[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]


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23-925

2005


 
               SIXTH IN A SERIES OF SUBCOMMITTEE HEARINGS

 
                    ON PROTECTING AND STRENGTHENING

 
                            SOCIAL SECURITY

=======================================================================

                                HEARING

                               before the

                    SUBCOMMITTEE ON SOCIAL SECURITY

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                             JUNE 16, 2005

                               __________

                           Serial No. 109-24

                               __________

         Printed for the use of the Committee on Ways and Means

                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

E. CLAY SHAW, JR., Florida           CHARLES B. RANGEL, New York
NANCY L. JOHNSON, Connecticut        FORTNEY PETE STARK, California
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM MCCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM MCDERMOTT, Washington
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. MCNULTY, New York
PHIL ENGLISH, Pennsylvania           WILLIAM J. JEFFERSON, Louisiana
J.D. HAYWORTH, Arizona               JOHN S. TANNER, Tennessee
JERRY WELLER, Illinois               XAVIER BECERRA, California
KENNY C. HULSHOF, Missouri           LLOYD DOGGETT, Texas
RON LEWIS, Kentucky                  EARL POMEROY, North Dakota
MARK FOLEY, Florida                  STEPHANIE TUBBS JONES, Ohio
KEVIN BRADY, Texas                   MIKE THOMPSON, California
PAUL RYAN, Wisconsin                 JOHN B. LARSON, Connecticut
ERIC CANTOR, Virginia                RAHM EMANUEL, Illinois
JOHN LINDER, Georgia
BOB BEAUPREZ, Colorado
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana
DEVIN NUNES, California

                                 ______

                    SUBCOMMITTEE ON SOCIAL SECURITY

                    JIM MCCRERY, Louisiana, Chairman

E. CLAY SHAW, JR., Florida           SANDER M. LEVIN, Michigan
SAM JOHNSON, Texas                   EARL POMEROY, North Dakota
J.D. HAYWORTH, Arizona               XAVIER BECERRA, California
KENNY C. HULSHOF, Missouri           STEPHANIE TUBBS JONES, Ohio
RON LEWIS, Kentucky                  RICHARD E. NEAL, Massachusetts
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin

                    Allison H. Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel

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 
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                            C O N T E N T S

                               __________

                                                                   Page

Advisory of June 9, 2005 announcing the hearing..................     2

                               WITNESSES

U.S. government Accountability Office, Barbara D. Bovbjerg, 
  Director, Education, Work force, and Income Security...........     5
The World Bank, Estelle James....................................    16

                                 ______

Cato Institute's Project on Global Economic Liberty, Ian Vasquez.    46
Center for Economic Policy Research, Dean Baker..................    60
Organisation for Economic Co-operation and Development, Edward 
  Whitehouse.....................................................    20
Thomas A. Roe Institute for Economic Policy Studies, David C. 
  John...........................................................    66
TOR Financial Consulting, Limited, David O. Harris...............    53
Watson Wyatt Worldwide, Julia Lynn Coronado......................    38

                       SUBMISSIONS FOR THE RECORD

Daniels, Margaret, Hurst-Euless-Bedford School District, Hurst, 
  TX, statement..................................................   105
Fransen, Marilyn, Rapid City, SD, statement......................   105
Gathro, Ronald J., Springfield, MA, statement....................   107
Hahn, Bruce, American Homeowners Grassroots Alliance, Arlington, 
  VA, statement..................................................   108
[Pending.].......................................................

 
                   SIXTH IN A SERIES OF SUBCOMMITTEE


 
                       HEARINGS ON PROTECTING AND


 
                     STRENGTHENING SOCIAL SECURITY

                              ----------                              


                        THURSDAY, JUNE 16, 2005

             U.S. House of Representatives,
                       Committee on Ways and Means,
                           Subcommittee on Social Security,
                                                    Washington, DC.

    The Subcommittee met, pursuant to notice, at 10:00 a.m., in 
room B-318, Rayburn House Office Building, Hon. Jim McCrery 
(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
June 9, 2005
No. SS-6

                 McCrery Announces Sixth in a Series of

                Subcommittee Hearings on Protecting and

                     Strengthening Social Security

    Congressman Jim McCrery (R-LA), Chairman, Subcommittee on Social 
Security of the Committee on Ways and Means, today announced that the 
Subcommittee will hold the sixth in a series of Subcommittee hearings 
on protecting and strengthening Social Security to hear the views of 
Members of the House. The hearing will take place on Thursday, June 16, 
2005, in room B-318 Rayburn House Office Building, beginning at 10:00 
a.m. or immediately following the conclusion of the full Committee 
hearing.
      
    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:

      
    The United States is not alone in facing the challenges of 
providing retirement security for an aging population. The world is 
undergoing a demographic transformation. By 2050, the number of 
individuals aged 60 years and over will increase from 600 million to 
almost 2 billion, according to findings by the United Nations Second 
World Assembly on Aging. As a result, the proportion of people aged 60 
years and over is expected to double from 10 percent to 21 percent.
      
    Many countries have already addressed the financial pressures that 
an aging population places on their social security programs, by 
reducing growth of traditional ``pay-as-you-go'' benefits, increasing 
tax revenues and creating personal accounts to help pre-fund future 
benefits. Policymakers in the United States can learn from the 
experiences of other countries by examining the effects of their 
choices on beneficiaries, public pension financing and their economies. 
While these choices are a reflection of a country's culture, values and 
previously existing social insurance system, they also provide a broad 
array of tested options for consideration.
      
    In announcing the hearing, Chairman McCrery stated, ``Many other 
nations face similar or even worse challenges, compared with the United 
States, in providing retirement security for seniors. Often these 
nations have updated their retirement systems by adding personal 
accounts to their programs, as well as modifying the benefit structure 
and taxes. As we examine options for strengthening Social Security for 
Americans, we can learn from what did or did not work well in other 
countries.''
      

FOCUS OF THE HEARING:

      
    The Subcommittee will examine the experiences of other countries in 
reforming their social security systems, including the effect of their 
choices in modifying traditional benefits and designing personal 
accounts on individual's benefits, social security financing, and the 
countries' economies.
      

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FORMATTING REQUIREMENTS:

      
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materials in alternative formats) may be directed to the Committee as 
noted above.

                                 

    Chairman MCCRERY. The hearing will come to order. Good 
morning, everyone. Welcome to our sixth Subcommittee hearing on 
protecting and strengthening Social Security. Today we will 
hear about changes that other countries have made to their 
Social Security promise as they, like us, cope with how both to 
ensure the retirement security of an aging population. Oliver 
Wendell Holmes, Sr., a physician and father of the great 
jurist, said, quote, ``Knowledge and temper shouldn't be much 
used until they are seasoned.'' During our hearing this morning 
we will have the benefit of seasoned knowledge from around the 
world as we will hear from Australia, Chile, Sweden, the United 
Kingdom, and others with experience in making significance 
reforms to their Social Security systems. Each nation's 
decisions are a reflection of their culture, values, and 
previously existing social insurance programs, and while the 
countries we will examine today have different economies and 
governmental structures from those of the United States, they 
face similar demographic changes. This gives us the opportunity 
to learn from their experiences what went well and what could 
be improved.
    All countries, like the United States, first had to decide 
whether or not to act in advance of a demographic crush that 
would eventually lead to a funding crisis in their Social 
Security program. They then faced the same basic choices we are 
now considering on how best to strengthen their Social Security 
programs, reduce promised benefits, increase taxes, or increase 
rates of return by prefunding future benefits. As we will hear 
today, dozens of countries decided to prefund benefits through 
personal accounts. They have taken a broad range of approaches 
in designing and financing the personal accounts, which gives 
U.S. policy makers a wealth of tested options from which to 
learn. We will also hear about the modifications other 
countries have made in the benefits and financing of their 
traditional defined benefit programs, and how the combination 
of all their choices have affected individual beneficiaries as 
well as their countries' economies. I welcome our distinguished 
panel, some of whom have traveled great distances to appear 
before us today, and I look forward to hearing their views. 
Now, I would like to ask the Ranking Member of the 
Subcommittee, Mr. Levin, for his comments.
    Mr. LEVIN. Thank you very much, and we do have an 
impressive array, and I look forward to the testimony. It is 
very true the United States is not alone in having dealt with 
this problem and we need the experience of other nations. I 
hope as we do that we will also continue to look at the 
experience of our Nation. I think there is much to learn from 
how we have handled Social Security, and it is my judgment that 
our experience has shown that the Social Security system has 
worked very well and should not be replaced. As I look at the 
experience of other countries, I think that it does raise 
questions of risk, of cost, also of reduction in benefits. So, 
we are anxious to hear what you have to say and draw upon the 
experience of other countries. Remembering the benefits that 
have accrued to our Nation, I hope we don't get lost in terms. 
As the Chairman knows, I think ``prefunding'' is now the word 
that is used instead of privatization, and we are very strong 
in our belief that privatization would be a serious mistake. 
So, let's get on. We have one, two, three, four, five, six, 
seven, eight. You exceed the record for the size of the panel, 
and this is going to be a busy day here on the floor. So, our 
colleagues may move in and out as they have other obligations, 
but we look forward to your testimony and I am sure there will 
be some serious questions. Thank you.
    Chairman MCCRERY. Thank you, Mr. Levin. I do want to point 
out though that the two terms are not synonymous. 
``Privatization'' and ``prefunding'' are not synonymous, and I 
think we will hear today that some countries have a blend of 
what you might term privatization and a guaranteed benefit 
structure. So, I think we should wait and listen and try to 
learn from their experiences.
    Mr. LEVIN. All for it.
    Chairman MCCRERY. Not trying to characterize what we or 
anyone else is trying to do. With that we will begin this 
morning's hearing. Our first witness is a familiar witness 
before the Committee on Ways and Means, Barbara Bovbjerg. Ms. 
Bovbjerg is a respected member of the bureaucracy here in our 
Nation's Capitol. Believe it or not, there are those, and she 
is certainly one. She is the Director of Education, Work force, 
and Income Security for the U.S. government Accountability 
Office (GAO). Then we have Dr. Estelle James, Consultant and 
former Lead Economist at the World Bank; Edward Whitehouse, who 
is the Administrator, Social Policy Division, Organisation for 
Economic Co-operation and Development (OECD) in Paris, France; 
Julia Coronado, Senior Analyst with Watson Wyatt Worldwide; and 
Ian Vasquez, Director of the Cato Institute's Project on Global 
Economic Liberty; David Harris, Managing Director, TOR 
Financial Consulting Ltd., Suffolk, United Kingdom (UK); Dean 
Baker, Co-Director of the Center for Economic and Policy 
Research; David John, Research Fellow at the Heritage 
Foundation.
    We are very pleased to have all of you with us this 
morning, and you have all submitted written testimony which 
will be included in its entirety in the record, and this 
morning we would ask that you summarize your written testimony 
in about 5 minutes. For those of you who may not be familiar 
with the process, there is a little machine on the front of 
your table and it is has got lights on it. The green light 
stays on about 4 minutes, then an amber light comes on, which 
will be on for about 1 minute; 4 plus 1 is 5. When the red 
light comes on that means your time is basically up, although I 
will certainly allow you a few extra moments if you are not 
finished rounding up your testimony. So, that is the procedure. 
Then, after each of you has testified, Members of the panel 
will ask questions that we would ask you to respond to. So, Ms. 
Bovbjerg, if you will begin.

