trade union
membership. Between August 1986 and August 1996, the level of trade
union membership reported by employees declined sharply from 46 percent
in 1986 to 31 percent in 1996.\4\
---------------------------------------------------------------------------
\4\ Australian Bureau of Statistics, 1998 Year Book Australia
(Canberra, Australia: AGPS, 1998), p. 215.
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Such a significant decrease coupled with the decline in traditional
union based industries such as heavy manufacturing further reinforced
the union's enthusiasm to support such retirement reforms as they felt
that they were in effect increasing their profile and relevance for
existing and potential members.
By 1986 circumstances were ideal for the introduction of a
widespread employment-based retirement incomes policy. The Federal
Government argued that as the Australian economy was undergoing a
period of significant economic readjustment from a largely primary
producer to becoming more services orientated, the old age pension
structure and its related drain on public finances could not be
sustained. Effectively the government insisted that it was in the
``public-interest'' to have a national, compulsory, employment-related
retirement income scheme in place.\5\
---------------------------------------------------------------------------
\5\ Sue Taylor, ``Australia's Mandatory Occupational Superannuation
Regime: An Evaluation of Opposing Claims--Is it a Policy Built on
Justice, Fairness, and Security in the Public-Interest or the
Entrenchment of the Power and Privilege of Politically Effective
Interest Groups?'' (Melbourne, Australia: 1999 Colloquium of
Superannuation Researchers, July 8-9 1999), p. 5.
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This aspect of the Australian political environment and how the
government of the day felt that it was acting in the best interests of
all Australians would be later echoed in 1992 by then Hon. Treasurer
Dawkins, when he commented that the retirement income scheme in place
would provide ``a coherent and equitable framework in which retirement
incomes objectives can be progressed'' and [would] permit a higher
standard of living in retirement than if we continued to rely on the
age pension alone.'' \6\
---------------------------------------------------------------------------
\6\ Senate Select Committee on Superannuation, ``Second Report on
Security in Retirement'' AGPS, (Canberra, Australia: 1992), p. 9.
---------------------------------------------------------------------------
Continuing wages pressure and demands by the union movement on the
government for a comprehensive superannuation policy to be initiated
saw the introduction of award superannuation, set at 3% of an
individual's yearly income. This amount was paid by the employer in the
form of a wage increase granted by the Conciliation and Arbitration
Commission, a Federal government body. Newly created industry funds
were effectively given a tremendous boost with this political decision.
These funds are sponsored by employer and employee organizations in one
or more industries and were established initially to receive the 3%
award contributions. Ongoing debate about the aging population and
growth in superannuation funds continued into the late 1980s.
With a delay to the 1990-1991 wage case occurring, where the ACTU
and the Government supported a further 3% round of award superannuation
the then government saw its opportunity to act in a decisive manner
towards retirement saving. In August 1991 the then Treasurer
foreshadowed the Government's intention of introducing a Superannuation
Guarantee Levy which would commence on July 1, 1992. In a statement
Security in Retirement, Planning for Tomorrow Today given on 30 June
1992, the then Treasurer, the Hon John Dawkins MP, reaffirmed the
government's position and direction on the aging of Australia's
population and the need for compulsory savings for retirement:
``Australia--unlike most other developed countries meets its
age pension from current revenues. Taxation paid by today's
workers is thus not contributing to workers' future retirement
security; the revenue is fully used to meet the annual cost
borne by governments.'' \7\
---------------------------------------------------------------------------
\7\ The Hon John Dawkins, MP, ``Security in Retirement, Planning
for Tomorrow Today'' AGPS, (Canberra, Australia: 30 June 1992), pp. 1-
2.
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The Superannuation Guarantee Charge Act 1992 requires all employees
to contribute to a complying superannuation fund at a level that
increased from 3% p.a. in 1992 to 9% per annum by July 1, 2002.
Although support for the Federal Government's comprehensive
superannuation reforms was quite pronounced, some opposition was
expressed by then Australian Democrats (a minor ``left leaning''
political party) leader Senator Kernot. She in contrast favored a
single, government-controlled, national portable system, similar to
that of a national provident fund. Although this approach gained some
initial minor support the Federal Government's proposed legislation
quickly generated wide acceptance through working in ``partnership''
with organized labor, business interests and industry associations.
In effect by embracing traditional opposition groups linked with
significant government reforms, criticism that may have hampered the
passage of important legislation, relating to superannuation reforms
was largely minimized. A further effective tactic used by the then
Federal Government was to employ government inquiries or private sector
research to highlight the inadequacies of Australia's level of
retirement system provision at the beginning of the 1990s. With these
inquiries being seen as delivering independent views or
recommendations, the Federal Government via the media felt vindicated
in implementing a mandated retirement system. Equally the Federal
Government argued that all Australians would be better off if
Australia's level of national savings were increased and thus
superannuation in part was seen to be addressing this problem.
Another method by which the Federal Government was able to engineer
significant change to the retirement system was through the use of an
effective public education campaign in 1994-1995, that was co-ordinated
by the Australian Taxation Office. Overall the total cost of the public
education campaign amounted to some $AUS 11 million. Through the
comprehensive use of the electronic and print media, the Federal
Government displayed strong political savvy in being seen as
introducing a retirement system that not only benefited the individual
but the nation as a whole. These two themes of individualism and
collectivism were to be stressed throughout the media campaign. Two
further factors that allowed political institutions to achieve
significant reforms in Australia was that the Westminster system of
government that had been inherited from the United Kingdom, which
allowed the relatively quick passage of debate and the implementation
of the Federal Government's retirement reform agenda.
With a controlling majority in the Lower House (House of
Representatives) and minority parties holding the balance of power in
the Upper House (Senate), no real effective delays in the reforms were
encountered. The Senate Select Committee on Superannuation, a
parliamentary appointed committee was also used effectively by the
government to hear, interpret or receive objections to the planned
reforms. Such a process of feedback and exchanging views encouraged a
spirit of ``consensus'' to be generated amongst many stakeholders of
differing political ideologies. Finally the very existence of well
established, professional industry associations in the form of the Life
Insurance Federation of Australia (LIFA) now the Investment & Financial
Services Association (IFSA) and the Association of Superannuation Funds
of Australia (ASFA) ensured that the affects and consequences of
proposed reforms could be simulated and well understood by
superannuation industry participants and bureaucrats alike. Unlike
Chile where individual retirement account reforms created a totally new
financial infrastructure, much of the superannuation infrastructure in
Australia had already existed under the previous voluntary
superannuation system. Thus important stakeholders and vested interests
like life insurance companies supported the reforms based on self
interest but also recognized how the existing financial infrastructure
would be well placed to implement the government's retirement
proposals. In effect the Federal Government had garnered support for
their reforms from traditional stakeholders who had been strong critics
of their previous economic policies. Such a shift in support in some
ways overwhelmed any organized opposition to these reforms.
Similarly in Australia, business saw the advantages of reforms to
retirement policy in terms of nurturing the capital market and overall
level of national saving. Some concerns were raised over the active
involvement of trade unions in the day to day operations of
superannuation funds but these concerns were alleviated through
adjustments in regulatory settings. A major concern for business after
the broadening of compulsion in 1992 was the increased costs that would
be levied on the employer as contributions lifted eventually to 9
percent by 2002. Larger business interests in many cases offered such
contributions already on voluntary basis through their in-house
corporate superannuation funds. Yet it was small business that strongly
opposed the reforms arguing principally that the increased burden of
cost linked with an expanded retirement provision would cause many
business failures. In summary business played only a moderate role in
supporting the government's reform agenda. This tacit support was co-
ordinated in part by large financial providers who would develop or
modify the financial infrastructure of such mandated retirement
accounts. Some moderate opposition from business interests also
centered on the political concept of individualism, in that the concept
should not force individuals to save for their retirement using a
particular financial product or mechanism.
Table 1: Details of the Prescribed Superannuation Requirements Linked
with the Mandated Second Pillar
Employer's
Prescribed Rate of
Employee Support
(%)
July 1, 1997--June 30, 1998......................... 6
July 1, 1998--June 30, 1999......................... 7
July 1, 1999--June 30, 2000......................... 7
July 1, 2000--June 30, 2001......................... 8
July 1, 2001--June 30, 2002......................... 8
July 1, 2002-03 and subsequent years................ 9
In March 1996, the then Labor Federal Government lost office and
was replaced by a conservative, Liberal Coalition Government under
Prime Minister John Howard. It had been the intention of the Australian
Labor Party, with trade union blessing to further expand the compulsory
nature of superannuation by gathering a 3 percent contribution from
individual workers and providing an additional 3 percent to certain
workers who met pre-defined income criteria. In total this would have
meant that many workers' individual superannuation contribution
accounts would have been receiving total contributions of 15 percent.
Treasury estimates suggest that over a forty-year period these
contributions would translate out to be approximately 60 percent of
one's salary on retirement.
With regard to the taxation of superannuation, Australia has
pursued a course which is quite unique and which on the whole I cannot
agree with in terms of design and the overall rate of taxation applied.
Based on Andrew Dilnot's model developed at the Institute of Fiscal
Studies in London, Australia's taxation of superannuation can be
described as TTT. Taxation of contributions at a rate of 15 percent,
along with possible additional taxation of 15 percent for members'
contributions earning over a certain threshold. A further tax of 15
percent is levied on the investment income of superannuation fund and
finally the benefits can be subjected to varying tax treatment of
between 0-30%, depending on timing of the contributions.
The profile of the second pillar of Australia's retirement system
depicts both a diversity and adequacy of return that reflects strong
and vigorous competition among the financial services industry in
Australia. Through a trustee structure, superannuation funds are
managed in the most efficient and effective manner for members.
I would like to now turn briefly to the mechanics associated with
selling, distribution and withdrawal of benefits from the
superannuation account. One of the reasons why Australia has been so
successful in keeping administrative costs low and also avoiding the
problems associated with mis-selling is through effective and cost
efficient regulation. Strict rules govern how superannuation policies
are sold and switched. Moreover consumers are required to receive
minimum levels of information about the superannuation products at the
time of sale and also on a regular basis. Clearly it is felt that, as
this is the largest financial transaction that a consumer will enter
into in their life, effective disclosure should be provided to
encourage transparency in the transaction. Increasingly superannuation
account holders are being provided with greater investment choices.
Some retail funds for example offer between 5-7 investment choices and
proposed legislation by the Federal Government will force employers to
offer choice of funds. Additionally specialized administration
companies have developed services that allow superannuation fund
trustees to outsource much of their investment and administrative
functions. This intense competition has led to in part returns being
maximized and administrative fees being minimized.
The success of consumer policy and integrated distribution
platforms has meant that large scale consumer detriment has been
minimized in Australia with its move towards a more fully funded
system. Through sound regulatory transparency and significant
improvements in the competency levels of distributors e.g., financial
advisers and financial planners public confidence in the overall
retirement system has continued to increase significantly. This
perception of security has nurtured a steady increase in the level of
overall voluntary contributions made into superannuation accounts. In
effect through sound regulation has come an acceptance by most
Australians that saving for one's retirement is beneficial on both an
individual and national basis.
Statistical and Demographic Highlights
By March 2001 the Australian superannuation system had combined
assets of $A497.1 ($US253.00) billion. For just over 9 million workers
this level of retirement savings is considered to be quite significant.
It is important to note that 19.8% of these assets are invested
internationally. Furthermore a large level of the superannuation assets
are invested in equities and unit trusts. This investment category has
grown sharply during the ``bull market'' period and is now estimated to
be 42% of superannuation assets in Australia.
Table 2: Overview of the Australian Superannuation Industry--June 2001
Number
Total of Funds Members
Type of Fund Assets (March (000's)
($billion) 2001)
Corporate............................... 78 3,283 1,504
Industry................................ 42 142 6,875
Public Sector........................... 108 94 2,776
Retail (including RSAs)--RSAs........... 102 278 11,168
Small Funds............................. 76 214,025 433
Annuities, life office reserves etc..... 44 na nq
-------------------------------
Total Assets/Funds/Members.............. 497 217,882 22,756
Source: APRA Bulletin, Australian Government Publishing Service, June
2001.
Like the United States, Australia has a demographic profile that
depicts a significant baby boomer population. As seen in Appendix 1,
Australia and the United States demographic profile will continue to
deteriorate over time. Such an effect is compounded by the growing cost
of each nations pensions unfunded liability. Moreover the seriousness
of both countries' demographic positions are highlighted in the two
tables linked with life expectancy and the elderly/youth ratio. Yet it
should be noted that both countries' demographic positions are much
healthier when compared with countries like Germany or France.
Administration costs continues to be a sensitive issue within the
Australian political and financial services environment. These costs
can vary widely between the types of superannuation funds found in
Australia. Through an authoritative survey conducted by the Association
of Superannuation Funds of Australia (ASFA), an average estimate of
$1.28 ($US0.65) per member per week was made for overall administration
costs in 1999-2000. It should be noted that this figure has declined
from $1.66 ($US0.84) per week two years earlier. Expressed in another
way, costs as a percentage of assets in June 2000 was calculated to be
1.29%. It is anticipated that this level of costs as a percentage of
assets will decline as the system matures.
Conclusions
For the United States the challenges of social security reform may
seem immense if not impossible from initial observations. Yet what
countries like Australia demonstrate is the ability for a nation to
give its people a greater ability to craft out a sufficient and
appropriate level of retirement wealth to meet expected future needs
and demands. Certainly no one country's experiences with regard to
social security reform can be easily translated to another. Yet what
countries like Australia can demonstrate to public policy planners in
the United States is the strong propensity that the individual is
ideally placed to determine his or her own retirement needs. Give
people certainty with regard to a retirement or social security model
and they then can best prepare for their own retirement. This
harnessing of the individual's need to maintain retirement security in
retirement will increasingly become a major political and social issue
in both Australia and the United States during this century.
