[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
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_____________________________________________________________________________
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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 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.













                            C O N T E N T S

                               __________
                                                                   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-
spaced copies of their statement, along with an IBM compatible 3.5-inch 
diskette in WordPerfect or MS Word format, with their name, address, 
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.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect or 
MS Word format, typed in single space and may not exceed a total of 10 
pages including attachments. Witnesses are advised that the Committee 
will rely on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press, 
and the public during the course of a public hearing may be submitted 
in other forms.
      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at ``http://waysandmeans.house.gov/''.
      
    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.

                                


    Chairman 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.
---------------------------------------------------------------------------
    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).

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    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \3\ Senate Select Committee on Superannuation: ``Safeguarding 
Super'', June 1992, p. 7, Canberra, Australia.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.''
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \4\ Private Pension Series, Private Pension Systems--Administrative 
Costs and Reforms, No 2.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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

                                
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