   STATEMENT OF BARBARA D. BOVBJERG, DIRECTOR OF EDUCATION, 
WORKFORCE, AND INCOME SECURITY, U.S. GOVERNMENT ACCOUNTABILITY 
                             OFFICE

    Ms. BOVBJERG. Thank you very much, Mr. Chairman, and thank 
you for the kind words. I am really pleased that you have 
invited me here again today to discuss other countries' 
experiences with public pension reform. Many countries, 
including the United States, are grappling with demographic 
change and its effect on their national pension systems and on 
their economies. Some nations have already undertaken pension 
reform, we may draw lessons from their experiences for the 
United States. Today I will present the preliminary results of 
our ongoing study for this Subcommittee of other nations' 
pension reforms. Our work examines the 30 member countries of 
the OECD plus Chile, the Nation that pioneered the use of 
individual accounts. I have organized my remarks around 
potential lessons from three general types of public pension 
reform approaches: first, adjustments within existing pay-as-
you-go (PAYGO) systems; second, the creation of dedicated 
reserves for advanced funding; and third, reforms involving the 
creation of individual accounts.
    First, lessons from changes to an existing system. Nearly 
all countries we studied have reduced benefits in their PAYGO 
systems as part of their reforms, and most have also raised 
contributions. Benefit reductions ranged from formula changes 
to reduced cost-of-living increases after retirement to 
creating a closer link between benefits and the contributions 
financing them. Contribution increases ranged from increasing 
contribution rates, to broadening the base on which 
contributions are levied, to increasing the number of years 
workers contribute. These changes were made to help ensure the 
financial stability of the existing system. At the same time, 
these countries took measures to ensure minimum retirement 
incomes. Most achieved this by providing a targeted means 
tested benefit. At least seven provided what they termed a 
basic retirement benefit of either a given amount per month or 
a minimum amount per year of contribution instead. Countries 
taking this approach were striving to achieve a careful balance 
between assuring benefit adequacy and maintaining incentives to 
work and save. Some like the UK retain such incentives by 
adopting so-called savings credits that allow retirees near the 
minimum pension level to retain a portion of any additional 
income they might earn.
    Let me turn now to countries' use of pension reserve funds. 
Eighteen of the countries accumulate reserve funds, and one 
clear lesson is that early action matters. Establishing reserve 
funds well before they will be needed makes it substantially 
more likely that assets will accumulate in time to do some 
good. Also, somewhat obviously, walling off these assets solely 
for the purpose of financing retirement programs makes a 
difference. Succumbing to temptation to spend such reserves to 
fund other public priorities undermines their original purpose.
    Finally, lessons regarding individual accounts. Eleven of 
the countries we examined restructured their pensions to 
incorporate some form of individual accounts. A major challenge 
for such accounts was how to pay for them. All countries 
creating individual accounts also made changes to their PAYGO 
systems to help reduce transition costs and to use budget 
surpluses as well. The countries that allow workers to opt in 
and out of the accounts had difficulty estimating costs and had 
to make additional changes to both the accounts and the PAYGO 
programs to compensate. One lesson here involves the tradeoff 
between allowing workers to maximize returns and ensuring 
benefit adequacy. Some countries address this issue by setting 
a guaranteed rate of return. Although this approach has assured 
a level of income adequacy, it also resulted in limited 
investment diversification which then brings returns below 
levels they might have otherwise achieved. All countries that 
adopted individual accounts also provide some sort of minimum 
benefit guarantee, but the guarantee itself can provide an 
incentive for risky investment decisions and a disincentive for 
voluntary contributions. The experience of other nations with 
individual accounts also suggests the importance of effective 
regulation. Some countries learned the hard way that regulating 
individuals' investment options was an important aspect of a 
program of accounts. Similarly, controlling fees and other 
administrative costs that can erode account returns can help 
ensure the viability of such a system.
    In conclusion, the countries we studied adopted different 
approaches that varied with the characteristics of their 
existing pension systems and with their economic and political 
conditions. Reforms adopted in one country are thus not easily 
replicated in another or, if replicated, don't necessarily lead 
to the same outcomes. Nonetheless, it is clear that effective 
reform requires cutting benefits, raising revenues, or both, 
and doing so well before the anticipated demographic changes 
take place. No matter what type of reform is undertaken, the 
sustainability of the pension system will depend on the health 
of the national economy. Reforms that offer incentives to 
postpone retirement, encourage employment and savings, and 
promote growth are most likely to produce an adequate and 
functionally sound system of retirement income over the long-
term. That concludes my statement. I await your questions.
    [The prepared statement of Ms. Bovbjerg follows:]
 Statement of Barbara D. Bovbjerg, Director. Education, Workforce, and 
         Income Security, U.S. Government Accountability Office

                         SOCIAL SECURITY REFORM

         Preliminary Lessons from Other Countries' Experiences

Mr. Chairman and Members of the Subcommittee:

    I am pleased to be here today to discuss our preliminary findings 
concerning other countries' experiences with national pension reform. 
Many countries, including the United States, are grappling with 
demographic change and its effect on their national pension systems. 
With rising longevity and declining birth rates, the number of workers 
for each retiree is falling in most developed countries. A rising 
dependency ratio is straining the finances of national pension 
programs, particularly programs in which contributions from current 
workers fund payments to current beneficiaries--a form of financing 
known as ``pay-as-you-go'' (PAYG). Demographic and economic challenges 
are less severe in the U.S. than in many other developed countries--the 
birth rate is not as low, a greater number of older people stay in the 
labor force, and immigration continues to provide young workers. Yet 
projections show that the Social Security program faces a long-term 
financing problem. Because some countries have already undertaken 
national pension reform efforts to address demographic changes similar 
to those occurring in the U.S., we may draw lessons from their 
experiences. It is important to remember, however, that reforms in one 
country may not be easily replicated in another or may not lead to the 
same outcome.
    We are in the process of preparing a report covering the 
experiences of countries that may be applicable to our own debate over 
reforms to the U.S. Social Security program--the 30 members of the 
Organisation for Economic Co-operation and Development (OECD) plus 
Chile, the nation that pioneered the use of individual accounts.\1\ My 
remarks today are based on an ongoing study and our observations are 
preliminary. We are focusing on (1) adjustments to existing PAYG 
national pension programs, (2) the creation of national pension reserve 
funds to help finance PAYG pension programs, and (3) reforms involving 
the creation of individual accounts.
---------------------------------------------------------------------------
    \1\ The OECD is a forum for the governments of 30 market 
democracies to work together on economic, social, environmental, and 
governance issues. The OECD works to promote economic growth, financial 
stability, trade and investment, technology, innovation, and 
development co-operation.
---------------------------------------------------------------------------
    To date our study has included interviews with, and analysis of 
materials provided by, officials and interest group representatives in 
Washington, D.C., Paris, and London. We met with pension experts and 
country specialists at the OECD as well as French and British experts, 
officials, and interest group representatives. We conducted our review 
in accordance with generally accepted government auditing standards.
    In summary, all OECD countries have, to some extent, reformed their 
national pension systems, and may offer lessons for the U.S. Countries' 
experiences adjusting PAYG national pension programs highlight the 
importance of considering how modifications will affect the program's 
financial sustainability, its distribution of benefits, the incentives 
it creates, and public understanding of the new provisions. Nearly all 
of the countries we are studying reduced benefits, and most have also 
increased contributions, often by increasing statutory retirement ages. 
Countries with national pension reserve funds designed to partially 
pre-fund PAYG pension programs provide lessons about the importance of 
early action and effective management. Some funds that have been in 
place for a long time have accumulated significant reserves to 
strengthen the finances of national pension programs. Countries that 
insulate pension reserve funds from being directed to meet social and 
political objectives may be better equipped to fulfill future pension 
commitments. In addition, regular disclosure of fund performance 
supports sound management and administration, and contributes to public 
education and oversight. Countries that have adopted individual account 
programs--which may also help pre-fund future retirement income--offer 
lessons about financing the existing PAYG pension program as the 
accounts are established. Countries that have funded individual 
accounts by directing revenue away from the PAYG program while 
continuing to pay benefits to PAYG program retirees have expanded 
public debt, built up budget surpluses in advance of the reform, cut 
back or eliminated the PAYG programs, or some combination of these. 
Important lessons regarding the administration of individual accounts 
include the need for effective regulation and supervision of the 
financial industry to protect individuals from avoidable investment 
risks. In addition, public education is increasingly important as the 
national pension system becomes more complex.
Background
    Social Security's projected long-term financing shortfall stems 
primarily from the fact that people are living longer and having fewer 
children. As a result, the number of workers paying into the system for 
each beneficiary is projected to decline. This demographic trend is 
occurring or will occur in all OECD countries. Although the number of 
workers for every elderly person in the U.S. has been relatively stable 
over the past few decades, it has already fallen substantially in other 
developed countries. The number of workers for every elderly person in 
the U.S. is projected to fall from 4.1 in 2005 to 2.9 in 2020. In nine 
of the OECD countries, this number has already fallen below the level 
projected for the U.S. in 2020. This rise in the share of the elderly 
in the population could have significant effects on countries' 
economies, particularly during the period from 2010 to 2030. These 
effects may include slower economic growth and increased costs for 
aging-related government programs.
    Historically, developed countries have relied on some form of a 
PAYG program and have used a variety of approaches to reform their 
national pension systems.\2\ In many cases, these approaches provide a 
basic or minimum benefit as well as a benefit based on the level of a 
worker's earnings. Several countries are preparing to pay future 
benefits by either supplementing or replacing their PAYG programs. For 
example, some have set aside and invested current resources in a 
national pension reserve fund to partially pre-fund their PAYG program. 
Some have established fully funded individual accounts. These are not 
mutually exclusive types of reform. In fact, many countries have 
undertaken more than one of the following types of reform:
---------------------------------------------------------------------------
    \2\ In other countries, ``social security'' often refers to a wide 
range of social insurance programs, including health care, long-term 
care, workers' compensation, unemployment insurance, etc. To generalize 
across countries, we use ``national pensions'' to refer to mandatory 
countrywide pension programs providing old-age pensions. We use 
``Social Security'' to refer to the U.S. Old-Age, Survivors, and 
Disability Insurance Program since that is how the program is commonly 
known.