Appendix 1
Table 3: Life Expectancy of Selected Developed Nations
--------------------------------------------------------------------------------------------------------------------------------------------------------
1950-1955 1960-1965 1970-1975 1980-1985 1990-1995 2000-2005 2010-2015 2020-2025 2030-2035 2040-2045
--------------------------------------------------------------------------------------------------------------------------------------------------------
AUSTRALIA................................. 69.57 70.91 71.70 75.21 77.60 78.74 79.74 80.67 81.48 82.29
CANADA.................................... 69.08 71.44 73.15 75.92 78.50 79.47 80.40 81.20 82.00 82.80
CHILE..................................... 54.75 57.92 63.44 70.57 74.21 75.65 76.88 77.95 78.84 79.61
CHINA..................................... 40.76 49.53 63.18 66.56 68.37 71.18 73.49 75.53 77.15 78.46
FRANCE.................................... 66.52 70.96 72.35 74.72 77.15 78.75 79.70 80.60 81.45 82.24
GERMANY................................... 67.50 70.30 71.00 73.80 76.00 77.82 78.89 79.84 80.67 81.45
IRELAND................................... 66.91 70.29 71.28 73.10 75.34 77.36 79.09 80.57 81.37 82.16
ITALY..................................... 66.00 69.92 72.11 74.54 77.16 78.83 79.80 80.69 81.46 82.24
JAPAN..................................... 63.94 68.96 73.30 76.91 79.50 80.34 81.09 81.86 82.65 83.44
NETH...................................... 72.11 73.38 73.96 75.98 77.26 78.39 79.34 80.27 81.06 81.86
SWEDEN.................................... 71.81 73.54 74.72 76.27 77.86 79.34 80.62 81.60 82.39 83.19
SWISS..................................... 69.23 71.67 73.81 76.16 77.67 79.13 80.04 80.91 81.69 82.49
UK........................................ 69.18 70.76 72.01 74.04 76.17 77.97 78.95 79.95 80.80 81.59
USA....................................... 69.02 69.96 71.30 74.48 75.66 77.35 78.67 79.67 80.57 81.36
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: United Nations: World Population Prospects 1950-2050 (1998 Revision).
Table 4: UN Elderly/Youth Ratio for selected developed countries
--------------------------------------------------------------------------------------------------------------------------------------------------------
1950-1955 1960-1965 1970-1975 1980-1985 1990-1995 2000-2005 2010-2015 2020-2025 2030-2035 2040-2045
--------------------------------------------------------------------------------------------------------------------------------------------------------
AUSTRALIA................................. 0.24 0.23 0.22 0.28 0.37 0.47 0.62 0.77 0.90 0.97
CANADA.................................... 0.20 0.18 0.20 0.29 0.40 0.55 0.73 0.91 1.04 1.06
CHILE..................................... 0.09 0.10 0.10 0.12 0.15 0.22 0.31 0.43 0.58 0.65
CHINA..................................... 0.10 0.10 0.09 0.10 0.15 0.24 0.35 0.54 0.83 1.01
FRANCE.................................... 0.38 0.36 0.39 0.46 0.50 0.67 0.80 0.95 1.09 1.15
GERMANY................................... 0.32 0.40 0.46 0.58 0.69 0.92 1.14 1.31 1.57 1.57
IRELAND................................... 0.29 0.28 0.28 0.27 0.31 0.42 0.50 0.63 0.76 0.90
ITALY..................................... 0.24 0.29 0.34 0.43 0.65 1.06 1.34 1.66 2.01 2.15
JAPAN..................................... 0.11 0.14 0.22 0.30 0.45 0.97 1.26 1.44 1.54 1.66
NETH...................................... 0.21 0.24 0.28 0.37 0.50 0.63 0.91 1.19 1.38 1.43
SPAIN..................................... 0.20 0.23 0.27 0.30 0.49 0.82 1.01 1.26 1.72 2.18
SWEDEN.................................... 0.35 0.40 0.49 0.62 0.72 0.77 1.09 1.18 1.26 1.29
SWISS..................................... 0.32 0.32 0.37 0.50 0.62 0.68 0.93 1.19 1.49 1.62
UK........................................ 0.37 0.39 0.41 0.52 0.61 0.67 0.84 0.96 1.11 1.15
USA....................................... 0.24 0.24 0.26 0.35 0.43 0.46 0.59 0.78 0.91 0.93
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: United Nations: World Population Prospects 1950-2050 (1998 Revision).
Table 5: Projected future state spending on pensions as a percentage of GDP
----------------------------------------------------------------------------------------------------------------
1995 2000 2010 2020 2030 2040 2050
----------------------------------------------------------------------------------------------------------------
Australia............................................... 2.6 2.3 2.3 2.9 3.8 4.3 4.5
Canada.................................................. 5.2 5.0 5.3 6.9 9.0 9.1 8.7
France.................................................. 10.6 9.8 9.7 11.6 13.5 14.3 14.4
Germany................................................. 11.1 11.5 11.8 12.3 16.5 18.4 17.5
Italy................................................... 13.3 12.6 13.2 15.3 20.3 21.4 20.3
Japan................................................... 6.6 7.5 9.6 12.4 13.4 14.9 16.5
Netherlands............................................. 6.0 5.7 6.1 8.4 11.2 12.1 11.4
New Zealand............................................. 5.9 4.8 5.2 6.7 8.3 9.4 9.8
United Kingdom.......................................... 4.5 4.5 5.2 5.1 5.5 4.0 4.1
United States........................................... 4.1 4.2 4.5 5.2 6.6 7.1 7.0
----------------------------------------------------------------------------------------------------------------
Source: OECD, cited in Johnson (1999).
Chairman Shaw. Thank you. Thank you, Mr. Harris.
I think, in listening to the various testimonies of the
witnesses with regard to other countries, I think there is a
tendency in the United States to feel that we invented
everything that is good, which of course is not true. And I
think that the purpose of this hearing is to reach out to other
countries who have had, and I think as Mr. Hewitt correctly
stated, perhaps a worse problem than we have but nevertheless
the same problem that we have. And just as we followed, I knew
we followed Chile and now I know that we followed Australia in
setting up a Social Security system, I think it is also
important that we listen to the other countries that have aging
populations as we do.
When Social Security was first put in existence, I think in
1935 or thereabouts, I am close, there were about 40 workers
per retiree. This made a very, very flattened and very
efficient pay-as-you-go system as a triangle or as a pyramid.
But as the age of the population grows, we find now we have
gone from 40 workers per retiree down to a little over three
workers per retiree.
One of the witnesses correctly stated, it was Mr. Bedell-
Pearce, I think, that aging of population and demographics of
population is probably one of the most accurate predictions
that we can make, and those in the position of making
predictions tell us that we are going to be shrinking down to a
little over two. Obviously, we have to do something. Obviously,
a pay-as-you-go system cannot continue to work.
Mr. Matsui mentioned the bill that Mr. Kolbe filed last
week, talking about the--and that particular bill actually
showed, at least the newspaper account showed actually a
diminution in the benefits for people that were 10 years from
retirement. That is exactly what I am hoping that, by acting
now, we can avoid.
Mr. Burtless, you made reference in your testimony to the
tremendous coverage that we have and the advantage that we have
as to many of our workers covered by private pension. What I
was listening for and didn't hear is, how are we going to
continue to hold the benefits at this level for those that are
not covered by a private pension?
The Social Security Administration, under the previous
administration, told us, and they have been very specific about
this, that we are facing about a $22 trillion deficit over the
next 75 years. How do you propose to pay those payments, if we
maintain the system as it is today?
Mr. Burtless. Well, I have testified before this and other
Committees frequently on this subject. I favor an increase in
the normal and early age at retirement. I favor modest
increases in the payroll contribution rate. And I think it is
OK if the trust fund is invested in higher yielding securities
than U.S. Treasury bonds. I am not strong on that because I
don't think economically it makes much difference what we
invest them in, but it certainly lowers the contribution rate
that would be required of workers.
Having said that, let me say I am no opponent of individual
or company pensions. I favor them. In fact, I would favor an
obligation that employers establish programs so that their
workers can save simply. For small employers, if this
obligation is too burdensome, I think that the Federal
Government should provide the withholding and the recordkeeping
of contributions to individual accounts. This would permit
pension contributions to occur at very little cost to the small
employer community.
Chairman Shaw. How, to what age? Do you have a model that
you have developed showing this, and if so, how high would we
have to raise the retirement age in order to sustain the
benefit level that we have today? And how high would the taxes,
the payroll taxes on American workers, have to be raised in
order to sustain the system at its existing level with a higher
retirement age?
Mr. Burtless. I think that the best source of information
about what an increase in the retirement age, either the early
or the normal retirement age, the impact of that on the balance
and the long-term solvency of Social Security can be obtained
from Steve Goss, the Chief Actuary of Social Security. I don't
pretend to be an expert on the actuarial calculations.
Chairman Shaw. Are you telling us that you don't know how
high you would have to raise the taxes or how high you would
have to go on the retirement age in order to sustain the----
Mr. Burtless. Well, we know. We know that roughly a 2-
percentage point increase in the current payroll tax for old
age and survivors and disability pensions, bringing it from
12.4 to 14.4 percent of wages, would cover the expected cost of
the system over the next 75 years.
If, in addition to that tax increase, you changed the
investment portfolio of the Social Security Trust Fund from all
government bonds to some combination of other assets, a safe
combination, then that 2-percentage point increase is not
entirely needed. You could increase the contribution rate less
because the investment earnings of the fund would cover a
larger share of the benefits.
Chairman Shaw. So what you favor is the trust fund actually
investing in the private sector. Is that correct?
Mr. Burtless. I don't think----
Chairman Shaw. There is no other place to go, if you are
not investing in government securities. I assume you would be
buying stocks and bonds in the private sector.
Mr. Burtless. Yes. I think that, at a minimum, we could
invest in mortgage-backed securities, in corporate bonds (where
there is no issue of how the government votes the shares), and
in real estate. There are a lot of assets that the government
can hold with an arms-length relationship, and that would have
higher expected yield over 75 years, than Treasury bonds.
Chairman Shaw. Am I correct, in summing up your testimony,
that you would agree that the existing system is not
sustainable unless we raise the retirement age, increase taxes,
and/or invest the trust funds in something other than
government securities, or a combination of all three?
Mr. Burtless. That is exactly right. That is what it takes
to fix Social Security.
Chairman Shaw. Thank you. I wanted to be sure that that
was----
Mr. Burtless. You could also do large transfers from the
rest of the government budget, of course. That was proposed by
President Clinton.
Chairman Shaw. Yes.
Mr. Burtless. In other words, there is a fourth solution.
The three that you mentioned are the three that would fix up
Social Security in the more or less traditional way that
Congress has used to fix Social Security----
Chairman Shaw. I assume that all of the witnesses, then,
would certainly agree--perhaps you would disagree as to the
solution to the problem, but you would agree that the existing
system as a pay-as-you-go system cannot be sustained. Am I
correct on that? Even though you may disagree with how we
should go about changing it.
[Witnesses nod.]
Chairman Shaw. I thank you.
Mr. Matsui.
Mr. Matsui. Thank you, Mr. Chairman.
Let me say this. Mr. Burtless, when the Chairman mentioned
$22 trillion being the amount of obligation, by your not
responding to that number, you are not suggesting that number
is correct, are you? Because the Social Security actuaries have
actually said that the amount of the deficit over the next 75
years is $3.1 trillion.
Chairman Shaw. Would the gentleman yield on that?
Mr. Matsui. Well, no. Let me ask him a question. And if you
bought out the system, it would be between $8 and $11 trillion,
not $22 trillion. Is that your understanding?
Mr. Burtless. My understanding is that the liabilities of
Social Security, if we closed it down tomorrow, we stopped
taking in new revenues and we just delivered on the promises
that have already been made, we are talking about $10 trillion,
roughly.
Mr. Matsui. Right, right.
Mr. Burtless. We have $1 trillion in the bank, and the $9
trillion difference represents the amount of money that we have
given to our parents, grandparents, great-grandparents over the
last 50 years in excess of their contributions into the system
and the investment earnings that their contributions have
earned. That is the unfunded liability at this point.
Mr. Matsui. And that comes to about $3.1 trillion.
Mr. Burtless. I think the $3.1 trillion is a different
calculation. It is the following: How much money is promised
and will continue to be promised from now on, and how much
revenues can we see coming into the system from now on? Now,
let's discount those two numbers back to the present. The $3
trillion is that difference.
Mr. Matsui. Let me, if I can complete my questions, in
terms of this about raising taxes or cutting benefits or
investing in the market, if you have private accounts, can you
solve the problem overnight and not do any of those things?
Mr. Burtless. I served on a commission that examined issues
connected with privatization, and I thought every Member of
this panel agreed that privatization in and of itself doesn't
solve any of the problems. There is one political problem that
it may reduce. Many people are fearful that if the government
owned a portfolio that included voting shares in America's
companies, that is a very dangerous thing to do. And so if
instead the surplus were accumulated in 140 million little
accounts of individual workers, this political problem would
disappear. But privatization does nothing to alleviate the
economic problem facing Social Security.
Mr. Matsui. If I could just interrupt you, then you are
basically saying no. It doesn't solve this problem just by
private accounts.
Mr. Burtless. No.
Mr. Matsui. In fact, if you read the Richard Stevenson
piece in the New York Times on Sunday, on the Kolbe-Stenholm
legislation, one would find that actually taking out 16 percent
of payroll or 2 percent of 12.4 percent, actually makes the
problem worse. I think in the article it said that instead of
2016, the shortfall begins to occur in 2007. Is that correct?
Mr. Burtless. That is right. If the system is left
unchanged, it is going to run out of funds in 2038. If we give
away 2 percent of payroll taxes to individual contributors over
the next 38 years, well, the cookie jar will be empty much,
much sooner.
Mr. Matsui. Right. Dr. Orszag, you mentioned only the
British system, and you didn't mention Sweden and Australia and
obviously other systems as well, particularly Chile. Was it
because you didn't study those, or have you studied those
systems?
Dr. Orszag. The real reason that I focused on the U.K. in
my testimony is that it provides the best example of a country
that does what President Bush has suggested.
Mr. Matsui. And the other ones really are not comparable.
Dr. Orszag. They all differ in some way. Either the system
is mandatory, unlike what President Bush is proposing, or it is
employer-based, unlike what President Bush is proposing.
Mr. Matsui. And with respect to Chile, you know, there is
this talk about general fund moneys. Chile, if I recall, Mr.
Pinochet was still the leader of Chile in 1981 when they went
over to the privatized system, and weren't they disposing of a
lot of the government-owned property and selling it, and so
that went into the overall budget of Chile. Is that correct?
Dr. Orszag. There were a lot of changes that were occurring
at the same time, including privatization and----
Mr. Matsui. And we don't know what went into the pension
system and what didn't. Is that correct?
Dr. Orszag. That's right, money is fungible. It is very
hard to trace what dollar went to what purpose.
Mr. Matsui. And in the English system, when they converted
over to that second tier, which is the private tier, you know,
voluntary private tier, there was some general fund monies as
well. Is that correct?
Dr. Orszag. The tax rebates reduce tax revenue, yes.
Mr. Matsui. Right, and the tax rebates would have gone to
the general fund otherwise.
Dr. Orszag. That is correct. They would have been part of
the National Insurance Fund.