      Adjustments to existing pay-as-you-go systems. Typically, 
these are designed to create a more sustainable program by increasing 
contributions or decreasing benefits, or both, while preserving the 
basic structure of the system. Measures include phasing in higher 
retirement ages, equalizing retirement ages across genders, and 
increasing the earnings period over which initial benefits are 
calculated. Some countries have created notional defined contribution 
(NDC) accounts for each worker, which tie benefits more closely to each 
worker's contributions and to factors such as the growth rate of the 
economy.
      National pension reserve funds. These are set up to 
partially pre-fund PAYG national pension programs. Governments commit 
to make regular transfers to these investment funds from, for example, 
budgetary surpluses. To the extent that these contribute to national 
saving, they reduce the need for future borrowing or large increases in 
contribution rates to pay scheduled benefits. Funds can be invested in 
a combination of government securities and domestic as well as foreign 
equities.\3\
---------------------------------------------------------------------------
    \3\ Reserve funds act as budgetary devices, or ``disciplinary'' 
devices, especially where they have been recently created. They help 
contain expenditures. Such containment is needed to achieve sustainable 
fiscal surplus.
---------------------------------------------------------------------------
      Individual accounts. These fully funded accounts are 
administered either by employers or the government or designated third 
parties. The level of retirement benefits depends largely on the amount 
of each person's contributions into the account during their working 
life, investment earnings, and the amount of fees they are required to 
pay.

    We are applying GAO's Social Security reform criteria to the 
experiences of countries that are members of the OECD as well as Chile, 
which pioneered individual accounts in 1981. We are assessing both the 
extent to which another country's circumstances are similar enough to 
those in the U.S. to provide a useful example and the extent to which 
particular approaches to pension reform were considered to be 
successful. Countries have different starting points, including unique 
economic and political environments. Moreover availability of other 
sources of retirement income, such as occupation-based pensions, varies 
greatly. Recognizing this, GAO uses three criteria for evaluating 
pension reforms:

      Financing Sustainable Solvency. We are looking at the 
extent to which particular reforms influence the funds available to pay 
benefits and how the reforms affect the ability of the economy, the 
government's budget, and national savings to support the program on a 
continuing basis.
      Balancing Equity and Adequacy. We are examining the 
relative balance struck between the goals of allowing individuals to 
receive a fair return on their contributions and ensuring an adequate 
level of benefits to prevent dependency and poverty.
      Implementing and Administering Reforms. We are 
considering how easily a reform is implemented and administered and how 
the public is educated concerning the reform.

    Because each country is introducing reforms in a unique 
demographic, economic, and political context these factors will likely 
affect reform choices and outcomes. For instance, several European 
countries we are reviewing have strong occupation-based pension 
programs that contribute to retirement income security. In addition, 
some countries had more generous national pensions and other programs 
supporting the elderly than others. All countries also provide benefits 
for survivors and the disabled; often these are funded separately from 
old age benefit programs. Some countries are carrying out reforms 
against a backdrop of broader national change. For example, Hungary and 
Poland were undergoing large political and economic transformations as 
they reformed their national pension systems. All of these issues 
should be considered when drawing lessons.
    In addition to the adjustments that countries have made to their 
existing PAYG systems, many countries have undergone other changes as 
well, indicating that change may not be a one-time experience. (See 
table 1.) Understanding the outcomes of a country's reform requires us 
to look at all of the changes a country has made.

              Table 1: Countries' National Pension Reforms
------------------------------------------------------------------------
       Groups of countries undertaking different types of reform a
-------------------------------------------------------------------------
                                        Adjustments to
 Only adjustments    Adjustments to        PAYG and
     to PAYG       PAYG and National      Individual     All Three Types
                      Pension Fund         Accounts
------------------------------------------------------------------------
Austria            Belgium            Australia          Denmark
------------------------------------------------------------------------
Czech Republic b   Canada             Chile d            Sweden
------------------------------------------------------------------------
Italy              Finland            Hungary            Switzerland g
------------------------------------------------------------------------
Germany c          France             Iceland e
------------------------------------------------------------------------
Turkey             Greece             Mexico
------------------------------------------------------------------------
                   Ireland            Poland
------------------------------------------------------------------------
                   Japan              Slovak Republic
------------------------------------------------------------------------
                   Korea              UK f
------------------------------------------------------------------------
                   Luxembourg
------------------------------------------------------------------------
                   Netherlands
------------------------------------------------------------------------
                   New Zealand
------------------------------------------------------------------------
                   Portugal
------------------------------------------------------------------------
                   Norway
------------------------------------------------------------------------
                   Spain
------------------------------------------------------------------------
                   U.S.
------------------------------------------------------------------------
Source: OECD, International Social Security Association, and the Social
  Security Administration.
a Member nations of the OECD and Chile.
b The Czech Republic's defined contribution account program is not
  included as an ``individual account reform'' as it is a voluntary
  supplementary program. For a discussion of these accounts, see U.S.
  General Accounting Office, Social Security Reform: Information on
  Using a Voluntary Approach to Individual Accounts, GAO-03-309
  (Washington, D.C.: Mar. 10, 2003), p. 46-54.
c Germany's Riester pension program is not included as an individual
  account reform because it is a supplement to the mandatory national
  pension program, rather than an alternative. For a discussion of these
  accounts, see U.S. General Accounting Office, Social Security Reform:
  Information on Using a Voluntary Approach to Individual Accounts, GAO-
  03-309 (Washington, D.C.: Mar. 10, 2003), p. 55-63.
d Chile is not an OECD country, but was included in our study because it
  pioneered individual account reforms.
e Iceland's mandatory occupation-based pension program allows for the
  creation of defined contribution individual accounts as a complement
  to defined benefit pensions. However, in practice, employers have not
  yet established these. Voluntary supplementary individual accounts are
  also available.
f The UK requires either participation in a state earnings-related
  pension program or an approved alternative including individual
  accounts.
g Switzerland's mandatory occupation-based pensions provide individual
  accounts that accrue credits at at least a minimum prescribed interest
  rate.

Adjustments to Existing PAYG Programs Show Importance of 
        Sustainability, Safety Nets, and Incentives to Work and Save
    The experiences of the countries that have adjusted their existing 
PAYG national pension programs highlight the importance of considering 
how modifications will affect the program's financial sustainability, 
its distribution of benefits, the incentives it creates, and the extent 
to which the public understands the new provisions.
PAYG Adjustments Prove Important to Financial Sustainability
    To reconcile PAYG program revenue and expenses, nearly all the 
countries we studied have decreased benefits and most have also 
increased contributions, often in part by increasing retirement ages. 
Generally countries with national pension programs that are relatively 
financially sustainable have undertaken a package of several far-
reaching adjustments. The countries we are studying increased 
contributions to PAYG programs by raising contribution rates, 
increasing the range of earnings or kinds of earnings subject to 
contribution requirements, or increasing the retirement age. Most of 
these countries increased contribution rates for some or all workers. 
Canada, for example, increased contributions to its Canadian Pension 
Plan from a total of 5.85 percent to 9.9 percent of wages, half paid by 
employers and half by employees. Several countries, including the UK, 
increased contributions by expanding the range of earnings subject to 
contributions requirements.
    Nearly all of the countries we are studying decreased scheduled 
benefits, using a wide range of techniques. Some techniques reduce the 
level of initial benefits; others reduce the rate at which benefits 
increase during retirement or adjust benefits based on retirees' 
financial means.