Mr. Matsui. Right. Let me, if I may just ask, let me ask in
terms of the British system, my understanding is, just from
reading some of the British newspapers, that there is a $15
billion pound problem in terms of the so-called mis-selling.
Can you explain that? That comes to, I think, U.S. dollars,
anywhere from $15 to $20 billion. Is that correct?
Dr. Orszag. Yes. The numbers vary. And just to explain very
briefly, the problem really involved people who had been in an
employer-provided plan, an occupational scheme, and were lured
into individual accounts, and the question is whether that was
an appropriate change for them or not. And the numbers that you
are mentioning, $15 to $20 billion, are the amounts the
financial firms are now ponying up to make the individuals
whole who were misled.
Mr. Matsui. And apparently, and I know my time has expired
but I think we will get a second round, 1.5 million people
actually have this problem, and not all of them have been paid
yet. This has been now, what, three or 4 years. Is that right?
Five years, perhaps?
Dr. Orszag. The numbers are still a bit fuzzy because it
hasn't all played out yet.
Mr. Matsui. And let me just, Mr. Burtless, I read your
written testimony and you talked about going all the way back
to 1871 and then projecting I guess 30 years in terms of, you
know, the market and how much the market actually would have
benefited individuals. And you indicate a one year difference
between 2000, if a person retired, and then if a person retired
in 2001, there would have been a reduction of one-third of
one's Social Security benefits. Can you just explain that,
because I think that was a fascinating analysis that you did.
Mr. Burtless. How much risk is associated with the high
returns people are sometimes promised in individual retirement
accounts that are invested in the United States stock market?
The calculation is this: Workers start to work when they are
22, and they stop working when they are 62. They save 2 percent
of their salary every year, and then when they retire they take
their savings to an annuity company and they purchase an
annuity. How much money do they have, if we just follow the
actual stock market performance over the last 130 years?
Well, you can look at about 90 or 91 different workers,
because that is how many 40-year periods there have been in
those 130 years, and you can say, ``Okay, well, what would this
person's pension have been upon retirement under this
assumption?'' And the calculation that you just mentioned was
performed for someone who retired at the end of March 2000, and
performed again for a person who retired at the end of March
2001.
The reason that there was such a big decline is because of
course the stock market declined in real terms in the United
States by almost 30 percent. But in addition the annuity
company, the company that sells you an annuity, has to invest
its funds. It makes its guess about how much it is going to be
able to earn on the funds it invests by what the yield is on
Treasury bonds. The Treasury yield, the long-term yield, fell
considerably between March 2000 and March 2001.
So there were two things that adversely affected the
retiree. Number one, the stock market fell, so the value of his
lifetime savings fell about 30 percent. And, then in addition
he had to pay a higher price to get an annuity. The result was
that the value of the annuity fell from an all-time high in
March 2000, by roughly a third in March 2001.
Mr. Matsui. It was a third, I thought, or 30 percent. So if
I could just conclude, two people who had the same investment
in stock, basically the same stocks, if one retired 12 months
sooner than the other, they would have about a third reduction
in their lifetime retirement benefits or projected retirement
benefits. Is that correct?
Mr. Burtless. That is correct. If the government received
many letters on the Social Security benefit notch, which was
far, far smaller than this, you can imagine the flow of mail
into Capitol Hill if this kind of a plan is adopted.
Mr. Matsui. Yes. If we thought the notch baby was a
problem, well. Thank you, Mr. Chairman.
Chairman Shaw. Mr. Matsui, are you speaking of treating the
next generation different than this generation?
Mr. Matsui. I don't understand what you mean.
Chairman Shaw. As far as creation of a new notch?
Mr. Matsui. No, not at all. In fact, that is what I am
worried about.
Chairman Shaw. That is exactly what this Committee is
worried about, and that is why we are having a hearing, because
I very much want to be sure that we do everything in our power
not to treat our children any differently than we are treated.
I don't want them having to pay a higher payroll tax, like Mr.
Burtless referred to. I don't want them having to work any
longer unless it is just simply for a question of them living
longer.
And particularly by the legislation that we are going to
pass, and I want to just give Mr. Burtless just an
opportunity----
Mr. Matsui. Mr. Chairman, in view of the fact that you
responded, may I just respond back to you? Because we talked
about the younger generation. My concern about the younger
generation is that if you take 2 percent of payroll which they
can put in an account, or 16 percent of the payroll tax in an
account, and you make whole the current generation of retirees,
you have got to come up with the difference someplace, and that
means you probably have to increase taxes on that young
population. And so you are basically double-taxing them for one
set of retirement----
Chairman Shaw. Well, every witness here has said that the
present plan cannot be sustained, and actually the memorandum
that you, Mr. Matsui, sent out to your Democrat colleagues
pointed up the fact that it could not be, that the present
system could not be fully funded at its existing level----
Mr. Matsui. Oh, no one is questioning that.
Chairman Shaw. Unless something is done. But I do want to
give Mr. Burtless an opportunity to correct something that he
said, and I don't think you meant to be as flip about this.
When you talk about giving away some of the payroll taxes,
surely you are not saying that putting money in an individual
retirement account which is going to be used to offset an
unfunded liability of the Social Security Administration upon
retirement of that worker is giving it away, is it? You didn't
mean to say that, did you?
Mr. Burtless. From the point of view of the obligations of
the existing Social Security system, yes, it is giving it away.
Because of all the calculations----
Chairman Shaw. Wait a minute. How in the world can you say
that? If we set up individual retirement accounts for future
workers that are going to retire 20 years from now, and as a
requirement they are going to take those individual retirement
accounts back to the Social Security Administration and they
are going to be used to help fund their retirement, you call
that giving it away?
Now, I am not one of those that is in favor of taking the
individual retirement accounts out of the payroll taxes, and
the plan that I have produced does not do that. What I do is
simply take the money out of the Treasury and send it away. But
I don't think putting money away for tomorrow's retiree is
giving it away.
Dr. Orszag. Mr. Chairman, if I may, I might be able to
clarify one thing. What you are referring to is using the
income from an individual account and offsetting the Social
Security benefits.
Chairman Shaw. Well, the income and principal.
Dr. Orszag. Right. Without that linkage between the income
from an individual account and the traditional Social Security
benefit, then it would be giving it away, from the perspective
of Social Security. That linkage is crucial for your plan, and
I think Mr. Burtless would agree that given that linkage, then
there could be some effect on the actuarial balance. But the
linkage is the key, between the income from the individual
account and the traditional benefit.
Chairman Shaw. Yes. Well, I can understand that, but also
when we talk about the deficit, the pending deficit in the
Social Security Trust Fund, and we start talking about it being
$3 trillion, that is in terms of today's dollars if you had
that money to put away somewhere and let it grow, which we
don't have over $3 trillion to set it out some way and let it
grow. So in terms of today's dollars, you might be able to say
that.
But when you are talking about what is going to be the
deficit over the next 75 years, I think all, everyone would
agree that it is going to be $22 trillion. And it is not in
terms of today's dollars, it is in terms of what is going to be
mounting up over a period of time. And the real disaster out
there, and we will all be dead and gone by the time it really
gets out there, but when you get into the 75th year, it is
growing so quick every year that if you take it out to 100
years, God knows what it is. It is huge, and it would bring
down the economy of the United States. It would bring down any
economy. And this is exactly what we are trying to avoid, and
this is what we have got to plan for.
Mr. Lewis.
Mr. Lewis. Thank you, Mr. Chairman.
Mr. Harris, did you want to weigh in on this? You looked
like you had something to say.
Mr. Harris. I think there is--you know, we can argue about
the facts, the figures and the numbers. I think we have to
really look closely here at empowering not so much the baby
boomer generation but generation X and beyond.
And I think what we did in Australia did, and certainly in
the United Kingdom, and there has been a lot of criticism in
the United Kingdom, but the most productive thing that both
these countries have done is given the individual generation
X's and Y's or whatever the ability to craft out their own
retirement needs, to harness cynicism and be constructive about
crafting out their own retirement needs. And I think that is
positive, I think this is healthy, and I think that is what
this country was built on, was the individual and individual
aspirations.
Mr. Lewis. Well, I agree. I have a son and a daughter that
are going to be burdened with a substantial and significant
increase in their taxes, payroll taxes, and then what are they
going to get for that? They are going to get an increase in
their age limit to retire, and then get less benefits. So I
think that is not fair in any----
Mr. Harris. It is going to be tough political to ask a
Congressman like yourself, do you cut benefits or do you
increase taxes? I wouldn't like to be in that position.
Mr. Lewis. Well, as the Chairman mentioned a while ago, we
are talking about a pyramid here. It was fine in the beginning,
but when you are on the short end of that stick, you are going
to come up losing, and that is exactly what is happening.
Mr. Burtless, you mentioned that the elderly in this
country compare unfavorably with other countries in regards to
poverty. Wouldn't increasing taxes or reducing benefits to
achieve solvency increase elderly poverty even further?
Mr. Burtless. Increasing taxes on the working-age
population in order to protect the guaranteed pension under
Social Security does not boost the poverty rate of the aged at
all. It----
Mr. Lewis. But reducing benefits?
Mr. Burtless. But reducing benefits, exactly as you
suggest, would tend to increase the poverty rate of old
Americans, depending on how the reduction in benefits is
structured.
Mr. Lewis. OK. Thank you.
Chairman Shaw. Mr. Becerra.
Mr. Becerra. Mr. Chairman, thank you very much. To all the
witnesses, thank you for your testimony, for being here.
Let me ask a question that takes us away a little bit from
the questions that have been asked earlier, and ask if any of
you have a particular comment with regard to the fact that we
have had an increased amount of immigration in this country
over the years as compared to some of the other more
industrialized nations, the G-5 nations which are often
compared. Has immigration in this country over the last couple
of decades helped our country deal with the impending problem
of Social Security and funding it into the future?
Mr. Hewitt. I would be happy to take a shot at that. It has
had a huge impact.
Mr. Becerra. Positive or negative?
Mr. Hewitt. A very positive impact. Immigrants have a
higher rate of birth when they first come here. Eventually they
adopt the birth rates of the majority. But most of the
population and labor force growth that we will experience over
the next 50 years, which sets us apart from the other
industrial countries, is the direct result of assumed high
rates of immigration. So our demographic profile is different
precisely because of that reason.
If I can also just throw in a side issue here, it is, the
fact that the U.S. population is slated to grow by 46 percent
over the next 50 years is one of the main reasons why it is so
much more difficult for the United States to meet the Kyoto
environmental accord requirements, because then our major
trading partners like Japan and the European Union, because
their populations are slated to shrink over this same period,
and part of that is indeed because they accept lower rates of
immigration.
Mr. Becerra. And I don't want to make light of the fact
that we have to watch population growth trends, regardless of
what country or any part of the globe, but does anyone disagree
with what Mr. Hewitt has just said with regard to immigration?
Mr. Harris. Thank you, Congressman. I wouldn't tend to
disagree with Paul's comments, but there is some divided
opinion on whether immigration or increased levels of
immigration ultimately solves your aging population. I refer to
Robert Brown of Canada, who is a leading academic in the field
of actuarial science, where he has expressed concerns that
Canada and Australia, two leading countries with large levels
of immigration have seen immigration levels increase but at the
same time family reunion schemes increase as well. So the net
initial factor is that there is a younger immigrant coming in,
in the case in Canada and Australia, initially, but then
increasingly family reunion schemes see older, if you like,
immigrants coming in and following on. So, if you like, the
impact of the benefit of immigration in the long term is
diluted slightly.
Dr. Orszag. If I could just add that in the United States,
the Social Security actuaries have examined this question. If
you look at the partial effect of higher levels of immigration,
it clearly shows up as an improvement in Social Security's
long-term financing.
Mr. Hewitt. If I can just add one minor point----
Mr. Becerra. Very quickly, if I could get to----
Mr. Hewitt. The U.N. has estimated that if the United
States were to use immigration to retain the same level of old
age dependency, workers/retiree ratio, that by 2050, 72 percent
of the U.S. population would be immigrants or their children.
Mr. Becerra. Wow. Dr. Orszag, let me ask you a question
with regard to private accounts and the creation of those
accounts. Some have said that when you talk about savings, that
this country has not done its best job in trying to get our
country, our people, to save, whether private accounts or
national savings altogether, which includes government savings
as well.
Some folks have also said that if you create these private
accounts, you might just displace current savings activities by
individuals who would view these private accounts as a way to
continue the savings they are otherwise doing, whether it is a
savings account, a regular savings account, passbook savings
account or checking account, or maybe in the stock market, but
now you are required or called upon to save in these private
pension accounts or Social Security accounts, that that might
just displace your own private or personal activity in savings
accounts. Is there a chance that, in creating these private
savings accounts, all we are doing is supplanting current
savings activities that Americans undertake?
Dr. Orszag. Yes, and in answering that question, I want to
emphasize the importance of the recent bipartisan agreement to
ensure that Social Security surpluses are devoted to paying
down public debt. Given that, if you divert revenue from the
Social Security Trust Fund into individual accounts, and
individuals don't respond at all in their behavior, all you are
doing is reducing government saving by $1 and increasing
private saving by $1 with no increase in national saving. Then
you need to consider how individuals could respond. For
example, if $1 in an individual account is more tangible than
$1 of reduced public debt, and so someone says, ``Well, I've
got $1 in my individual account, I don't need to put as much
into my 401(k) or IRA or other type of saving,'' the net effect
could actually be a reduction in national saving.
Mr. Becerra. Thank you. Thank you, Mr. Chairman.
Chairman Shaw. Mr. Pomeroy.
Mr. Pomeroy. Mr. Chairman, over here? Really? Great.
Chairman Shaw. I was looking at him, indicating that I
wasn't going to go to him, I was going to go to you.
Mr. Pomeroy. No one has ever been that nice to me before. I
want to thank you for calling on me to inquire, and for holding
this hearing. I think this has been one of the more interesting
panels that I have had the opportunity to listen to as a Member
of this Subcommittee. I appreciate it a lot.
I think that the perspective we can learn from
international experience is very important. On the other hand,
I do think it also has to be kept in perspective. Some of
those, you wonder what the reaction of some would be that so
favor, for example, the Chilean experience, if it was proposed
to them, ``Well, Chile has reduced their crime rate. We should
adopt the Chilean crime code.'' I mean, you know, they would
say, ``Let's look at it but let's not, I mean, let's make our
own judgments here. This is a very different country, a very
different circumstance.'' So, too, is it as we evaluate the
situations leading up to the reforms and how they are
implemented.
Mr. Harris, you used to be an insurance regulator?
Mr. Harris. Yes, sir.
Mr. Pomeroy. So did I.
Mr. Harris. Yes, I know that.