      Increased years of earnings. To reduce initial benefits 
several countries increased the number of years of earnings they 
consider in calculating an average lifetime earnings level. France 
previously based its calculation on 10 years, but increased this to 25 
years for its basic public program.
      Increased minimum years of contributions. Another 
approach is to increase the minimum number of years of contributions 
required to receive a full benefit. France increased the required 
number of years from 37.5 to 40 years. Belgium is increasing its 
minimum requirement for early retirement from 20 to 35 years.
      Changed formula for calculating benefits. Another 
approach to decreasing the initial benefit is to change the formula for 
adjusting prior years' earnings. Countries with traditional PAYG 
programs all make some adjustment to the nominal amount of wages earned 
previously to reflect changes in prices or wages over the intervening 
years. Although most of the countries we are studying use some kind of 
average wage index, others, including Belgium and France, have adopted 
the use of price indices. The choice of a wage or price index can have 
quite different effects depending on the rate at which wages increase 
in comparison to prices. We see variation in the extent to which wages 
outpace prices over time and among countries.
      Changed basis for determining year-to-year increases in 
benefits. In many of the countries we are studying, the rate at which 
monthly retirement benefits increase from year-to-year during 
retirement is based on increases in prices, which generally rise more 
slowly than earnings. Others, including Denmark, Ireland, Luxembourg, 
and the Netherlands, use increases in earnings or a combination of wage 
and price indices. Hungary, for example, changed from the use of a wage 
index to the Swiss method--an index weighted 50 percent on price 
changes and 50 percent on changes in earnings.
      Implemented provisions that provide a closer link between 
pension contributions and benefits. Countries that have adopted this 
approach stop promising a defined level of benefits and instead keep 
track of notional contributions into workers' NDC accounts. Unlike 
individual accounts, these notional defined accounts are not funded. 
Current contributions to the program continue to be used largely to pay 
benefits to current workers, while at the same time they are credited 
to individuals' notional accounts. When these programs include 
adjustments that link benefits to factors such as economic growth, 
longevity, and/or the ratio of workers to retirees, they may contribute 
to the financial sustainability of national pension systems.

    Several countries, such as Sweden and the UK, have undertaken one 
or more of these adjustments to their PAYG programs and have achieved, 
or are on track to achieve relative financial sustainability. Others, 
including Japan, France, and Germany, may need additional reforms to 
fund future benefit commitments.
Maintenance of a Safety Net and Work and Saving Incentives Proved 
        Important
    All of the countries have included in their reforms provisions to 
ensure adequate benefits for lower-income groups and put into place 
programs designed to ensure that all qualified retirees have a minimum 
level of income. Most do so by providing a targeted means-tested 
program that provides more benefits to retirees with limited financial 
means. Two countries--Germany and Italy--provide retirees access to 
general social welfare programs that are available to people of all 
ages rather than programs with different provisions for elderly people.
    Twelve countries use another approach to providing a safety net: a 
basic retirement benefit. The level of the benefit is either a given 
amount per month for all retirees or an amount based on years of 
contributions to the program. In Ireland, for example, workers who 
contribute to the program for a specified period receive a minimum 
pension. Chile set a minimum pension equal to the minimum wage--about 
one-quarter of average earnings as of 2005. In addition, several of the 
countries we are studying give very low-income workers credit for a 
minimum level contribution. Other countries give workers credit for 
years in which they were unemployed, pursued postsecondary education, 
or cared for dependents.
    In selecting between the many reform options, policy makers need to 
strike a careful balance among the following objectives: provide a 
safety net, contain costs, and maintain incentives to work and save. 
Costs can be high if a generous basic pension is provided to all 
eligible retirees regardless of their income. On the other hand, means-
tested benefits can diminish incentives to work and save. The UK 
provides both a basic state pension and a means-tested pension credit. 
Concerned about the decline in the proportion of preretirement earnings 
provided by the basic state pension, some have advocated making it more 
generous. Others argue that focusing safety-net spending on those in 
need enables the government to alleviate pensioner poverty in a cost 
effective manner. However, a guaranteed minimum income could reduce 
some peoples' incentive to save. In view of this disincentive, the UK 
adopted an additional means-tested benefit that provides higher 
benefits for retirees near the minimum income level. This benefit, 
called the savings credit, allows low-income retirees near the minimum 
pension level to retain a portion of their additional income. However, 
any loss of income due to means-testing still diminishes incentives to 
save. Without changes to pension rules, the proportion of pensioners 
eligible for means-tested income is expected to increase to include 
almost 65 percent of retiree households by 2050.
Implementation, Administration, and Public Education Are Important
    The extent to which new provisions are implemented, administered, 
and explained to the public may affect the outcome of the reform. 
Poland, for example, adopted NDC reform in 1999, but the development of 
a data system to track contributions has been problematic. As of early 
2004, the system generated statements indicating contributions workers 
made during 2002, but there was no indication of what workers 
contributed in earlier years or to previous pension programs. Without 
knowing how much they have in their notional defined accounts, workers 
may have a difficult time planning for their retirement. Some 
governments have had limited success in efforts to educate workers 
about changes in provisions that will affect their retirement income. 
For example, a survey of women in the UK showed that only about 43 
percent of women who will be affected by an increase in the retirement 
age knew the age that applied to them.
Early Action and Effective Management Help Make National Pension 
        Reserve Funds Successful
    Another type of pension reform is the accumulation of reserves in 
national pension funds, which can contribute to the system's financial 
sustainability depending on when the funds are created or reformed and 
how they are managed. Countries that chose to partially pre-fund their 
PAYG programs decades ago have had more time to amass substantial 
reserves, reducing the risk that they will not meet their pension 
obligations. A record of poor fund performance has led some countries 
to put reserve funds under the administration of relatively independent 
managers with the mandate to maximize returns without undue risk.
Early Action Matters
    Establishing reserve funds ahead of demographic changes--well 
before the share of elderly in the population increases substantially--
makes it more likely that enough assets will accumulate to meet future 
pension obligations. In countries such as Sweden, Denmark, and Finland, 
which have had long experiences with partial pre-funding of PAYG 
programs, important reserves have already built up. These resources are 
expected to make significant contributions to the long-term finances of 
national pension programs. Other countries that have recently created 
pension reserve funds for their pension program have a tighter time 
frame to accumulate enough reserves before population aging starts 
straining public finances. In particular, the imminent retirement of 
the baby-boom generation is likely to make it challenging to continue 
channeling a substantial amount of resources to these funds. France, 
for example, relies primarily on social security surpluses to finance 
its pension reserve fund set up in 1999, but given its demographic 
trends, may be able to do so only in the next few years. Similarly, 
Belgium and the Netherlands plan on maintaining a budget surplus, 
reducing public debt and the interest payments associated with the 
debt, and transferring these earmarked resources to their reserve 
funds. However, maintaining a surplus will require sustained budgetary 
discipline as a growing number of retirees begins putting pressure on 
public finances.
Effective Management Can Contribute to Financial Sustainability
    Examples from several countries reveal that pre-funding with 
national pension reserve funds is less likely to be effective in 
helping ensure that national pension programs are financially 
sustainable if these funds are used for purposes other than supporting 
the PAYGO program. Some countries have used funds to pursue industrial, 
economic, or social objectives. For example, Japan used its reserve 
fund to support infrastructure projects, provide housing and education 
loans, and subsidize small and medium enterprises. As a result, Japan 
compromised to some extent the principal goal of pre-funding.
    Past experiences have also highlighted the need to mitigate certain 
risks that pension reserve funds face. One kind of risk has to do with 
the fact that asset build-up in a fund may lead to competing pressures 
for tax cuts and spending increases, especially when a fund is 
integrated in the national budget. For example, governments may view 
fund resources as a ready source of credit. As a result, they may be 
inclined to spend more than they would otherwise, potentially 
undermining the purpose of pre-funding. Ireland alleviated the risk 
that its reserve fund could raise government consumption by prohibiting 
investment of fund assets in domestic government bonds.
    Another risk is the pressure that groups may exert on the 
investment choices of a pension reserve fund, potentially lowering 
returns. For example, Canada and Japan have requirements to invest a 
minimum share of their fund portfolio in domestic assets, restricting 
holdings of foreign assets to stimulate economic development at home. 
Funds in several countries have also faced pressure to adopt ethical 
investment criteria, with possible negative impacts on returns. In 
recent years, some countries have taken steps to ensure that funds are 
managed to maximize returns, without undue risk. Canada, for example, 
has put its fund under the control of an independent Investment Board 
operating at arm's length from the government since the late 1990's. 
Several countries, including New Zealand, have taken steps to provide 
regular reports and more complete disclosures concerning pension 
reserve funds.
Individual Account Reforms Show the Importance of Funding Decisions and 
        Ensuring Benefit Adequacy
    Countries that have adopted individual account programs--which may 
also help pre-fund future retirement income--offer lessons about 
financing the existing PAYG pension program as the accounts are 
established. Some countries manage this transition period by expanding 
public debt, building up budget surpluses in advance of implementation, 
reducing or eliminating the PAYG program, or some combination of these. 
In addition, administering individual accounts requires effective 
regulation and supervision of the financial industry to protect 
individuals from avoidable investment risks. Educating the public is 
also important as national pension systems become more complex.
Approach to Funding Individual Accounts Affects Sustainability of 
        National Pension System
    It is important to consider how different approaches to including 
individual accounts may affect the short-term and long-term financing 
of the national pension system and the economy as a whole. A common 
challenge faced by countries that adopt individual accounts is how to 
pay for both a new funded pension and an existing PAYG pension 
simultaneously, known as transition costs. Countries will encounter 