Mr. Pomeroy. A very twisted and shared common experience.
As you say at the end of your testimony, the individuals
are ideally placed to really shape their own decisionmaking.
Would you include in that voluntary, whether or not they ought
to participate in private accounts as a voluntary matter, and
whether or not the decision to annuitize should be voluntary?
Mr. Harris. I have got some sympathy for this view. I think
the individual is best placed to determine the requirement for
having, if you like, the appropriate tools for ideal public
education facilities, information. What was crucial in the
Australian experience, and other countries, but certainly
Australia, was that politicians like yourself mounted a very
effective public education campaign to allow the individual to
have necessary, if you like, information appropriate decisions.
Going on to your second question about annuitization, I
think I have some support for compulsory annuitization. I am
concerned in some countries, in our case in Australia, where
individuals had in the past relied on lump sum payments and saw
them quickly eroded.
Mr. Pomeroy. I think that is going to be a very major issue
facing our private retirement system under our defined
contribution experience, and Mr. Chairman, I would commend that
topic to you for one we should explore on the private savings
side, somewhere, whatever Committee has jurisdiction of that
one, or the whole Committee.
The Chairman, the co-chairman of this, President Bush's
retirement or Social Security Commission, Senator Moynihan, has
spoken favorably about the voluntary nature of a private
account system and the opposition to mandatory annuitization.
Mr. Burtless, what would be the compound effect of those two
features in a private account format that could be
contemplated?
Mr. Burtless. Well, I agree with Peter Orszag that a
problem with voluntary withholding from the Social Security
system is that the people who are likely to opt out are the
people such as myself who have high earnings and therefore have
very good investment opportunities outside of Social Security.
But it is unfortunately the case that it is also people like me
that pay for the benefits of a lot of older people and people
with lower incomes. So I fear that the selective withdrawal of
people from the traditional Social Security system is going to
adversely affect the level of benefits that we can pay under
the guaranteed pension program to the people who remain in the
traditional system.
Mr. Pomeroy. Right. In other words, right now a moderate
wage earner gets a higher portion of their income replaced
under Social Security than a more affluent level wage earner.
Is that correct?
Mr. Burtless. Yes.
Mr. Pomeroy. And making it voluntary, you would tend to
have the higher earners opting out, leaving the lower earner,
probably leaving the lower earner with a lower income
replacement rate, in other words, less relative benefit.
Correct?
Mr. Burtless. I think the loss of revenues from my
contributions to Social Security, and from people like me,
would mean that the basic guaranteed pension under Social
Security would have to be scaled back more than would be the
case if we just tried to reform the current compulsory system.
Your second question had to do with compulsory
annuitization upon retirement. In my testimony I suggested if
we do have a system of individual accounts, then prudence
requires that we require people to annuitize at least enough of
their saving in this plan so that they do not immediately spend
all of that nest egg and then become eligible for means tested
benefits.
Mr. Pomeroy. Right. I have got one more question I have got
to ask, but I do think those two points, voluntary
participation and voluntary annuitization, show that in the end
choice, although wonderful, can vastly undermine the security
of the Social Security system.
Mr. Burtless. Right, right.
Mr. Pomeroy. A final question for Mr. Palmer. At the outset
of your testimony, you indicate that there was an unfairness, a
redistributional unfairness in the design of the old system.
Would you--I am really out of time, so I am trying to figure,
will we have a chance to go around?
Chairman Shaw. Well, let me, I am going to get the feeling
of everybody.
Mr. Pomeroy. All right. I yield back. Thank you, Mr.
Chairman. I will get to you later.
Chairman Shaw. Mr. Hulshof.
Mr. Hulshof. Thanks, Mr. Chairman. As you know, a couple of
weeks ago when you came to my district, for those of you who
perhaps were unaware, we had an official field hearing of the
Social Security Subcommittee in Columbia, Missouri, which is my
hometown, and it was a very interactive format, I think roughly
250 to 300 people on the campus. We had all age groups
represented.
And it was very interactive in the sense that we had Ron
Gephartzbauer. Probably many of you know Ron, who is an
actuarial expert, and he presented various options to fix the
long-term solvency of Social Security, and then we had people
at tables who tried to come up with a 100-percent solution. And
we weren't thrusting our opinions upon them, but we really were
listening.
I am happy to report to you, Mr. Chairman, that one of the
college classes who spent that afternoon with us, Dr. David
Weber's class, then took that hearing as their beginning point,
and each of the students, the 20 or so students from probably
20 years of age to 25, then wrote papers on this long-term
solvency problem, and probably 18 out of those 20 papers that
were turned in, I am told, focused on some individual
personalization or private account as part of a solution. So I
hope, Mr. Harris especially, you talked about cynicism, and
perhaps skepticism is a milder term as far as what our task is,
and I hope that we can get beyond that, and I think I certainly
appreciate you all being here today.
Just in the couple of minutes that I have got, Mr.
Burtless, you mentioned the flow of mail that Members of
Congress receive and have received on the notch issue. I don't
plan to be here in the year 2038, I will just make that public
announcement now, at least in Congress in 2038. I don't want to
be a Member of Congress, or it would be interesting to converse
with a Member of Congress about flow of mail if inaction is
what Congress ultimately concludes to do as far as those
benefit cuts that are inevitably going to occur if we do
nothing.
Were you a Member of the Brookings Institute back in 1983,
during the----
Mr. Burtless. I was.
Mr. Hulshof. During the Greenspan? Because I wasn't here
then, either, but reading back, higher taxes, lower benefits,
that sound eerily familiar to something, that discussion that
occurred 18 years ago. And I thought that the Greenspan
Commission, by increasing payroll taxes and raising the
retirement age, that is, lowering benefits, was going to fix
Social Security, and yet here we are just 18 short years later
talking about, at least from your testimony, talking about the
same solutions.
Mr. Burtless. It is certainly true that if you establish a
fully funded pension system, and people are willing to live
with the pensions that the financial markets will deliver to
them on their retirement, it is certainly the case that you can
fix the problems of the pension system once and for all.
But, bear in mind, that is the system we had in 1935.
Americans found it unsatisfying then. They thought that relying
completely on private markets to give them their retirement
incomes, 6 years after the 1929 crash, wasn't really enough.
They wanted some other source of support that doesn't depend on
how financial markets operate over the course of their career.
In particular, workers didn't want to depend solely on
financial markets, which might fall very near the point of
their retirement.
Mr. Hulshof. Mr. Bedell-Pearce, this is just a comment to
you, but the mark of a good American politician is to take an
unrelated subject and try to weave it into something completely
unrelated, so let me attempt to do that.
Mr. Burtless, you mentioned that the liberalized pension
laws that we have passed, and you are exactly right, the tax
relief measures that the President signed have liberalized
those pension laws. I would be remiss, however, if I didn't say
to my colleagues, though, as you know the Senate put a sunset
on those pension changes, and H.R. 2316 that Mr. Ryan and I
have cosponsored would make permanent those tax relief
measures, and I would urge your sponsorship of that
legislation.
How did I do, Mr. Bedell-Pearce? Did I weave that in
appropriately?
Mr. Bedell-Pearce. Very well.
Mr. Hulshof. Thank you. I do want just, seriously, in about
the 30 seconds or a minute that I have left, Mr. Burtless, in
your testimony in answer to Mr. Matsui you talk about potential
variation of retirement income due to stock market
fluctuations. In your example, you assume that everyone remains
100-percent invested in the stock market up until the time they
choose to retire. Was that part of your assumptions?
Mr. Burtless. Right, but this is based on a larger research
program in which I also look at different kinds of investment
strategies that people could follow.
Mr. Hulshof. I thought the answer, though, to Mr. Matsui's
question was 100-percent participation in the stock market.
Mr. Burtless. That is exactly right. That is what gives you
the highest expected return over your career, but also exposes
you to larger than average risk. That is the tradeoff.
Mr. Hulshof. So therefore, if workers in their advancing
years gradually phase out of stocks into less variable
investments like Treasury bonds----
Mr. Burtless. They would have a smaller expected pension
but they would have a less variable one.
Chairman Shaw. OK. In the interests of time, thank you. We
are going to try to finish up.
Mr. Cardin.
Mr. Cardin. Thank you, Mr. Chairman. And Mr. Chairman, I
want to make a brief statement and then ask a question. If it
could be answered for the record later in writing, I would
appreciate it. And then I would yield to Mr. Doggett, so that
we can get to the floor for votes.
It seems to me that we are talking about two separate
issues here on which there is virtually no disagreement. They
are very much related. The first deals with adequately
financing our current Social Security system, and I think, Mr.
Burtless, you pointed out, and rightly so, that if all of a
sudden we are going to change the philosophy and go to 100
percent away from pay-as-you-go and we want to fund it
completely, we just transfer $9 trillion and take over that
liability, send it to an insurance company. No, we don't even
send it to an insurance company. They would probably do a
little less because they get a better return. But that is what
it would cost.
No one is talking about that. No one is talking about
moving completely away from having current workers help pay for
current retirees, but that if we want to finance it under the
current system, then we either have to put some new revenues in
equal to about 2 percent of payroll--we can do that through a
better return on the Social Security system, or transferring in
general tax revenues to do it, that will work--or reduce
benefits, which we use different terminology for, such as
raising the age of retirement or integrating with private
accounts, but it is a reduction of the obligations of the
Social Security system.
The second issue is one there is also no disagreement, and
that is, we have got to do a better job of enforcing private
accounts in this country. We have got to increase individuals'
ability to put money away for their own retirement. I don't
think anybody disagrees with that. And the only part of the tax
bill that I really liked was that bill that had the name
Portman-Cardin attached to it and was signed by the President,
that sort of helped that along.
I guess my point, though, is that as we look at moving
toward individuals taking on more personal responsibility, one
thing is clear: When you are moving from a defined benefit
system to a defined contribution system, you not only have the
market risk that Mr. Matsui refers to, and rightly so, but you
have the investment risk, whether individuals really will get
adequate education and be informed, and how do you deal with
the inherent conflicts that are out there, with people who are
selling products also being involved with giving advice?
And I would be curious as to how other countries have dealt
with that. We don't have time for a verbal response. If there
is a written response or material, I would appreciate that.
And the second is, how do you deal with protecting to make
sure that individuals don't invade those funds? Under our
current retirement systems, you can invade and pay a penalty,
or without penalty, use it for education or health care or
first time homeownership and all these other temptations that
are out there. How do you make sure that it is really there for
retirement, if we are going to be relying more and more upon
individuals' own private investments in retirement in the
future?
And if you all could help us with what is happening in
other countries in regard to those two issues, I would
certainly appreciate it.
Mr. Chairman, I would yield the balance of my time to Mr.
Doggett.
[The following was subsequently received:]
Cato Institute
Washington, DC 20001-5403
1. There are three points that I would like to make. First, in
Chile there was a roughly 6-month period between the day on which the
reform was approved (4 November 1980) and the day on which the new
system started (1 May 1981). In that time, the architect of the reform,
Dr. Jose PiZera, who was then the Chilean Minister of Labor and Social
Security, would appear once a week on national television for three
minutes each time to explain different features of the system.\1\
Second, the Pension Fund Administration companies also perform an
educational campaign, explaining the main features of the system in
flyers that are available at the branch offices of those companies.\2\
During a recent trip to Chile, I walked into a branch office of a
Pension Fund Administration company in downtown Santiago and I asked
the saleswoman some basic questions about the Chilean system. I found
her to be very polite, helpful and knowledgeable of the system. Third,
the Pension Fund Administration companies are supervised by a highly
technical and very transparent government agency that imposes stiff
penalties to those companies that commit fraud or provide misleading
information to their clients. Furthermore, that regulatory agency
provides very clear and concise information about the private pension
system.\3\
---------------------------------------------------------------------------
\1\ See Jose PiZera (1991) El Cascabel al Gato. Santiago: Editorial
Zig-Zag.
\2\ I would like to request that the Subcommittee make the attached
copies of those fliers part of the congressional record.
\3\ The official website of the Superintendencia de AFPs, as the
regulatory body is known, can be found at http://www.safp.cl.
---------------------------------------------------------------------------
2. In Chile, workers are only allowed to use the savings
accumulated in their pension savings accounts for retirement purposes.
If a worker has enough funds accumulated in his account to obtain an
annuity that is equivalent to at least 120 percent of the minimum
pension, as defined by the Chilean congress, and to 70 percent of his
average salary over the last 10 years of his working life, that worker
may withdraw in a lump sum those excess savings and use them for any
purpose.
Other countries, such as Mexico, for instance, allow workers who
have been unemployed for at least 45 days to withdraw the lesser of 10
percent of the cumulative balance in their account or the equivalent of
75 times their daily taxable base salary if they have contributed to
the account for at least 250 weeks and have made no withdrawals in the
previous 5 years. Workers with 150 weeks of contributions may withdraw
from their account the equivalent of their monthly salary if they are
getting married. Although it would probably be best that the savings be
used for retirement purposes only--especially in the presence of a
government guarantee of some kind, which creates a moral hazard--
workers should be the ones deciding what to do with their money.\4\
---------------------------------------------------------------------------
\4\ See L. Jacobo Rodriguez ``In Praise and Criticism of Mexico's
Pension Reform.'' Cato Institute Policy Analysis no. 340, April 14,
1999.
---------------------------------------------------------------------------
L. Jacobo Rodriguez
Assistant Director
Chairman Shaw. Mr. Doggett.
Mr. Doggett. Thank you very much, Mr. Chairman.
Our colleagues, Mr. Kolbe and Mr. Stenholm, I think their
proposal was referred to earlier in this hearing, have come
forward with a proposal that recognizes that if Social Security
cannot indefinitely meet all of its obligations as currently
structured, that you have to do one of two things, either raise
taxes or cut benefits, and they propose a little of both. I
don't agree with their proposal, but I think they are at least
honest in the way that they look at this whole issue.
And I would suggest, after listening to the recommendations
of the President's Commission, that the most instructive
experience from abroad that we have is not necessarily that
that we received some testimony on today, but it is a few
hundred years back in the era of the alchemist. Because if we
have a Social Security fund that is already stretched now in
its ability to meet its responsibilities, and we suddenly
siphon off some percentage of it for private individual
accounts, out of that same fund that is already stretched to
the limit, unless alchemy has received a new level of ability
to generate something from nothing, we will put even more
demands on the fund and we will reduce guaranteed benefits to
many Americans.
We had Secretary Thompson testify about Medicare here a few
weeks ago in front of the Committee, and he made it clear that
the discussion of guaranteeing benefits was going to be only
for those who are nearing retirement, that is, people about my
age or just slightly lower at maybe 50. And everyone else who
might have been paying into the Social Security system for 20
or 25 years has no guarantee that their benefits will be there.