transition costs depending on whether the individual accounts redirect 
revenue from the existing PAYG program, the amount of revenue 
redirected, and how liabilities under the existing PAYG program are 
treated.
    The countries we are examining offer a range of approaches for 
including individual accounts and dealing with the prospective 
transition costs. Australia and Switzerland avoided transition costs 
altogether by adding individual accounts to their existing national 
pension systems, which are modest relative to those in the other 
countries we are studying.\4\ Some countries diverted revenue from the 
existing PAYG program to the individual accounts. The resulting 
shortfall reflects, in part, the portion of the PAYG program being 
replaced with individual accounts and the amount of PAYG revenue being 
redirected to fund the accounts. For example, transition costs may be 
less in countries such as Sweden or Denmark where the contribution to 
individual accounts is 2.5 percent of covered earnings and 1 percent, 
respectively, than for Poland or Hungary, which replaced a larger 
portion of the PAYG program.
---------------------------------------------------------------------------
    \4\ Australia's national PAYG program consistently replaces 
approximately 25 percent of average wages (23 percent in 2005); 
Switzerland's national PAYG program replaced approximately 26 percent 
of average wages in 2005.
---------------------------------------------------------------------------
    All of the countries we are reviewing also made changes to their 
PAYG program that were meant to help reduce transition costs, such as 
increasing taxes or decreasing benefits. In addition, Chile built a 
surplus in anticipation of major pension reform, and Sweden had large 
budget surpluses in place prior to establishing individual accounts. 
Countries also transfer funds from general budget revenues to help pay 
benefits to current and near retirees, expanding public borrowing. If 
individual accounts are financed through borrowing they will not 
positively affect national saving until the debt is repaid, as 
contributions to individual accounts are offset by increased public 
debt.\5\ For example, Poland's debt is expected to exceed 60 percent of 
GDP in the next few years in part because of its public borrowing to 
pay for the movement to individual accounts.
---------------------------------------------------------------------------
    \5\ Additionally, increased government debt may crowd out private 
sector access to lending markets and dampen the economic growth 
individual accounts are meant to access.
---------------------------------------------------------------------------
    It is sometimes difficult for countries to predict their transition 
costs. In particular, countries that allow workers to opt in or out of 
individual account programs have had difficulty estimating costs. For 
example, Hungary and Poland experienced higher than anticipated 
enrollment from current workers in their individual account programs, 
leaving the existing PAYG program with less funding than planned. As a 
result, both countries had to make subsequent changes to their 
individual account and PAYG programs.
Balancing Opportunities to Realize High Returns and Benefit Adequacy Is 
        Important
    Countries adopting individual accounts as part of their national 
pension system have had to make trade-offs between giving workers the 
opportunity to maximize returns in their accounts and ensuring that 
benefits will be adequate for all participants. Some countries set a 
guaranteed rate of return to reduce certain investment risks and help 
ensure adequacy of benefits. These guarantees may, however, result in 
limited investment diversification with a potentially negative impact 
on returns. In Chile, for example, fund managers' performance is 
measured against the returns of other funds. This has resulted in a 
``herding'' effect because funds hold similar portfolios, reducing 
meaningful choice for workers. All the countries with individual 
accounts provide some form of a minimum guaranteed benefit so retirees 
will have at least some level of income. Some experts believe that a 
minimum pension guarantee could raise a moral hazard whereby 
individuals may make risky investment decisions, minimize voluntary 
contributions, or, as in the case of Australia where the minimum 
guarantee is means-tested, may spend down their retirement assets 
quickly.
    It is important to consider the payout options available from 
individual accounts, as these can also have substantial effects on 
adequacy of income throughout retirement. For example, an annuity 
payout option can help to ensure that individuals will not outlive 
their assets in retirement.\6\ However, purchasing an annuity can leave 
some people worse off if, for example, the annuities market is not 
fully developed, premiums are high, or inflation erodes the purchasing 
power of benefits. Several countries also allow for phased withdrawals, 
in some cases with restrictions, helping to mitigate the risk of 
individuals outliving their assets and becoming reliant on the 
government's basic or safety-net pension. Some countries offer a lump-
sum payment under certain circumstances, such as small account 
balances, and Australia allows a full lump-sum payout for all retirees.
---------------------------------------------------------------------------
    \6\ The countries we reviewed require a range of annuity options, 
including, for example, inflation indexed, joint and survivor, or 
gender-neutral.
---------------------------------------------------------------------------
Effective Regulation, Implementation, and Education Can Protect 
        Individuals
    Important lessons can be learned regarding the administration of 
individual accounts, including the need for effective regulation and 
supervision of the financial industry to protect individuals from 
avoidable investment risks. Some countries have expanded their 
permitted investment options to include foreign investments and 
increased the percentage of assets that can be invested in private 
equities. The experiences of countries we are studying also indicate 
the importance of keeping administrative fees and charges under 
control. The fees that countries permit pension funds to charge can 
have a big influence on the amount of income retirees receive from 
their individual accounts. Several countries have limits on the level 
and types of fees providers can charge. Additionally, the level of fees 
should take into consideration the potential impact not only on 
individuals' accounts, but also on fund managers. In the UK, for 
example, regulations capping fees may have discouraged some providers 
from offering pension funds. To keep costs low, Sweden aggregates 
individuals' transactions to realize economies of scale.
    Some countries' experiences highlighted weaknesses in regulations 
on how pension funds can market to individuals. The UK's and Poland's 
regulations did not prevent problems in marketing and sales. Poland 
experienced sales problems, in part because it had inadequate training 
and standards for its sales agents, which may have contributed to 
agents' use of questionable practices to sign up individuals. The UK 
had a widely-publicized ``mis-selling'' scandal involving millions of 
investors. Many opened individual accounts when they would more likely 
have been better off retaining their occupation-based pension. 
Insurance companies were ordered to pay roughly $20 billion in 
compensation.
    Countries' individual account experiences reveal pitfalls to be 
avoided during implementation. For example, Hungary, Poland, and Sweden 
had difficulty getting their data management systems to run properly 
and continue to experience a substantial lag time in recording 
contributions to individuals' accounts. In addition, Hungary and Poland 
did not have an annuities market that offered the type of annuity 
required by legislation.
    Education becomes increasingly important as the national pension 
systems become more complex. It is particularly important for workers 
who may have to make a one-time decision about joining the individual 
account program. Several countries require disclosure statements about 
the status of a pension fund, and some provide annual statements. To 
help individuals choose a fund manager, one important component of 
these statements should be the disclosure of fees charged. Some 
countries have done a better job of providing fund performance 
information than others. For example, Australia requires its fund 
providers to inform members through annual reports clearly detailing 
benefits, fees and charges, investment strategy, and the fund's 
financial position. In contrast, Hungary did not have clear rules for 
disclosing operating costs and returns, making it hard to compare fund 
performance.
Concluding Observations
    Demographic challenges and fiscal pressure have necessitated 
national pension reform in many countries. Though one common goal 
behind reform efforts everywhere is to improve financial 
sustainability, countries have adopted different approaches depending 
on their existing national pension system and the prevailing economic 
and political conditions. This is why reforms in one country are not 
easily replicated in another, or if they are, may not lead to the same 
outcome. Countries have different emphases, such as benefit adequacy or 
individual equity; as a result, what is perceived to be successful in 
one place may not be viewed as a viable option somewhere else.
    Although some pension reforms were undertaken too recently to 
provide clear evidence of results, the experiences of other countries 
may suggest some lessons for U.S. deliberations on Social Security 
reform. Some of these lessons are common to all types of national 
pension reform and are consistent with findings in previous GAO 
studies. Restoring long-term financial balance invariably involves 
cutting benefits, raising revenues, or both. Additionally, with early 
reform, policy makers can avoid the need for more costly and difficult 
changes later. Countries that undertook important national pension 
reform well before undergoing major demographic changes have achieved, 
or are close to achieving, financially sustainable national pension 
systems. Others are likely to need more significant steps because their 
populations are already aging.
    No matter what type of reform is undertaken, the sustainability of 
a pension system will depend on the health of the national economy. As 
the number of working people for each retiree declines, average output 
per worker must increase in order to sustain average standards of 
living. Reforms that encourage employment and saving, offer incentives 
to postpone retirement, and promote growth are more likely to produce a 
pension system that delivers adequate retirement income and is 
financially sound for the long term.
    Regardless of a country's approach, its institutions need to 
effectively operate and supervise the different aspects of reform. A 
government's capacity to implement and administer the publicly managed 
elements of reform and its ability to regulate and oversee the 
privately managed components are crucial. In addition, education of the 
public becomes increasingly important as workers and retirees face more 
choices and the national pension system becomes more complex. This is 
particularly true in the case of individual account reforms, which 
require higher levels of financial literacy and personal 
responsibility.
    In nearly every country we are studying, debate continues about 
alternatives for additional reform measures. It is clearly not a 
process that ends with one reform. This may be true in part because 
success can only be measured over the long term, but problems may arise 
and need to be dealt with in the short term. The positive lessons from 
other countries' reforms may only truly be clear in years to come.
    Mr. Chairman and Members of the Subcommittee, this concludes my 
prepared statement. I'd be happy to answer any questions you may have.
GAO Contacts and Staff Acknowledgements
    For further information regarding this testimony, please contact 
Barbara D. Bovbjerg, Director, Education, Workforce, and Income 
Security Issues at (202) 512-7215. Alicia Puente Cackley, Assistant 
Director, Benjamin P. Pfeiffer, Thomas A. Moscovitch, Nyree M. Ryder, 
Seyda G. Wentworth and Corinna A. Nicolaou, also contributed to this 
report.