They are left to the risk of the market.
And so I think it is interesting to hear about the
experiences in other countries. We can learn something about
it. But we face the basic mathematics that this is a fund that
we need to work on to be sure that it can indefinitely meet its
current responsibilities, and you don't do that by siphoning
off the money for a new social experiment, which is what the
President's Commission with all of its Members committed to do
that before they were ever selected for the Committee.
With those brief comments, I would yield to my colleague
from North Dakota, who I know had another question.
Mr. Pomeroy. Just a very quick one for Mr. Palmer. Looking
at the chart that is attached to Mr. Burtless' testimony, you
see the United States at 12-percent poverty rate in seniors,
Sweden at 1 percent. Looking at that 12-percent figure for the
United States, a very unfortunate way to be a leading country
in that category, I think you would have a hard time making the
case that our benefit structure under Social Security is
unfairly redistributed. Do you have a comment on that?
Mr. Palmer. Yes. I could perhaps respond to your first
comment also.
Sweden does very well in its present system, and most
probably in the future system, in taking care of low-income
earners. In the future there will be a guaranteed benefit which
will cover all low-income earners in Sweden, so I would suspect
that we will continue to be as we are today in that respect.
Chairman Shaw. I am going to have to break this up now so
we can make the vote, but I do want to at least point out here
that this is the last hearing where we will have Jeff McLynch,
who is the Democrat staff Member on this Committee. He leaves
us effective this week. We want to thank him for his service to
the Committee. We have worked together on some occasions, and
it has been a pleasure, Jeff, to have you, and we wish you
Godspeed.
[Applause.]
Chairman Shaw. I also want to thank this fine panel. In our
rush to get to vote, I don't want to neglect you. We do have
some more questions that we will send to you and ask for your
response in writing.
[Whereupon, at 12:04 p.m., the hearing was adjourned.]
[Questions submitted from Chairman Shaw to the panel, and
their responses follow:]
Center for the Strategic and International Studies
Washington, DC 20006
September 10, 2001
1. ``You spoke about changes in the old-age dependency ratio as a
disadvantage of pay-as-you-go systems. Could you describe the economic,
demographic, and political risks to which pay-as-you-go systems are
exposed? Do you believe, as some have argued, that the United States
(or for any country for that matter) can economically `grow' its way
out of the funding crunch?''
Pay-as-you-go systems rely on tax payments, and as such are prone
to financing crises when tax receipts do not grow as fast as
beneficiary populations. In most developed countries the pension
population is expected to rise by roughly 70 percent over the next
forty years, while real GDP is expected to grow by roughly half that
much. In addition, European and Japanese working age populations are
destined to shrink by roughly 10-15 percent over the same period--
producing a near-doubling of ``dependency ratios'' of pensioners to
workers. This leaves huge unfunded health and pension shortfalls that
eventually could require a tax increase equivalent to 20 percent of
payroll or more in most developed countries. Because such tax increases
may prove economically counter-productive and could generate tax
resistance, especially in continental European countries where payroll
taxes already average above 30 percent, there is a significant
political risk to current and future benefits. Finally, to the extent
that these shortfalls could lead to large budget deficits in countries
that already carry a high national debt burdens, pay-as-you-go systems
pose an economic risk as well.
Demographic risk is heightened by the uncertainty surrounding
medical technology. Currently, U.S. retirees collect Social Security
for an average of 19 years. Each additional year of life expectancy
therefore adds about 5 percent to retirement costs. Since 1950, average
life expectancy has grown by 11 years in Europe, 8.6 years in the U.S.;
and 17.6 years in Japan. Over the next 50 years, lifespans are
projected to rise another 6.1 years in Europe; 5.1 years in the U.S.;
and 6.5 years in Japan. In other words, governments are forecasting a
significant slowing of longevity gains. Yet, many leaders in the
biomedical field predict that we are nearing significant breakthroughs
in cures for a number of diseases which attack the aged. Clearly, such
breakthroughs, while welcome, could dramatically worsen financing
pension prospects.
Europe and Japan are facing unprecedented economic risks as a
result of depopulation. Shrinking numbers of workers and consumers will
constitute a worsening drag on economic growth for the foreseeable
future. After 2025, Europe's economic growth rate is projected to
average .5 percent a year, while in Japan it is projected to average 6
percent. For this tepid growth to occur, however, productivity gains
will need to remain at their historical average of 1.4 percent a year.
Militating against rising productivity in depopulating countries is the
fact that shrinking domestic markets (with fewer consumers each year)
will tend to see very low returns to capital. Such trends would tend to
drive domestic savings abroad in search of higher returns.
While America does not expect to undergo depopulation between now
and 2040, very slow growth among working age populations (20-64 years),
will remove what has been an important source of economic stimulus. The
workforce expanded by about 11 percent a decade from 1950-2000, but
will slow to less than 2 percent a decade from 2010-2040. After 2025,
GDP growth in the U.S. will slow to about 1.6 percent a year--again,
assuming historical rates of productivity growth. For the U.S. to
``grow its way out of'' fiscal strains resulting from the deteriorating
dependency ratio under its pay-as-you-go financed Social Security
system, productivity growth would have to remain significantly above
the long-term trend for decades.
2. ``Do you think that more countries will turn to using individual
accounts in their Social Security systems as populations age, and
why?''
Clearly, there has been a trend toward the adoption of individual
accounts as mechanisms for compulsory retirement provision. This trend
is likely to continue for three basic reasons.
First, being defined-contribution schemes, individual accounts are
fully funded and, as such, do not contribute to deficit spending
pressures. Moreover, where governments provide financial guarantees for
retirement security, as underscored by the experience under the U.S.
Employee Retirement and Income Security Act (ERISA), it is less costly
to insure a funded than an unfunded retirement system. Second,
individual accounts can help to insulate populations in depopulating
countries from adverse national economic trends. In countries where
declining numbers of workers and consumers combine to limit returns on
investment, the ability to invest in faster-growing markets abroad will
become a key source of retirement security. Third, defined contribution
schemes entail no actuarial penalty for delaying retirement. Both
rising longevity and the prospect of worker shortages suggest that
longer work lives may be in store in most of the developed world.
3. ``What has been the experience of countries that invested
through Trust Funds rather than through individual accounts? Have they
performed well? Have their investment decisions been influenced by
political considerations? Are they doing better or worse than countries
that invest through individual accounts?''
According to the World Bank, the investment of Provident Fund
moneys by the governments of Malaysia and Singapore have achieved lower
rates of return, on average, than have individual account investments
in other countries. It should also be pointed out, however, that Japan,
which has a robust private pension system, has also experienced low
rates of return. Meanwhile, in Canada, initial reports are that trust
funds being invested by the government have achieved returns on par
with privately managed pension funds. Under ERISA, private pension
managers are required to invest retirement savings solely in the best
interests of the client. These strictures seldom apply elsewhere in the
world, but conceivably could be applied to the investment of U.S. trust
funds. Meanwhile, provident fund moneys have been invested in
infrastructure and other government programs, which have tended to
lower rates of return. There are concerns that similar pressures would
arise in the U.S., should Congress decide to invest trust fund assets
in markets. In Canada, for example, 80 percent of trust fund moneys
must be invested in domestically registered companies. But rates of
return on individual accounts can also be reduced by the imposition of
non-economic fiduciary rules--such as the requirement that a share of
pension funds be invested in government debt instruments or within
national borders.
4. ``What do you think the U.S. could learn from the pension
reforms in Sweden, Chile, the United Kingdom, and Australia?''
There are four main lessons. First, individual accounts are popular
where they have been introduced. Working people tend to like them for
their transparency, and to feel more secure once they are in place.
This is inevitably the case where concern about governmental fiscal
capacity is the principal source of individual retirement security.
Second, administrative costs can be held to acceptable levels. While it
is difficult to implement individual accounts for the entire working
population, it is possible to hold costs down through passive investing
and limiting opportunities for course-correcting by the accountholders.
Third, the transition from unfunded to funded retirement systems can be
expensive and take a long time to implement. In the cases of Sweden,
Australia, and Chile, the individual account was financed through
additional payroll levies. Fourth, the experiences of these and other
countries that have moved toward individual accounts in recent years
belies the argument that privatization is an ``ideological attack'' on
Social Security. As often as not, the reformers have been from the
``left''. Rather, reform has come from the frank recognition that
government finances in the future will be too precarious for
individuals to depend on for a comfortable retirement.
Paul S. Hewitt
Prudential plc,
London,\1\ England
September 11, 2001
Question 1. Why did the United Kingdom decide upon asset-based fees
for the new stakeholder pension rather than contribution-based fees or
flat fees?
The UK wants stakeholder pensions to be as simple as possible for
the customer. In particular it is important that the charges are
transparent and easy to compare. This leads to the conclusion that
there should only be one type of charge (be it asset-based,
contribution-based or flat fee), otherwise comparison is difficult. The
UK has used the overall reduction in yield as part of disclosure of
more complicated charging structures for several years, although it is
not clear that customers understand that concept.
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\1\ Prudential plc is a leading international financial services
group (not related to the U.S. company with a similar name) and has
been a key player in UK pension provision for more than 70 years.
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Flat fees would be inappropriate since they would have been
comparatively large for lower rate contributors, who are one of the
target groups for stakeholder pensions. However, flat fees can be
charged for advice in addition to the asset-based fee.
The choice between asset-based and contribution-based fees should
reflect the actual incidence of costs for the provider and the way
those vary during the lifetime of the investment. Given the option to
vary the type of asset held, this indicates a need to reflect the
actual asset choice, which may vary from 1 year to the next. It is
clear, however, that neither a contribution-based fee nor an asset-
based fee truly reflects the actual incidence of costs.
To quote from the government's paper on the proposed charging
structure:
``Requiring charges to be levied as a percentage will
be beneficial to those with relatively small pension funds.
Where charges are levied as a fixed cash sum, there can be a
disproportionate effect on those with small savings. In cases
where Members stop paying into a scheme, a fixed charge can
erode the value of savings if the investment returns are lower
than the fixed charge.
Requiring schemes to apply only percentage charges
will mean some pooling of costs between scheme Members. This is
a feature of most collective arrangements. The government
considers that pooling of costs in this way within stakeholder
pension schemes is appropriate, in order to deliver the
benefits of transparency and flexibility which a percentage
charge brings.''
Question 2. Could you describe how regulation of personal pensions
works in the United Kingdom? What agencies or organizations are
involved and what are their responsibilities? How have the regulatory
structure and requirements imposed on personal pension providers
changed since the mis-selling scandal to avoid future incidents of mis-
selling?
Approval of personal pensions is initially required from the Inland
Revenue in order for the scheme to be given the tax advantages granted
to UK pensions. The pension providers have to operate the scheme within
the rules of approval in order to maintain those tax advantages.
Personal pension schemes are provided by institutions currently
regulated under the Financial Services Act (to be replaced by the
Financial Services and Markets Act as from 30th November
2001). The overall regulator is to be the Financial Services Authority
(FSA), which will regulate both the prudential supervision and the
conduct of business of the relevant financial institutions.
Pensions mis-selling was one of many issues that informed the
thinking about regulatory arrangements. The switch from separate
regulators to a single regulator (the FSA) will ensure consistency of
treatment of all regulated institutions and allow the regulator to act
more quickly than was possible under the previous system of self-
regulation.
One aspect of regulation not covered by the FSA is on employers
involved in the processing of premiums. Responsibility for ensuring the
pension contributions deducted at source by an employer are transmitted
efficiently to the scheme rests with the Occupational Pensions
Regulatory Authority, who have a similar role in relation to
occupational pension schemes (OPSs)--they are responsible for the
regulation of all aspects of OPSs covered under the Pensions Act 1995.
The requirements upon personal pension providers have not changed
fundamentally--they were, and still are, required to avoid mis-selling.
It has always been clear that encouraging employees to leave their
active membership of an OPS and join a personal pension was very likely
to be bad advice. The training and competence scheme for salespeople
has been improved since the mis-selling of 1988-1993.
Before the regulators' mis-selling review in 1993, most personal
pension providers had already started to introduce systems to allow
someone thinking of transferring the value of their past benefits to
compare the deferred benefit that they were proposing to give up under
their OPS to the benefits that they might reasonably anticipate under
an alternative personal pension.
The mis-selling review itself clarified the scope of the Financial
Services Act. Although Membership of an OPS was not, itself, classified
as an investment under the Act, ``best advice'' did require someone to
be encouraged to find out more about the OPS alternative if it could be
better than a personal pension. Since most employers in the UK do not
contribute to an employees personal pension, an OPS is very likely to
be the individual's best choice.
Question 3. Could you describe the types of information the public
is required to receive regarding investment choices and what entity
provides that information (e.g. the government, the fund manager, and
so forth)? Why did the United Kingdom decide to deliver information in
that particular way?
Again this is undergoing a process of ongoing development, not
least with the introduction of the Financial Services and Markets Act
which gives the FSA responsibility for promoting public understanding
of the financial system.\2\ The FSA is also reviewing the current
system of disclosure in the light of technological developments and
increasing access to the Internet, together with customer research
suggesting that some aspects of the detailed information disclosure are
failing.
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\2\ Extract from the FSA strategy document for promoting public
understanding of the financial system. ``Work to achieve this aim falls
under two main headings:
Education for financial literacy--to provide individuals
with the knowledge aptitude and skills base necessary to become
questioning and informed consumers of financial services and manage
their finances effectively;
Consumer Information and Advice--to provide impartial
information and generic advice to help enable consumers to plan their
finances and make informed choices, while not being prescriptive or
recommending individual products and services, or telling people to
save.''
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There is already a thorough system of disclosure. Anyone seeking
advice is required to be given suitable advice, which requires
initially that the flow of information be from the individual to the
adviser. Based on that fact-find, the advisor will explain the choice
of investment products, and within that the choice of provider and the
choice of investment from the product/provider combination. The adviser
will pass on information prepared by the providers, which will include
the investment principles relevant to the particular funds. The adviser
will also prepare a letter explaining the significant features of the
background fact-find on which the advice was given. This combines
delivery both face to face and in writing (and potentially over the
Internet), with generic and individual advice reflecting the particular
needs of the person being advised.
During the course of the accumulation of a pension, the private
schemes are required to provide annual benefit statements. This annual
disclosure of information is gradually being extended to include
further information regarding the specific scheme investments. Pension
providers are increasingly expected to publish their statements of
investment principles including any investment policy that they might
have on ethical and environmental issues. Projections of an
individual's State benefits are also available on request.