                                 

    Chairman MCCRERY. Thank you, Ms. Bovbjerg. Dr. James.

 STATEMENT OF ESTELLE JAMES, PH.D., CONSULTANT AND FORMER LEAD 
                   ECONOMIST, THE WORLD BANK

    Dr. JAMES. Thank you very much for inviting me. Over the 
past 20 years, more than 30 countries, spread across Latin 
America, Eastern and Central and Western Europe, Australia, and 
Hong Kong, have added privately funded managed plans to their 
mandatory Social Security systems. They did this for several 
reasons: to prevent public costs from rising, to increase 
national saving, to improve work incentives and therefore to 
augment economic growth, as the previous speaker said. 
Contributions to the accounts range from 2.5 percent of wages 
in Sweden, to 12.5 percent in Chile, and they are projected to 
supply between 30 and 90 percent of total benefits. It varies a 
lot across countries. In this discussion I am going to consider 
both income streams that come from the personal accounts, as 
well as the traditional defined benefit, as part of the 
country's Social Security system, so long as it is financed by 
taxes or mandatory contributions. In other words, I am defining 
Social Security as, in some sense, coming from these mandatory 
sources, whether it is the personal account or the defined 
benefit. I discuss how these countries financed the account, 
financed the transition, protected low earners and kept 
administrative costs low.
    I am going the summarize my four major points, and then I 
will go on as long as I have time to explain where they come 
from. The major lessons I draw are: first, in comparison with 
other countries, current and projected benefits from and 
contributions to the U.S. Social Security system are relatively 
low. We are at the low end of the spectrum. That leaves us with 
the question, do we want to maintain those scheduled benefits 
or cut them, and this is really the central question that we 
are faced with. To maintain the scheduled level of benefits 
will cost more money than we are paying now. That is going to 
be the case, I believe, whether we do it through the personal 
account part or the traditional part. However, I think we will 
get higher returns and better economic incentives from this 
extra money if it goes into personal accounts. This obviously 
implies funding the account mainly through a small add-on. 
Although most countries in Latin America and Eastern and 
Central Europe with funded private plans used a carve-out from 
existing payroll taxes, several OECD countries used the 
mandatory add-on, and our initial conditions have more in 
common with these OECD countries as I will explain in a minute.
    Second point, one reason why countries adopted personal 
accounts was to increase national saving and economic growth, 
making more goods and services available for everyone. This 
effect depends heavily on how the accounts and the transition 
are financed. National saving will increase if the accounts are 
funded by an add-on or if they are funded by a carve-out whose 
transition costs are not primarily debt financed. Chile is a 
very good example. Chile financed the transition to personal 
accounts out of a surplus on the rest of its public budget, 
both initially and even to this very day, and extensive 
analysis shows that this is largely responsible for the 
increased national saving that has fueled Chile's economic 
growth. Point number three: every country that has personal 
accounts also has a public safety net, so, it is certainly not 
an either/or proposition. The two definitely go together, and 
every country includes a minimum pension, as the previous 
speaker indicated, to cushion financial and labor market risk.
    Point number four, accounts can be organized through the 
retail market, as in most of Latin America and Eastern and 
Central Europe, or through the institutional market, as in 
several other countries, and in the United States we have the 
Thrift Saving Plan, which is an often cited example. The 
institutional market has much lower administrative and 
marketing costs because it benefits from greater economies of 
scale and bargaining power. There is also a tradeoff, and the 
tradeoff is less worker choice and less insulation from 
political pressures. So, those are my four points, and I just 
want to go back now and explain how I came to these 
conclusions, where those points come from.
    First, the issue of funding the account through an add-on 
versus a carve-out. What did other countries do? Countries that 
include funded privately managed plans in their Social Security 
systems fall into two different groups: Latin America and 
Eastern and Central European countries on the one hand, and 
several OECD countries on the other hand. Now, in most Latin 
American and Eastern and Central European countries personal 
accounts were created during the nineties and early 2000s as a 
remedy for public systems that were already on the verge of 
insolvency, much further along than we are in this country. 
Payroll taxes were extremely high, often over 25 percent of 
wages. Tax evasion was also high. Workers retired well before 
age 60 and promised replacement rates were overly generous; for 
example, 70 to 80 percent of the worker's wage. An add-on 
contribution for the accounts clearly was not an option for 
this group. The new accounts were funded by a carve-out from 
the existing payroll tax, which was already too high.
    In contrast, several OECD countries, such as Australia, 
Switzerland, Netherlands, and Denmark, started out with 
relatively modest public benefits, not very different on 
average from benefits in the United States but more 
redistributive. They had a different structure. In addition, in 
these countries, employers have long provided pension plans, on 
a voluntary or collectively bargained basis, to about half the 
labor force. That also has some similarities to the United 
States. As an alternative to increased public expenditures on 
pensions and as a way to raise national saving, in the eighties 
and early nineties these countries decided to make funded 
employer-sponsored plans mandatory for virtually the entire 
labor force. In effect, these plans became part of the Social 
Security systems because they were mandated through an add-on 
for employers that didn't already provide them. The add-on has 
reached 9 percent in Australia. The cost is actually higher in 
some of the other countries, and the combined target 
replacement rate is now 60 to 65 percent, obviously higher than 
ours.
    Chairman MCCRERY. Dr. James, can you sum up so we can move 
on? We will get to a lot of this in questions.
    Dr. JAMES. Okay, sure. I will just say the old employer 
plans were mainly Defined Benefit (DB), but they are 
increasingly Defined Contribution (DC) and many employers are 
also shifting their old plans to DC, so, they are moving in the 
distribution of individual accounts. In terms of transition 
costs, the countries that used an add-on did not face 
transition costs because they added money. The ones that used a 
carve-out did face transition costs, and they financed these 
costs by downsizing benefits and through a mix of fiscal 
stringency and debt finance. Chile, as I mentioned, ran a 
surplus on the rest of its budget to finance the transition. In 
fact, even today they spend 2 to 3 percent of their Gross 
Domestic Product (GDP) on phasing out the old system, but no 
debt financing. It all comes out of surplus on the rest of its 
budget, which has enhanced its national saving. All of these 
countries include a safety net and minimum pension, which may 
come from a minimum pension guarantee, a flat benefit, or a 
means tested benefit. There are different forms, but they all 
have some kind of minimum pension. Administrative costs, as I 
mentioned, can be reduced by using the institutional market. We 
find this in the employer-sponsored plans and in some smaller 
countries like Bolivia, Kosovo, Panama, whose costs are quite 
low. So, I think if this plan is structured through the 
institutional market we can keep our costs low too.
    [The prepared statement of Dr. James follows:]
     Statement of Estelle James, Ph.D., Consultant and Former Lead 
                       Economist, The World Bank
    Over the past 20 years more than 30 countries, spread across Latin 
America, Eastern, Central and Western Europe, Australia and Hong Kong, 
have added funded privately managed plans to their mandatory social 
security systems. They did this to prevent public costs from rising, to 
increase national saving and to improve work incentives. Contributions 
to the accounts range from 2.5% of wages in Sweden to 12.5% in Chile 
and they are projected to supply between 30 and 90% of total benefits. 
In this discussion I consider both income streams--that coming from the 
personal accounts as well as the traditional defined benefit--as part 
of the country's social security system, so long as it is financed by 
taxes or mandatory contributions. I discuss how these countries funded 
the accounts, financed the transition, protected low earners and kept 
administrative costs low. The major lessons I draw are:

    1.  In comparison with other countries, current and projected 
benefits from and contributions to in the U.S. social security system 
are relatively low. We need to decide whether we wish to maintain or to 
cut the scheduled level of mandatory retirement income--this is our 
central question. To maintain the scheduled level of social security 
benefits will cost more money than we are paying now, whether we do it 
through the personal account part or the traditional part. We will get 
higher returns and better economic incentives from this extra money if 
it goes into personal accounts--but this implies funding the accounts 
mainly through a small add-on. Although most countries in Latin America 
and Eastern and Central Europe with funded private plans used a carve-
out from existing payroll taxes, several OECD countries used a 
mandatory add-on. Our initial conditions have more in common with these 
OECD countries.
    2.  One reason why countries adopted personal accounts was to 
increase national saving and economic growth--therefore more goods and 
services for everyone. This effect depends heavily on how the accounts 
and the transition are financed. National saving will increase if the 
accounts are funded by an add-on or by a carve-out whose transition 
costs are not debt-financed. Chile financed its transition out of a 
surplus on the rest of its public budget--and extensive analysis shows 
that this is largely responsible for the increased saving that has 
fueled Chile's economic growth.
    3.  Every country that has personal accounts also has a public 
safety net, including a minimum pension, to cushion financial and labor 
market risk.
    4.  Accounts can be organized through the retail market, as in most 
of Latin America and Eastern and Central Europe, or through the 
institutional market, as in several other countries and in the Thrift 
Saving Plan in the U.S. The institutional market has much lower 
administrative and marketing costs because it benefits from greater 
economies of scale and bargaining power (but the trade-off is less 
worker choice and less insulation from political pressures).
1. Funding the accounts through an add-on versus a carve-out
    Countries that include funded privately managed plans in their 
social security systems fall into two different groups: Latin America 
and Eastern and Central Europe, on the one hand, and several OECD 
countries, on the other hand. In most Latin American and Eastern and 
Central European countries personal accounts were created during the 
1990's and early 2000's as a remedy for public systems that were 
already on the verge of insolvency. In these countries payroll taxes 
were extremely high (often over 25% of wages), tax evasion was also 
high, workers retired well before age 60 and promised replacement rates 
were overly generous--for example, 70-80% of the worker's wage. An add-
on contribution for the accounts clearly was not an option for this 
group. The new accounts were funded by a carve-out from the existing 
payroll tax, which was already too high.
    In contrast, several OECD countries, such as Australia, 
Switzerland, Netherlands and Denmark, started out with relatively 
modest public benefits--not very different, on average, from benefits 
in the U.S., but more redistributive. In addition, in these countries 
employers have long provided pension plans, on a voluntary or 
collective bargained basis, which covered about half the labor force. 
As an alternative to increased public expenditures on pensions and as a 
way to raise national saving, in the 1980's and early 1990's these 
countries decided to make funded employer-sponsored plans mandatory for 
virtually the entire labor force. In effect, these plans became part of 
their social security systems, through an add-on for employers that 
didn't already provide them. The add-on has reached 9% in Australia, 
more in the other countries, and the combined target replacement rate 
is now 60-65%. The old employer plans were mainly defined benefit but 
the new ones are mostly defined contribution and many employers are 
also shifting their old plans to defined contribution (that is, to 
individual accounts).
    I believe this add-on strategy for financing individual accounts 
would be the best for us too, except that I would organize it through 
workers, not employers, and I would aim for a much smaller add-on (of 
about 2%). This would hold our total benefit roughly where it is 
projected to be now, while allowing the traditional part of the system 
to become smaller and remain solvent.
2. Transition costs
    The OECD countries did not face transition costs, because they did 
not divert money, they added-on. The Latin American and Eastern-Central 
European countries did face transition costs. They financed these costs 
in part by downsizing benefits and by a mix of fiscal stringency and 
debt finance. The transition has been intensively studied in Chile. 
Chile cut its obligations by raising retirement age substantially. It 
accumulated a budget surplus ahead of time to cover its early 
transition costs. The government is still paying 2-3% of GDP per year 
for the remnants of the old system, but it does so entirely by 
generating a surplus in the rest of its budget. In other words, no 
public debt finance is involved. Financing the transition without 
increasing the public debt is the major reason why Chile has increased 
its national saving, which in turn has increased its rate of economic 
growth.
    If we in the U.S. want to use pension reform as a way to increase 
national saving, either we must use an add-on or we must come up with a 
plan for transition finance that does not depend heavily on enlarging 
the public debt. Otherwise, we will be canceling out the increased 
private saving with increased public dissaving.
3. Minimum pension and other safety nets
    All these countries include a safety net and guarantees to protect 
low earners. Every one of them has a minimum pension of some sort--
examples are a minimum pension guarantee in Chile, a flat benefit that 
goes to every older resident in the Netherlands, or a widespread 
means--and asset-tested benefit in Australia. This cushions the risk 
from the accounts and from the labor market. In Switzerland, Mexico and 
Estonia the safety net rises with years of contributions, to bolster 
work incentives.
4. Administrative costs--retail versus institutional market
    Most of the countries in Latin America and Central-Eastern Europe 
used the retail market to put workers into funds. But some countries, 
such as Bolivia, Panama (civil service) and Kosovo, have experimented 
with the institutional market. Large employer funds in the OECD also 
use the institutional market.
    In the retail market pension fund managers can freely enter the 
industry, they establish a direct relationship with workers, and 
administrative costs tend to be relatively high, because of high 
marketing costs, diseconomies of dealing with many small accounts and 
price-inelasticity of demand in retail financial markets. Costs start 
out well over 10% of assets. Even though they fall steeply with asset 
growth, in countries as advanced as the UK they still exceed 1%, which 
will reduce final pensions by 20%.
    In contrast, in the institutional market records are usually 
centralized, the money in small accounts is aggregated, and a 
competitive bidding process is held to choose a limited number of fund 
managers, among whom workers can choose. Administrative costs are cut 
by 2/3, because scale economies and bargaining power are larger and 
marketing costs are smaller. There is a trade-off of course--less 
choice for workers and greater danger of political pressure, if the 
bidding is organized by government. Sweden tries to mimic the fees of 
the institutional market while keeping the greater choice of the retail 
market, but it does so by imposing price controls. The institutional 
model is used by the U.S. Thrift Saving Plan and it was recommended by 
the President's Commission for our individual account system. I think 
this is appropriate for a system with many small accounts. After 7-8 
years, administrative costs in this system would be.3%, which is lower 
than in other countries and also lower than in most mutual funds in our 
country.

                                 

    Chairman MCCRERY. Thank you, Dr. James. Mr. Whitehouse.

 STATEMENT OF EDWARD WHITEHOUSE, ADMINISTRATOR, SOCIAL POLICY 
     DIVISION, ORGANISATION FOR ECONOMIC CO-OPERATION AND 
                   DEVELOPMENT, PARIS, FRANCE

    Mr. WHITEHOUSE. Thank you. I shall try and be briefer. It 
is a great pleasure to be here, and I think it is very useful 
for this Committee to look at the international experience. As 
the previous speakers have said, there is a vast amount of 
experience on structural pension reform around the world, and I 
think there are some lessons that can be learned for the United 
States. As both of the previous speakers have pointed out, the 
starting point is rather different in the United States than it 
was in the countries of Latin America and Eastern Europe. To 
start with, the target benefit level under Social Security is 
relatively low. It promises about a 50-percent replacement rate 
after a full career. That compares with about 65 or 70 percent 
in the rest of the OECD countries, which was the target of the 
starting point in the Latin American and Eastern European 
countries as well. So, the carve-out question is rather 
different when you have a much bigger starting point in your 
public pension system than it is when the starting point is as 
it is in the United States.
    In the first part of my written testimony, I put the U.S. 
pension scheme into an international context to try and show 
how the target benefit level compares with comparable 
countries, and also to look at income distribution analysis, 
which shows that currently, pensioners in the United States 
look to be doing quite well. Their incomes are quite large 
relative to most of the population as a whole. However, there 
is an issue of pension or prosperity, that on a standard 
international definition, 20 percent of older people in the 
United States are classed as poor, and that is double the 
average for the 30 rich countries who are members of the OECD, 
which is around 10 percent, and it is very much higher than 
countries such as France, Germany, and Britain, which have a 
much lower old age poverty rate. So, I think an issue that 
perhaps should be addressed in Social Security reform is 
thinking about what to do about poorer pensioners.
    As far as personal accounts go, one major issue which Dr. 
James touched on, is this question of the administrative 
expenses, and we found particularly in Latin America there has 
been--in the early years of reform this has been very 
controversial--extremely large marketing expenses; rather 
wasteful competition between different pension providers who 
are essentially offering the same product, because the 
portfolios of the different funds are very similar, the 
marketing being the sole reason for people to switch often 
between funds. There are very obvious ways the United States 
can avoid falling into that trap of this wasteful competition. 
Dr. James mentioned the Thrift Saving Plan (TSP). I am not sure 
that that can be a direct model for a personal account system 
because the TSP is for Federal Government employees, so, there 
is only one employer. When we are dealing with personal 
accounts, we are dealing with a multitude of employers, and so, 
I think something like TIAA-CREF might be a better example. 
Clearly, the United States is in a much better position in 
terms of its financial markets for organizing a system of 
personal accounts than was, for example, Chile or the countries 
of Eastern Europe, where capital markets there could best be 
described as nascent in times of reforms. There is a corollary 
of that, which is that therefore, the benefits to the U.S. 
economy of such a reform are commensurately lower. It is easier 
to organize, but the capital market development, which is so 
important in Latin America, so important in Eastern Europe, is 
already there. You have the most advanced capital market there 
is, already. So, the wider economic effects are likely to be 
smaller in the reform in the United States than they are in 
other countries.
    The final issue I address in the written testimony is a 
rather complex one which I will try and summarize in 30 
seconds. It is this issue of who is covered by the reform and 
what are the terms of trade for people switching to the new 
personal accounts. In reading the proposals of the President's 
Commission on Strengthening Social Security, people are likely 
to be offered a choice of where they can take some of their 
contributions out of Social Security and put them into their 
personal account, and then their Social Security benefits are 
reduced by that amount of contribution plus an interest rate. 
How that interest rate is set is going to be crucial to whether 
or not these personal accounts will actually work. Set the 
interest rates too high, no one is going to choose that option. 
Set the interest rate too low, and you have a huge fiscal 
problem. As I explained in detail in the written testimony, the 
UK made a very grave mistake when it introduced the individual 
accounts/pension option, because it gave people far too large 
an incentive to switch to the new individual account. So, I 
look forward to answering your questions. Thank you.
    [The prepared statement of Mr. Whitehouse follows:]
Statement of Edward Whitehouse, Administrator, Social Policy Division, 
    Organisation for Economic Co-operation and Development, Paris, 
                               France\1\
---------------------------------------------------------------------------
    \1\ Edward Whitehouse, a British national, works in the Social 
Policy Division of the OECD Secretariat in Paris. He is co-author of 
the recent report, Pensions at a Glance, a comprehensive study of 
pension systems in the 30 OECD countries (OECD, 2005). He has advised 
numerous governments on pension reform, including Hungary and Poland, 
and has written many studies of the pension system in the United 
Kingdom (such as Dilnot et al., 1994 and Whitehouse, 1998). He 
previously worked as co-editor of the World Bank's Pension Reform 
Primer, a resource for people designing and implementing pension 
reforms around the world.
    This testimony represents a personal view and commits neither the 
OECD Secretariat nor any of its member governments.
    Edward Whitehouse, ELS/SPD, OECD, 2 rue Andre Pascal, 75775 Paris 
Cedex 16, France. Telephone: +33 1 45 24 80 79. Fax: + 33 1 45 24 90 
98. E-mail: [email protected].
---------------------------------------------------------------------------
    Countries around the world need to reform pension systems to meet 
demographic challenges and to reflect changes in labor markets and 
industrial, economic and social structures. There are valuable lessons 
to be learned from other countries' experiences. But the inherent 
complexity of pension systems has, in the past, hampered effective 
transmission of policy experiences across borders.
    This testimony is in four parts. The first puts the United States' 
pension system in an international context. It uses three kinds of 
evidence: calculations of pension entitlements at an individual level, 
comparisons of older people's incomes with the rest of the population 
and how public pension spending is likely to develop.
    The second part looks at structural pension reforms that have 
introduced some kind of mandatory `individual accounts' (defined-
contribution pension plans) as a substitute for all or part of public, 
earnings-related pensions. These have now been introduced by 10 
countries in Latin America and more than 10 in Eastern Europe.
    The third part of the testimony investigates an important but often 
overlooked feature of fundamental pension reform. Are the new defined-
contribution accounts mandatory or voluntary? Which age groups are 
covered? If there is a choice, what are the terms of trade between 
remaining only in the public pension program and switching to a mixed 
public/private pension?
    The issue of administrative charges for defined-contribution 
pensions is addressed in the fourth part. How large are these fees in 
different countries? What policies can help keep charges low?
1. The pension system of the United States in an international context
    There are three main approaches to comparing pension systems 
between countries. The most common is the `fiscal' approach, which 
looks at current and prospective pension expenditures. This is useful 
for assessing the financial sustainability of a retirement-income 
system, but it gives only the total for pension spending and is silent 
on how that spending is distributed among older people. The second 
method is income-distribution analysis. This compares the incomes of 
today's older people with the incomes of the population as a whole. 
This is a backward-looking measure, since the incomes of today's 
pensioners depend on past rules of the pension system and past economic 
conditions. The third method is a microeconomic approach, calculating 
prospective pension entitlements for today's workers. Unlike fiscal 
projections, this looks explicitly at the distribution of pensions 
among workers of different characteristics. Unlike income-distribution 
analysis, it is forward-looking, assessing the pension promises made to 
today's workers under today's rules.
Microeconomic approach
    The OECD recently published the first comprehensive, microeconomic 
analysis of pension entitlements in the report Pensions at a Glance 
(OECD, 2005). This first report (in what is hoped will be a biennial 
series) calculated prospective pensions of full-career workers at 
different levels of earnings.\2\ The analysis includes all mandatory 
sources of retirement income: resource-tested benefits (including 
social assistance), basic and minimum pensions, public, earnings-
related schemes and mandatory private schemes (both defined-benefit and 
defined-contribution). The calculations use common macroeconomic and 
financial assumptions to isolate the effect of pension-system design 
from these other factors. The parameters used are those applying in 
2002, although subsequent reforms that have been legislated are assumed 
to be fully in place. The results, therefore, show the long-term stance 
of the pension system.
---------------------------------------------------------------------------
    \2\ Ongoing work is extending the analysis to include people with 
long absences from the labor market due to caring for children or long-
term unemployment.
---------------------------------------------------------------------------
    The two charts below (Figure 1) show the `net replacement rate'. 
This is the pension, net of any income taxes and contributions due, 
divided by individual earnings, again net of taxes and contributions. 
Both charts show selected countries: OECD (2005) provides data for all 
30 member countries of the OECD.
    The left-hand panel shows the net replacement rate for a full-
career with earnings equal to the economy-wide average each year. The 
highest net replacement rate is in Luxembourg, where the pension 
entitlement is calculated to be 110 percent of earnings when working. 
At the other end of the scale, the lowest net replacement rate is in 
Ireland, where it is 37 percent. The OECD average net replacement rate 
for an average earner is 69 percent. The replacement rate in the United 
States is low: along with Ireland and the United Kingdom shown in the 
charts, only Korea, Mexico and New Zealand have lower net replacement 
rates at this earnings level.
    The right-hand panel shows the position of a low earner. The OECD 
average replacement rate at half-average earnings is 84 percent. This 
is higher than the replacement rate for an average earner because most 
OECD countries, the United States included, have redistributive pension 
systems. At this earnings level, the replacement rate in the United 
States is 61 percent. This is the lowest among the OECD countries apart 
from Mexico and the Slovak Republic. Countries with wholly flat-rate 
pensions, such as Ireland, with means-tested public schemes, such as 
Australia, or with predominantly flat-rate systems, such as the United 
Kingdom naturally have a large difference between the replacement rate 
at average and at low earnings. The main reason that low earners have 
very low pensions in the United States, despite the progressive benefit 
formula in social security, is the low value of the safety-net benefit. 
The means-tested program, supplemental security income (SSI), provides 
a minimum income worth 20 percent of average earnings. The safety-net 
retirement income across all 30 OECD countries is worth nearly 30 
percent of average earnings (on average).