Both the regulator and the Government produce generic information
on other aspects of the investor's choice, including the operation of
State entitlements. The regulator has also introduced a set of
``decision trees'' to help an individual in the choices associated with
the new stakeholder pensions. Again, this combines face to face and
written material, since a number of pathways on the decision trees
highlight the need for individual advice.
In order to help simplify the investment choice for someone who has
chosen to contribute to a stakeholder pension but does not want to take
advice over the choice of individual funds, every stakeholder scheme is
required to nominate a suitable default investment option.
Question 4. The United Kingdom's system allows people to opt back
into the second tier of the government pension plan if they are unhappy
with the private system. What percentage opts back into the government
program, and what is the primary reason for doing so?
Although the UK system allows for opting back in, the individual is
not required to give a reason for so-doing. However, our experience is
that in almost all cases the decision to opt back into the State second
tier pension is based on advice from the private pension provider. This
advice relates to the comparative advantage of the rebate offered by
the UK Government as compared with the benefit being given up. For
example, there is a cap on the maximum rate of rebate (which is age-
related) which means that at the oldest ages the individual would be
best advised to rejoin the State second pension.
The advice to opt out may also depend on the salary of the person
involved, since the second tier of the government pension plan is
earnings related. It may also depend on the individual's other on-top
voluntary contributions. Hence, as an individual's circumstances
change, it may be natural to opt back in.
Question 5. The United Kingdom's system has been criticized for
having high administrative costs. Is it correct that the government's
rebate to persons contracting out to Appropriate Personal Pensions
(APPs) takes into consideration that administrative costs are higher
and provides a more generous rebate? Does the government end up
absorbing some of the additional administrative costs?
The level of the rebate depends on the type of private scheme that
the individual is contracting out into. As explained in the answer to
question 6 below, the type of private scheme determines the method and
timing of the payment of the rebate and this is reflected in the level
of the rebate. For example, the rebates to contract out to an
appropriate personal pension \3\ (APP) are age related, whereas those
for those contracting out into a defined benefit pension scheme they
are not.
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\3\ Personal pensions are an alternative to the State Earnings
Related Pension Scheme (SERPS). These instruments are similar to IRAs.
Investments in personal pensions are composed of the rebate the worker
receives from for contracting out of the SERPS plan along with any
additional voluntary contributions. The part of the personal pension
that comprises the rebate is known as an Appropriate Personal Pension.
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The level of rebate recommended by the Government Actuary to the
Secretary of State depends on a number of assumptions, of which the
administrative costs are one. However, it is not surprising that the
assumed administration costs are higher where the scheme can be a
standalone APP with no additional voluntary contributions as compared
with a defined benefit scheme offering larger overall benefits.
Question 6. How much time passes between the time personal pension
contributions are earned and when they are paid to the worker's
account? Are the contributions invested or credited with interest in
the interim?
Contributions are invested as soon as they are received. Employers
are required to ensure that contributions deducted from salary are paid
to the provider, by the 19th of the following month, for
investment in the workers' accounts. No interest is credited in the
interim.
Contributions are paid net of basic rate tax relief. Tax relief is
reclaimed by the provider directly from the Inland Revenue and is
received on average 2 weeks after the contribution. Providers can
choose whether they regard the tax relief as also being invested at the
time when the net contribution is received, or invest the two elements
separately on their different dates of receipt.
If the question relates to the rebate, they are paid to the
personal pension scheme after the end of the year in which they are
earned. They will not be triggered until the employers tax returns for
the fiscal year concerned have been submitted. On average, rebates are
received about 6 months after the end of the tax year. There is no
interest specifically paid for the time that has passed, although this
is allowed for in the calculation of the rebate. This also partly
explains a difference between the rebate on an APP and an OPS. The
Government has decided that in the case of an OPS, the employer simply
pays reduced National Insurance contributions and hence there is almost
no delay in crediting this to the scheme.
Question 7. Peter Orszag stated that administrative costs eat up
43% of an account's value over a worker's lifetime. However, research
by Edward Whitehouse indicates costs are much lower. Would you agree
that Dr. Orszag's calculation is too high, and why?
Dr Orszag's work was surprising, not least because it represented a
very particular form of analysis. 43% is a very startling figure until
you recognize that it compares an investment being administered with an
equivalent investment giving exactly the same investment performance
but assuming no costs whatsoever. The analysis demonstrates particular
issues, and could usefully be extended to similar products in other
regimes, provided it fully reflects the potential negative consequences
of not administering the product in that way.
One area of particular surprise to providers was that quarter of
the overall cost calculated came from the purchase of an annuity. It is
generally recognized that people are living longer than was assumed
when annuities were purchased--this should imply that there is an
overall benefit to the individual and this appears not to have been
built in to the analysis. Instead, the costs reflect the fact that
annuity providers base their assumptions on the profile of people who
purchase annuities rather than on that of the population in general.
The other reason why Dr Orszag's work is potentially misleading is
that although it indicates what lessons can be learned from such
analysis, they relate to a regime which has progressed. The personal
pension regime in the UK is generally falling into line with
stakeholder pensions. Here there is a maximum fund charge of 1% per
annum and there is no charge on transfer.
Edward Whitehouse's paper published by the OECD,\4\, provides a
useful comparison across 13 countries including the UK, Australia and
Sweden. We note that he refers to Dr Orszag's analysis, concluding that
this ``substantially overstates the average charge burden resulting
from transfers''. He calls upon evidence from the British Household
Panel Survey to question the rates of transfer extrapolated by Dr
Orszag.
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\4\ Private Pension Series, Private Pension Systems--Administrative
Costs and Reforms, No 2.
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Question 8. How much do you think companies will charge for
investment advice on top of the maximum stakeholder fee?
Many in the UK believe that the market for investment advice in the
UK will move over to a fee basis. This will be fully transparent and
will be paid by all those seeking advice including those who make no
investment as a result. This will allow the fee to reflect the time
spent in the consultation.
Question 9. Will companies be able to profitably operate with the
1% limit on fees in stakeholder plans? How will they cut costs to stay
profitable?
Commercial companies are choosing to operate in this market where
the charge cap applies. It should be assumed that companies believe
that they will be able to operate profitably within this limit.
The product offering is more limited than was the case with
personal pensions. The UK has a history of operating a type of fund
investing predominantly in equities where the overall return is
smoothed to reduce volatility. These ``with-profits'' funds offer
guarantees and demand capital support that cannot be met from within
the 1% limit. These products are thus, in general, not being offered in
stakeholder plans. There is a particular emphasis on tracker funds in
order to keep costs to a minimum.
The UK market is following the US in seeking to encourage the
maximum use of technology using a business to business approach,
whereby an employer provides front-end administration on their
Intranet. By so-doing, the individual and the human resources function
can ensure that employer aspects of salary deduction are in place,
leaving the stakeholder plan to focus on the operation of the pure
scheme-related administration. Even so, the charge cap in the UK is
lower than the charges that would currently be made on equivalent
schemes in the US.\5\
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\5\ Whilst it may be difficult to compare like with like, a fact-
finding visit to the US in 1999 by a group of pension specialists
reached the conclusion that the equivalent charge in the U.S. was
between 1.4% and 1.7% depending on the level of technology support, in
practice this being Internet access and self-service.
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Question 10. Under what circumstances can the personal pension be
passed to the worker's estate?
Personal pensions will almost invariably provide a death benefit of
the return of the fund if death occurs before retirement. If death
occurs after retirement, the appropriate personal pension, used for
contracting out, has to provide a joint life benefit which will
continue to the surviving spouse. The annuity arising from voluntary
contributions will depend on the individual's choice at retirement.
Annuities purchased with a guarantee that payments will continue for 5
or 10 years irrespective of the survival of the individual will be paid
into the worker's estate.
Since 1995, there has been an alternative method of taking income
from a personal pension. Instead of purchasing an annuity, income can
be withdrawn from the fund within limits set by the Government Actuary.
There are detailed rules, but the important aspect in relation to the
question is that the fund that remains on the death of the individual
will be passed to the worker's estate. Income drawdown cannot continue
beyond age 75 \6\ at which point an annuity must be purchased and the
circumstances referred to in the previous paragraph apply.
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\6\ There is ongoing debate in the UK about the requirement for
compulsory annuitisation at age 75.
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Question 11. How are personal pensions handled in cases of divorce?
Are married workers required to take a joint and survivors annuity at
retirement? How much does the annuity provide to the surviving
spouse?''
A personal pension fund forms part of the total assets to be split
between the divorcing parties. Wherever possible, divorcing couples
will try to ensure that existing arrangements do not require costly
sale and repurchase (of, for example, a house) and hence they are
similarly likely to keep personal pension arrangements unchanged.
However, either before or after retirement, pensions can either be
shared (ie. payment to both parties but contingent on the combined
circumstances of both) or split (ie. payment as required at the time of
divorce and with the future operation of the distinct funds contingent
on the circumstances of each individual partner).
Married workers with a personal pension are not required to take a
joint and survivors annuity at retirement, except for the Appropriate
Personal Pension element wherein they are also required to include a
limited level of protection against price inflation.
In general a spouse's pension is likely to provide 50% of the
amount that would have been payable to the original scheme Member. The
payment to the surviving spouse will then continue to be paid in the
same manner (for example, with limited price inflation).
Keith Bedell-Pearce
Executive Director
National Social Insurance Board
Stockholm, Sweden
September 12, 2001
Note that the publicly mandated financial account scheme,
translated literally from Swedish the Premium Pension System, is
managed by a public agency, Premiepensionsmyndigheten, which is
referred to here using its Swedish acronym, the ``PPM.''
Question 1: Could you explain more about how Sweden minimizes
individual investment risk (e.g. minimum benefit guarantees, etc.)?
1. The individual bears the risk of his or her own portfolio
choice(s) in the Swedish financial account scheme. To help minimize the
risks involved and to aid the participant in making an informed choice
the following can be observed:
(A) The basic requirement for a fund to operate in Sweden is that
the fund complies with the rules of the EU directive on Undertakings
for Collective Investment in Transferable Securities, the UCITS--
directive. The Swedish regulations are an implementation of the
directive. The Swedish regulations contain however some provision with
regard to the disclosure of costs that are not included in the
directive. However, to participate in the public scheme funds must
provide share price information electronically to the PPM on all
banking days. Fund values are published in the major newspapers on a
daily basis and people can change funds at any time, if they so choose.
(B) The PPM has produced two publications--the Fund Catalogue and
the brochure with instructions, guidance and so forth. The information
includes systematically presented and easily comparable measures of
risk and historical data on returns for all funds. People can gain some
assistance in judging their personal risk profile with the help of
questions in one of the brochures. The same information--and
considerably more, for example on fund particulars, can be found on the
PPM Web site ``http://www.ppm.nu/''>www.ppm.nu
(C) There is a general guarantee level that is available from age
65 and is financed with general revenues from the state budget. A full
guarantee requires 40 years of residence in Sweden between the ages of
16 and 65. An individual has a right to a full guarantee amount if he
or she no earnings-related benefit at all. Otherwise, the guarantee
works as a supplement to whatever the individual has from the NDC and
FDC schemes up to the maximum level that is guaranteed.
Question 2: Does Sweden provide any special accommodations for
small FDC accounts? If so, what accommodations?
2. Sweden provides no special accommodations for small FDC
accounts. Accounts are kept for everyone who has been registered in the
system at sometime. Note that fund transactions can occur on any
working day, but all transactions for a given fund are performed daily
on a net (all purchases minus all sales) basis. The participating funds
keep no individual accounts.
Question 3: How much time elapses between when contributions are
earned and when they are deposited in the worker's investment choice?
Are the funds invested or credited with interest during the iterim?
3. Around 18 months lapse on average between when funds are
collected and when they are actually available for individual
investments. This is because of the general taxation procedures: By
law, Sweden establishes how much a person has earned (and contributions
that should have been paid) after individuals and employers have filed
their yearly tax returns. Money is kept on an interim account at the
National Debt Office (Treasury) and earns a bond rate of return.
Question 4: How often can workers change their investment choices?
Are they any additional charges for frequent changes in investment
allocations?
4. Workers can switch funds as often as they like, free of cost to
themselves. This way of dealing with switching is seen as being
important especially in the initial years of the scheme. Also, fund
switches have no tax consequences (like capital gains tax), which is a
difference compared to the treatment of normal holdings in private
investment funds.
Question 5: You mentioned in your testimony that the average
administrative costs are less then 1%. Do you expect that the
government's 0.3% share of the total charge will decrease as the system
matures? Do you think the investment funds charges will decrease as the
system matures?
5. First, the fee that PPM charges, 0.3 per cent, is at present not
sufficient to cover total PPM costs, so the PPM is building up a debt
in the National Debt Office. As the system grows, the money
corresponding to the 0.3 per cent will grow too and after a few years
the PPM will be able to pay back its debt. The debt will be fully paid
off by the year 2018. From then on the PPM fee will be lowered to,
perhaps, 0.1 per cent. (In fact, the PPM will probably have to lower
the fee to 0.25 or 0.20 earlier to make the debt ``last'' all the way
to 2018).
Second, as the system grows, the total assets held by funds will
also grow. The PPM's rebate system reduces the actual fee for PPM as a
fund's holdings of PPM assets increase. This will press fees down
toward a level of 0.4 per cent--according to the PPM rebate schedule.
This means that the long-run fee for the PPM and the average fund held
by individuals could stabilize within the range of 0.5-0.7 per cent,
depending on the distribution of individual choices among.private funds
and where the PPM fee actually ends up.
Question 6: Is Sweden concerned that advertising and competition to
attract investors could drive up administrative costs?
6. The Swedish scheme is designed to minimize advertising. There
was considerable advertising when participant's made their first
choices, probably because fund managers realized that most people would
not switch very often. There will be advertising peaks every year as
people receive their account statements. However, there was relatively
little advertising when account statements were sent out in 2001. This
suggests that advertising costs will not be high. However, even here we
will have to wait a while and analyze what happened.
Question 7: What is the administrative cost for annuitization?
7. The cost of creating and managing annuities is included in the
overall fee of the PPM (see above).
Question 8: You mentioned workers receive an overall replacement
rate of 54% from both the government-run pension and the employer
pension, at a conservative interest rate. What do you estimate is the
replacement rate for just the government portion of benefits (notional
defined-contribution benefits plus funded defined-contribution
benefits)?
8. Assuming a 5% real rate of return on financial assets, the
public system, including both the NDC and FDC components, will give a
replacement rate of around 52% at age 65 and 56% at age 66, for an
individual who works all years from age 22--given present life
expectancy estimates. (This can be derived from Table 2 in the appendix
to my written statement.)
Question 9: How do you share individual accounts in the event of
divorce? Can a man voluntarily give a portion of his account to his
spouse if he chooses?
9. Spouses and registered partners can transfer their yearly FDC
account increments to each other. The transfer must be one whole year's
account increment. Spouses notify the intended transfer to a local
insurance office by January 31 in the year in which the contributions
are paid. The transfer continues, unless one of the spouses notifies
the insurance otherwise. Money cannot be transferred back again, and
the contribution is reduced by 14% upon transfer.
The reduction factor of 14% reflects the PPM actuary's assumptions
about:
how much more money will be transferred from men to women
than vice versa
how much longer women will live, compared to men
an estimate of average fund returns
to what extent transfers will be determined by the
participant's knowledge of his or her own health conditions.
Question 10: How will the government invest the funds of a worker
choosing a fixed annuity at retirement?
10. People can choose to keep their money in the investment funds
of their choice even during the withdrawal period, or they can transfer
all their funds to the PPM and claim a fixed annuity. The PPM will
invest its funds in accordance with the rules in the Insurance Business
Act (1982:713), i.e. the same rules that apply to private life
insurance companies. This means a mix of equity (at present 25 per
cent) and bonds of different kinds (75 per cent) but also an
opportunity to expand some time in the future into, for example, real
estate.
Question 11: Why did the government decide to include stocks in the
``non-choosers'' fund?
11. It was believed that on average the equity market would perform
better than the bond market and that for this reason a mixed portfolio
would be ``fairer'' than a pure bond fund for persons with little or no
knowledge of financial markets, and who presumably would be among the
main ``participants'' in this fund.
Question 12: Who decides how the non-choosers fund is invested? How
does Sweden insure political considerations do not influence the fund's
composition?
12. The Board of Directors are responsible for formulating a
strategy for the ``non-chooser'' fund and the manager for executing it.
The fund is to operate according to normal fund principles, and is
audited. In principle, the audit should uncover investments that are
not motivated by normal financial market considerations. (At the time
of the introduction of the new system, Sweden already had some
experience of public funds investing in the private equity market. Even
within the framework of the old system, a small share of the reserve
assets were invested in equities. The first equity fund in the PAYGO
reserve system was established in 1974, and has been rated as one of
Sweden's most successful funds on the equity market.)
Edward Palmer
CATO Institute
Washington, DC 20001-5403
1. What percentage of retirees draws a minimum pension from the
government? How is that figure expected to change over time as personal
accounts buildup?
As of January 1999, the last month for which I have data, the
government had supplemented 19,715 pensions, including 6,050 old-age
pensions, out of over 300,000 pensions, in its role as the financial
guarantor of last resort in the new private system. Because the new
system has tougher requirements to qualify for the minimum pension and
is far more efficient than the old one, the cost to the Chilean
taxpayer of providing a general safety net is lower than under the old
system. I would expect that figure to decrease over time, if the
pension funds continue to have returns that are above 4 percent in real
terms.
2. Chile has been criticized for having high administrative costs?
Do you believe this criticism is accurate? What has the rate of return
been net of administrative costs?
The often-cited figure of 18-20 percent represents administrative
costs as a percentage of current contributions, which is not how
administrative costs are usually measured. This figure is usually
obtained by dividing the commission fee, which is on average equivalent
to 2.3 percent of taxable wages, by the total contribution (10 percent
plus the commission).\1\ This calculation fails to take into account
that the 2.3 percent includes the life and disability insurance
premiums (about 0.7 percent of taxable wages on average) that workers
pay, which are deducted from the variable commission, and thus
overstates administrative costs as a percentage of total
contributions.\2\ Also, if, for instance, the mandatory contribution
were lowered to 5 percent of total wages instead of 10 percent, then
administrative costs measured as a percentage of the total contribution
would increase from 18.69 percent to 31.51 percent (2.3/(2.3 + 5)),
even if those costs measured in absolute terms or as a percentage of
assets under management remained the same.
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\1\ 2.3/(10+2.3) = 0.1869, or 18.69 percent.
\2\ Commissions are also overstated in the case of workers who
receive gifts or outright lump sums from sales agents as an enticement
to transfer from one AFP to another.
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When administrative costs are compared to the old government-run
system, the criticism is not accurate. Chilean economist Raul Bustos
Castillo has estimated the costs of the new system to be 42 percent
lower than the average costs of the old system.\3\ However, comparing
the administrative costs of the old system with those of the new one is
inappropriate, because the underlying assumption when making that
comparison is that the quality of the product (or the product itself)
being provided is similar under both systems, which is certainly not
the case in Chile.
---------------------------------------------------------------------------
\3\ See Raul Bustos Castillo, ``Reforma a los Sistemas de
Pensiones: Peligros de los Programas Opcionales en America Latina.'' In
Baeza and Margozzini, pp. 230-1.
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Furthermore, the Congressional Budget Office reported in 1999 that,
``In Chile, the country with the longest experience with private
retirement accounts, [administrative costs] can be equivalently
expressed as 1 percent of assets, which is similar to costs of mutual
funds in the United States.'' \4\ The CBO report goes on to say that,
``It is difficult to convert a charge on contributions to a charge on
assets (typical for a U.S. mutual fund). The calculation depends on the
rate of return and the length of the investment horizon and therefore
does not yield a single figure.'' \5\ Chilean economist Salvador Valdes
has estimated the average annual cost of the AFP system to be
equivalent to 0.84 percent of total assets under management over the
life cycle of the worker, which is lower than the average cost of the
mutual fund industry in Chile but higher than other savings
alternatives.\6\
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\4\ See Congressional Budget Office, Social Security Privatization:
Experiences Abroad, sec. 2, p. 7 (January 1999).
\5\ Ibid., sec. 3, p. 11.
\6\ See Salvador Valdes, ``Las Comisiones de las AFPs Caras o
Baratas?'' Estudios Publicos, Vol. 73 (Verano 1999): 255-91.
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To the extent that such administrative costs are still considered
too high, that is the result of government regulations on the
commissions the AFPs can charge and on the investments these companies
can make. The existence of a ``return band'' prevents investment
product differentiation among the different AFPs. As a result, the way
an individual AFP tries to differentiate itself from the competition is
by offering better service to its customers. One way to provide better
service would be to offer a discount on the commission fee to workers
who fit a certain profile--e.g., workers who have maintained their
account for an extended period of time or who contribute a certain
amount of money to their accounts; however, government regulations do
not allow that. Those regulations state that the AFPs may only charge a
commission based on the worker's taxable income and expressed as a
percentage of that income.
Another reason administrative costs are not as low as they could be
is that AFPs have a monopoly in the administration of pension savings
accounts. Mutual funds, banks, insurance companies, and individuals
themselves are not allowed to manage those accounts. The existence of
this monopoly (which is part of the fragmentation of the financial
services industry in Chile across product lines) prevents the
establishment of one-stop financial supermarkets, where consumers can
obtain all their financial services if they so choose.\7\ Such
supermarkets would substantially reduce administrative costs by
eliminating the duplication of commercial and operational
infrastructure.
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\7\ Allowing banks and other financial institutions to enter the
AFP industry might present potential conflicts of interest. In
principle, so long as those institutions compete under the same rules
as other market participants, they should be allowed to administer the
pension savings accounts of Chilean workers. It is likely that in a
market environment banks would have to develop effective separations
between the banking department and the administration of pension
accounts to attract and protect workers' investments. Furthermore, the
banks may invest in instruments of a higher quality to allay any fears
that the public might have about the safety of the investments.
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The average rate of return net of administrative costs for the
average retirement savings account has ranged from 7.18 percent to 7.50
percent, depending on the type of account, from 1981 in April 2001,
according to the Chilean government agency that regulates the industry.
3. Some people say that women and low-wage workers will
disproportionally end up receiving the minimum benefit guarantee,
increasing income disparity. Do you believe this is correct, and why?
That claim is partially accurate. It is true that women and low-
wage workers are likely to accumulate less than the average worker.
Women because they tend to earn less than men, have more irregular
professional lives and may stop contributing to their accounts at age
60 (that age is set at 65 for men). (Women also tend to live longer, a
factor that also contributes to making the average pension for women
lower than the average pension for men, all things being equal.) All
those characteristics are common to women everywhere and not just
Chilean women and should not be considered features of the Chilean
system. Since the new system gives every worker property rights in his
or her contributions, every worker with 20 years of contributions will
receive at least the minimum pension. That was not the case in the old
pay-as-you-go government system, a system that especially penalized
women (and other workers) with irregular professional lives.
Low-wage workers in general accumulate less than average workers
because they are low-wage workers. Low-wage workers also tend to start
working at an earlier age than other workers, which conceivably can
make up for the smaller amount contributed per period, and to have a
shorter life expectancy, which conceivably can allow workers to make
larger withdrawals per period of time than other workers with a longer
life expectancy.
Therefore, it is not correct to say that women and low-wage workers
will disproportionally end up receiving the minimum pension. The reform
was undertaken under the assumption that if a worker contributes to his
account 10 percent of his salary for 35 years, and the real rate of
return on his investment is 4 percent on average, he will have enough
funds accumulated in his account upon retirement to fund a pension that
is equivalent to 70 percent of the average salary over the last 10
years of his working life.
I think that focusing on whether income disparity increases under a
private system or not is mistaken. What matters is that poor workers
(as well as rich ones) have property rights in their contributions and
can invest their savings in productive investments, so that they live
their old age with comfortable means, even if other workers are much
wealthier. The income disparity between Bill Gates and I, for instance,
matters nothing to me. What matters to me is that Bill Gates has
developed the tools that allow me to become a more productive worker
and, consequently, earn a higher salary, which in turn allows me to
live more comfortably now and in my old age.
4. You mention that the current commission structure encourages
funds to seek out higher-wage workers. How would your suggestions to
liberalize commission structure (allow funds to offer discount and
different combinations of price and service) affect low-wage workers?
Would funds be interested in attracting low-wage workers?
AFPs are not allowed to offer discounts for permanence, for making
voluntary contributions, for groups, or for maintaining a specific
balance in an account. For instance, if workers were able to negotiate
group discounts, then their bargaining power would significantly
increase. That would allow them to negotiate lower commissions, which
would benefit low-wage workers the most. Funds would continue to seek
out low-wage workers so long as the marginal cost of administering the
account of a low-wage worker (of a group of low-wage workers) does not
exceed the marginal revenue derived from administering those accounts.
If the administration companies were allowed to adjust their service to
the ability and desire of workers to pay for those services, low-wage
workers would have nothing to lose if the commission structure were
liberalized. Those concerned that the services provided to low-wage
workers would drop to unacceptable low levels need not be, as the
government already mandates a minimum of services that AFPs have to
provide to their clients.
5. If the worker dies before retirement, what happens to the
account balance? What if the worker dies after retirement?
If a worker dies before retirement, the balance in his account
belongs to the beneficiaries of his estate, as workers now have
property rights in their contributions. If a worker dies after
retirement and if he chooses the programmed withdrawal option, then the
balance in his account belongs to the beneficiaries of his estate. If
he chooses to purchase an annuity from an insurance company, the
balance in his account upon retirement is used to purchase the annuity
and the account is closed, so money is left to the beneficiaries of his
account.
6. The government has started allowing companies to lower their
variable fees while raising flat fees. What effect will this have on
workers at different wage levels?
Increases in flat fees and reductions in variable fees would
eliminate the cross-subsidy from high-wage workers to low-wage workers
that is present today.
7. Why did Chile choose to primarily base administrative fees on
contributions and not assets?
When the system began, AFPs were allowed to charge fixed and
variable commissions on assets under management, fixed and variable
commissions on contributions, or any combination thereof. AFPs were not
allowed to offer discounts for permanence, group discounts, discounts
for making voluntary contributions, or for maintaining a specific
balance in the account. In 1987, the commission structure was changed
by eliminating all commissions on assets under management.\8\ This
change had the effect of providing a cross subsidy to (1) workers who
do not contribute to their accounts regularly, because the fund manager
is still providing a service (administering the account of those
workers) for which he is not receiving compensation; and (2) to low-
income workers, because the administrative costs of managing the
account of wealthier workers are not proportionally higher than the
administrative costs of managing the accounts of low-income workers,
although the commissions paid by high-income workers are proportionally
higher than those paid by low-income workers. In that sense, it cannot
be said that the commission structure is fair, because some workers are
paying more than others are for the same type of service.\9\
---------------------------------------------------------------------------
\8\ The issue of the commission structure has generated a vast
literature in Chile. See, for instance, Salvador Valdes, ``Comisiones
de AFPs: Mas libertad y menos regulaciones.'' Economia y Sociedad
(January/March 1997), pp. 24-26; Salvador Valdes, ``Libertad de Precios
para las AFP: Aun Insuficiente.'' Estudios Publicos 68 (Spring 1997),
pp. 127-47; Jose de Gregorio, ``Propuesta de Flexibilizacion de las
Comisiones de las AFP: Un Avance para Corregir las Ineficiencias.''
Estudios Publicos 68 (Spring 1997), pp. 97-110; and Alvaro Donoso,
``Los Riesgos para la Economia Chilena del Proyecto que Modifica la
Estructura de las Comisiones de las AFP.'' Estudios Publicos 68 (Spring
1997), pp. 111-126.
\9\ The unfairness does not come from the fact that some workers
are paying more than others for the same type of service. In a free-
market economy sellers should be able to price discriminate if they
wish to in order to capture the consumer's surplus. The problem here is
that the government is mandating this price discrimination.
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The rigidity in the commission structure prevents the AFPs from
adapting the quality of their service to the ability to pay for that
service of each segment of the population and also explains why the
AFPs have an incentive to capture the accounts of high-income workers
and attempt to do so by offering them better customer service.\10\ AFPs
will continue to spend money until the marginal cost of trying to
capture new accounts is equal to the marginal revenue derived from
those accounts. In addition, the AFPs generally do not charge entry
fees, even though the law allows them to do that, which means that
consumers do not pay a penalty by changing from one AFP to another.\11\
---------------------------------------------------------------------------
\10\ Critics of privatization often point to the giving of toasters
and other consumer goods as incentives to switch from one AFP to
another as proof of the excesses of the Chilean system. Retail banks in
the United States engage in similar practices on college campuses
without any negative effects to the banking system or consumers. Of
course, these practices have decreased as the banking industry has been
deregulated and banks in the United States have found other ways of
competing with each other, such as offering better interest rates or
lower fees.
\11\ Entry fees are usually given back (or a part thereof) by sales
agents as a rebate to their customers as an enticement to switch from
one AFP to another. Exit fees are not allowed by law in an effort to
promote competition.
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8. How does the government certify the companies that offer
individual accounts? How does the government keep politics out of the
decision on what companies to certify and what investments they may
use?
There is free entry and exit into the industry, even for foreign
companies, provided that certain capital requirements, which are
specified in advance, are met. The minimum capital required to create
an AFP is 5,000 Unidades de Fomento (UF), a Chilean indexed unit of
account. If an AFP has 5,000 affiliates, then the minimum increases to
10,000 UF; if it has 7,500 affiliates, then it increases to 15,000 UF;
and when an AFP reaches 10,000 affiliates, the minimum capital
requirement increases to 20,000 UF. By specifying clear and simple
rules in advance, the whole process of creation of management companies
is completely depoliticized. The government agency that regulates the
industry sets, within the framework of the law, general investment
rules in conjunction with the Central Bank of Chile. Both the Central
Bank and the regulatory agency are highly technical and independent
agencies.
9. Could you explain in more detail how the government's rate of
return guarantee works? For example, doesn't the government require
that investment returns exceeding certain amounts be set aside for
buffering returns in case they fall below certain prescribed amounts in
the future? Doesn't the government guarantee funds that go bankrupt?
How many funds have gone bankrupt and at what cost to the government?
Each year each AFP must guarantee that the real return of the AFP
is not lower than the lesser of (1) the average real return of all AFPs
in the last 12 months minus 2 percentage points and (2) 50 percent of
the average real return of all AFPs in the last 12 months. If the
returns are higher than 2 percentage points above the average return of
all AFPs over the last 12 months, or higher than 50 percent of the
average return of all AFPs over the preceding 12 months, the ``excess
returns'' are placed in a profitability fluctuation reserve, from which
funds are drawn in the event that the returns fall below the minimum
return required. For instance, if the industry's average return for the
preceding 12 months is 10 percent and an AFP has a return of 17
percent, then the ``excess returns'' are 2 percentage points (10
percent plus 50 percent of the average return, which is 5 percent,
equals 15 percent, which is the threshold in this case). If, on the
other hand, the industry's average return is 2 percent and an AFP has a
return of 4.5 percent, then the ``excess returns'' are 0.5 percentage
points (2 percents plus two percentage points equals 4 percent, which
is the threshold in this case, since it is higher than 2 percent plus
50 percentage of the average, 1 percent, which would be equal to 3
percent. Should an AFP not have enough funds in the profitability
reserve, funds are drawn from a cash reserve, which is equivalent to 1
percent of total assets under management. If that reserve does not have
enough funds, then the government makes up the difference and the AFP
is liquidated. To date, no AFP has gone bankrupt, although three have
been liquidated for not meeting the minimum capital requirements, so
the cost to Chilean taxpayers has been zero. It is also worth noting
that the system establishes two different legal entities for the
management company and the fund it administers, which is the property
of workers. So, it is possible that a management company go bankrupt
(that is, its net worth is negative) without it affecting the fund.
10. Could you describe the pay out requirements for personal
accounts?
The new private system provides workers with three different types
of retirement benefits:
(a) Old-Age Pensions. Male workers must reach the age of 65 and
female workers the age of 60 to qualify for this pension. However, it
is not necessary for men and women who reach these respective ages to
retire, nor do they get penalized if they choose to remain in the labor
force. No other requirements are necessary.
(b) Early Retirement Pensions. To qualify for this option, a worker
must have enough capital accumulated in his account to purchase an
annuity that is (1) equal to at least 50 percent of his average salary
during the last 10 years of his working life; and (2) at least 110
percent of the minimum pension guaranteed by the state.\12\
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\12\ There is now a bill before the Chilean congress that would
increase the percentage from 110 percent of the minimum pension to 150
percent.
---------------------------------------------------------------------------
(c) Disability and Survivor's Benefits. To qualify for a full
disability pension, a worker must have lost at least two thirds of his
working ability; to qualify for a partial disability pension a worker
must have lost between 50 percent and two thirds of his working
ability. Survivor benefits are awarded to a worker's dependents after
the death of said worker. If he did not have any dependent individuals,
whatever funds remain in his pension savings account belong to the
beneficiaries of his estate.
Types of Pensions. There are three retirement options:
(a) Lifetime Annuity. Workers may use the money accumulated in
their accounts to purchase a lifetime annuity from an insurance
company. This annuity provides a constant income in real terms.
(b) Programmed Withdrawals. A second option is to leave the money
in the account and make programmed withdrawals, the amount of which
depends on the worker's life expectancy and those of his dependents. If
a worker choosing this option dies before the funds in his account are
depleted, the remaining balance belongs to the beneficiaries of his
estate, since workers now have property rights over their
contributions.
(c) Temporary Programmed Withdrawals with a Deferred Lifetime
Annuity. This pension option is basically a combination of the first
two. A worker who chooses this option contracts with an insurance
company a lifetime annuity scheduled to begin at a future date. Between
the start of retirement and the day when the worker starts receiving
the annuity payments, the worker makes programmed withdrawals from his
account.\13\
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\13\ This option is ideal for workers who are about to retire at a
time when the value of their accounts is down.
---------------------------------------------------------------------------
In all three cases a worker may withdraw in a lump-sum (and use for
any purpose) those funds accumulated in his account over and above the
money necessary to obtain a pension equal to at least 120 percent of
the minimum pension and to 70 percent of his average salary over the
last 10 years of his working life.
11. If a worker takes programmed withdrawals, but outlives his
account balance, what happens? Is there a safety net to insure he still
has a source of income?
If a worker outlives the balance in his account, then the
government provides the minimum pension, as defined by the Chilean
Congress, if that worker has contributed to his account for a minimum
of 20 years. If a worker does not have at least 20 years of
contributions, he may apply for a welfare-type pension that is lower
than the minimum pension. So, yes, there is a safety net under the
Chilean private pension system, as there was one under the old
government-run system. However, since the new system is far more
efficient than the old one, the cost to the Chilean taxpayer is
considerably lower.
12. Chile has been criticized in the past for having high rates of
transfers between funds. What actions has the government taken to help
reduce transfer rates?
Because of investment regulations and rules on fees and
commissions, product differentiation is low. Thus companies compete by
offering gifts or other incentives for workers to switch to their
companies. Switchovers increased dramatically from 1988, the year when
the requirement to request in person the change from one AFP to another
was eliminated, until 1997, when the government reintroduced some
restrictions to make it more difficult for workers to transfer from one
AFP to another. The number of transfers in 1998-2000 decreased to less
than 700,000, less than 500,000 and slightly more than 250,000,
respectively, from an all-time high of almost 1.6 million in 1997.
L. Jacobo Rodriguez
Assistant Director
Watson Wyatt Worldwide
Surrey, England
Congressman E. Clay Shaw, Jr.
Chairman,
Subcommittee on Social Security
Committee on Ways and Means
B316 Rayburn House Office Building
Washington, DC 20515
UNITED STATES
Dear Congressman Shaw:
Social Security and Pension Reform: Lessons from Other Countries--
Questions
Thank you for the opportunity to speak before the Subcommittee on
Social Security concerning Australia's approach toward Social Security
reform. Detailed below are my responses to your questions in respect to
my testimony of 31 July 2001.
Question 1: Could you explain what steps Australia takes to
minimize individual investment risk?
1. Australia in respect to its second pillar does not adopt a
position whereby systematic attempts are made to minimize individual
investment risk. Indirect methods are used to provide consumers with an
ability to identify and evaluate investment risk through effective
disclosure of key features linked to associated retirement products. In
effect regulators argue that through increasing the ``transparency'' of
the retirement vehicle consumers will be best placed to evaluate their
individual propensity toward investment risk. Additionally the role of
the intermediary is in some part crucial in minimizing investment risk
for the consumer. Central to the intermediary/ client relationship is
the ``know your client'' rules whereby the intermediary should
highlight or be aware of adverse investment risk that could affect
consumers.
Question 2: How does Australia accommodate lower-wage workers to
help insure their accounts are not consumed by administrative costs?
Could you tell us more about Retirement Savings Accounts and the extent
to which workers choose this type of account?
2. The structure of the superannuation industry in Australia
accommodates lower-wage workers through specific types of low cost,
high volume retirement accounts. Industry funds that are largely
affiliated with trade unions offer retirement accounts with low fees as
a result of lean administrative structures and distribution structures
that are highly efficient and effective. Second Retirement Savings
Accounts (RSAs), offered largely by banks provide low cost/high volume
alternatives for consumers and product providers alike. These products
have limited investment options and are mainly invested in fixed
interest securities. In effect these products contain or reduce risk
and minimize associated administrative costs. Such products are ideal
for consumers who enter or leave the work force on a regular basis.
RSAs are in part similar to certain aspects of the Thrift Savings Plan
(TSP) in terms of providing consumers with easily understandable, low
cost alternatives to that provided by commissioned intermediaries. An
annual statement is normally provided to consumers that reflect the
overall balance, fees charged and rates of return generated on the
account. With the relatively high levels of market returns linked with
equity based retirement accounts in recent years, the comparatively low
investment returns generated by RSAs has meant that these accounts are
generally unpopular. Additionally with little if any commissions being
associated with intermediaries who sell RSAs such products have only
reached a level of $A3.1 billion at March 2001. This is a growth of
6.1% since March 2000 with the share of total superannuation assets in
RSAs remaining at less than 1%.
Question 3: Could you provide a brief description of the regulatory
structure and rules that govern how superannuation policies are sold
and switched? Could you describe the type of information workers are
required to receive when buying superannuation products and on a
regular basis?
3. Comparatively speaking Australia has suffered little if any
consumer detriment linked with the sale and distribution of
superannuation products. In 1998 the Australian government decided to
separate regulatory responsibility for superannuation accounts between
solvency (Australian Prudential Regulatory Authority) and consumer
protection regulators (Australian Securities and Investment
Commission). In respect of the selling of superannuation accounts
consumers are required to have a needs analysis prepared by the
intermediary that provides an analysis of his or her financial position
and also details the recommendations made or attributed to the
corresponding retirement product. Such use of a needs analysis is
fundamental to the ``know your client'' rules that are central too much
of the regulation surrounding the selling and switching of retirement
policies. Equally for switching a retirement policy, a needs analysis
has to be completed by the intermediary justifying the move of the
policy based on sound economic or financial grounds. Along with being
provided with a needs analysis the consumer is required to be given a
customer information brochure (CIB) that details the key features and
policy illustrations of the product and also how complaints will be
handled on both an external and internal basis. Finally a Customer
Advice Record (CAR) is provided to the consumer that details the
financial relationship that the intermediary has with the product
manufacturer.
Question 4: Why did Australia choose to not regulate the structure
or level of administrative charges, except in the case of small
accounts?
4. Sound economic advantages exist for why administrative charges
were not regulated in Australia with respect to financial services. It
was the Federal Labour government's view of the day that market forces
were best placed to set associated fee or administrative charges on
these retirement products. It was felt that with appropriate disclosure
consumers would be best placed to evaluate fee and commission levels
and thus move toward product manufacturers who offered retirement
products that were better value for money. Additionally the Federal
government was concerned that if fee levels were set at a very low
level market distortions would take place and that limited distribution
of superannuation policies would take place. On an economic basis it
was also argued that market efficiencies would be stifled if companies
simply set administrative fees at a maximum permissible level.
Question 5: The Australian system has been criticized for having a
substantial portion of the population take their account as a lump sum
and end up receiving need-based benefits. What fraction annuitizes
their accounts? How will the affect government expenditures on retirees
in the future relative to the system prior to reform?
5. This criticism is quite dated and outmoded with respect to
individuals taking lump sums versus annuity benefits. Alterations in
taxation policy have meant that in recent years it has become less
favourable for individuals to take a lump sum benefit. Often retirees
take a retirement benefit as a lump sum, pay out their mortgage and
invest the remainder in an allocated pension product. An allocated
pension has grown sharply in Australia since their introduction in
1992. The product operates through a calculation of life expectancy
versus the sum invested. Using associated actuarial calculations, an
annual pension is paid until the initial amount capital plus net
returns are exhausted. Such products are more advantageous compared
with traditional annuity products in that the rates of return have been
significantly higher and that the consumer has greater flexibility to
pass capital residues onto their spouse or siblings. Lump sums,
excluding outward transfers, accounted for 79% ($5.6 billion) of the
benefits paid during the March quarter. The remaining 21% ($1.5
billion) of benefits were paid in pensions. Outward transfers accounted
for 57% of all fund withdrawals during the March quarter. As mentioned,
much of the lump sum payments are reinvested into traditional allocated
pension products. You will note in my testimony that I provided
estimates of Australia's expenditure as a percentage of GDP for its
corresponding first pillar. Anecdotal evidence indicates that overall
expenditure will be contained as average superannuation balances
progressively increases over time.
Question 6: Why do so few workers annuitize their accounts, and why
do even fewer choose a lifetime annuity despite tax incentives to do
so?
6. This question has been largely answered in Question 5. I would
add that annuity rates in Australia are low by comparison with Europe
and North America as a result of a smaller population base. In contrast
pension streams generated by allocated pension products are much higher
which has led to a rapid increase in this type of retirement product
held by Australians. It seems on a cultural level that Australians are
more reluctant to purchase annuities as they see life insurance
companies largely benefiting if an individual dies too early rather
than living too long.
Question 7: How many investment choices are workers in corporate,
industry, or public sector funds provided?
7. The number of investment choices varies widely between the
various types of superannuation schemes. As an average between 5-7
investment choices are largely provided by superannuation schemes as
whole. Moreover employees are demanding greater investment choice in
their superannuation schemes as they recognize that a diversified
portfolio is crucial in maximizing overall retirement returns. In
general industry funds have lower levels of investment choice compared
with corporate or retail superannuation, although this general
observation is changing rapidly as industry funds increase their
abilities to publicly offer services to the broader work force.
Question 8: What happens to account balances if a married worker
divorces or dies before retirement?
8. The question is largely dependent on the approach and the rules
linked with the superannuation trust deed. Generally pre-determined
spouse benefits will be provided by the plan based on certain levels of
coverage and Membership of the superannuation scheme. Intended
legislation will see superannuation balances considered in the divorce
settlements of married or defacto couples in Australia. At this stage
some ambiguity still exists over how differing types of superannuation
accounts will be treated after divorce. This point is particular
relevant with regard to corporate defined benefit plans and how
associated superannuation will be segregated or transferred into the
non-members' (spouse's) name.
Finally on a more personal level Congressman Shaw I would like to
express my deepest regret over the terrorist attack launched against
the United States of America this week. I do hope that the Committee
and its staff are safe and well and that this senseless act can be
resolved speedily.
Yours sincerely,
David O. Harris
Consultant