   Figure 1. Prospective net replacement rate for full-career worker

Average earnings
[GRAPHIC] [TIFF OMITTED] T3925A.001

Half-average earnings
[GRAPHIC] [TIFF OMITTED] T3925A.002

                           Source:OECD (2005)

    In countries with low mandated pension replacement rates, there is 
space for voluntary retirement-income provision to develop. In Canada, 
the United Kingdom and the United States, for example, both company and 
individual pensions are widespread. The chart for the average earner 
therefore shows the entitlements under a `typical' pension plan for 
these three countries. In Canada and the United Kingdom, this is a 
defined-benefit plan. For the United States, it is a 401(k), into which 
the worker and his employer are assumed to pay contributions of the 
national average (9.5 percent of earnings).\3\ With these voluntary 
programs, the replacement rates for these three countries look rather 
closer to continental Europe. But these replacement rates are 
conditional on having a full-career covered by a voluntary plan. The 
issue then turns to the following questions. Are some people saving 
enough in defined-contribution schemes? Do people have significant gaps 
where they are not covered by a voluntary, private pension? How will 
the penalty to changing jobs in defined-benefit plans affect retirement 
incomes?
---------------------------------------------------------------------------
    \3\ The average contribution rate is taken from the Employee 
Benefits Research Institute/Investment Company Institute (EBRI/ICI) 
survey of 401(k) plans. OECD (2005) provides details of the modeling 
for Canada and the United Kingdom and calculations for a typical 
defined-benefit plan for the United States. It also includes a 
sensitivity analysis of the results.
---------------------------------------------------------------------------
Income-distribution analysis
    Figure 2 shows two charts that summarize the information relating 
to older people in the OECD's latest cross-country study of income 
distribution (Forster and Mira d'Ercole, 2005).\4\ Again, selected 
countries are presented here while the original paper provides 
information for many more.
---------------------------------------------------------------------------
    \4\ See also Disney and Whitehouse (2001, 2002).
---------------------------------------------------------------------------
    The left-hand panel shows the net income of 66-75 year olds as a 
proportion of the net income of the population as a whole. The OECD 
average is 87 percent. In the United States, the figure is the highest 
of the OECD countries at 97 percent. Most of the OECD countries are 
clustered closely together. One reason that the United States performs 
well on this measure, while mandatory replacement rates under social 
security are so low, is due to voluntary, private pension provision. 
But the main reason is due to the importance of labor-market income in 
the United States, even among these 66-75 year olds. Earnings make up 
30 percent of the gross income of this age group in the United States. 
In most of Europe, this figure is only around 10 percent. Australia, 
Canada and New Zealand lie between the two, with around 20 percent of 
gross income of older people coming from earnings.\5\
---------------------------------------------------------------------------
    \5\ The low measure of relative incomes of older people in 
Australia reflects the fact that many withdrawals from private pensions 
are in the form of lump sums rather than income streams. These are not 
measured in income-distribution analysis. This is also an important 
factor in Ireland and the United Kingdom, although to a more limited 
extent.
---------------------------------------------------------------------------
    The right-hand panel shows the old-age poverty rate for the same, 
selected countries. This is defined as the percentage of 66-75 year 
olds with an income below half the population median. In addition to 
Australia and Ireland (shown in the chart), only Greece, Mexico and 
Portugal have a higher old-age poverty rate than the United States. The 
OECD average (11 percent) is nearly half the rate in the United States. 
This reflects the low value of SSI relative to safety-net incomes for 
older people in other OECD countries and narrow coverage of low-income 
workers by private pensions.

                 Figure 2. Income distribution measures

Relative incomes of older people
[GRAPHIC] [TIFF OMITTED] T3925A.003

Old-age poverty rate
[GRAPHIC] [TIFF OMITTED] T3925A.004

    Note: all incomes are household incomes adjusted for household 
                composition using an `equivalence scale'

                Source: Forster and Mira d'Ercole, 2005

Fiscal projections
    The OECD has also compared the effects of aging on a range of 
public spending programs. The chart below (Figure 3) looks at public 
spending on pensions alone. Public pension expenditure in 2000 averaged 
7.5 percent of gross domestic product (GDP) across 21 countries. (Other 
countries' data are available in Dang, Antolin and Oxley, 2001.)
    Italy had the highest spending on this measure, nearly double the 
OECD average. Australia's spending, at 3 percent (less than half the 
average) was the second lowest. The United States spent around the same 
as the United Kingdom, around 4.5 percent of GDP. The arrows show how 
spending will change between 2000 and the projected peak (between 2030 
and 2050). Italy's series of pension reforms have reduced the growth 
rate of pension spending. It is expected to peak at 16 percent of GDP, 
less than in France or Germany (on the policies in place in 2000). The 
peak in the United States is estimated to be 6 percent of GDP, compared 
with an OECD average of 10 percent.

            Figure 3. Current and projected pension spending
[GRAPHIC] [TIFF OMITTED] T3925A.005

  Note: peak values are in 2050, except Italy and the United Kingdom 
   (2030), France and the United States (2035) and Netherlands (2040)

                 Source: Dang, Antolin and Oxley (2001)

2. International experience of introducing individual accounts
    Some 25 countries around the world have now introduced individual 
accounts as a substitute for all or part of their public, pay-as-you-go 
pension schemes. The spread of these schemes through Latin America from 
the mid 1990s and through Eastern Europe in the years since then is 
quite dramatic. Many more countries are at various stages of the reform 
process, including Lebanon and Ukraine.
    It is important to note that these reformed pension systems are 
very diverse, despite the common theme of individual accounts. Bolivia, 
Chile, El Salvador and Mexico, for example, have shifted nearly all 
retirement-income provision to the defined-contribution plans (although 
all of them retain publicly provided minimum pensions. In contrast, 
Argentina retains a large basic scheme (expected to provide around two-
thirds of total pension benefits in the long term). Costa Rica and 
Uruguay retain earnings-related public schemes (which are likely to 
provide more than three-quarters of total benefits). All countries in 
Eastern Europe retain public, earnings-related plans as a complement to 
the new defined-contribution schemes. The balance between the two again 
varies. Half or more of pension benefits in the long term are likely to 
come from the funded component in Croatia, Latvia and Poland, compared 
with a third in Hungary and 16 percent in Bulgaria, for example.
    Differences in the relative role of public and private provision in 
these new pension systems also arise because of differences in the size 
of the mandatory contribution. In Bulgaria, for example, the 
contribution is just 2 percent of earnings and it is 2.5 percent in 
Sweden. Contribution rates in Latvia and Lithuania were initially set 
low (2 and 2.5 percent respectively), but are planned to increase over 
time to 10 and 5.5 percent respectively. In Latin America, total 
contributions (including survivors' and disability insurance and 
administrative charges) exceed 10 percent of earnings in Chile, 
Colombia and El Salvador.
    The mandatory contribution to the superannuation guarantee in 
Australia is 9 percent. Contribution rates are also fairly high in 
Hungary (8 percent), Poland (7.3 percent) and the Slovak Republic (9 
percent). The minimum contribution to personal pensions in the United 
Kingdom (for individuals choosing that option) varies with age, from 
3.8 to 9 percent. Again, the other elements of the pension system 
differ. In Australia, for example, the individual accounts were added 
onto the public, means-tested pension. In the United Kingdom, those 
choosing the personal-pension option are also entitled to public basic 
and means-tested pensions.

  Table 1. The spread of defined-contribution pension schemes: Latin 
                  American, Eastern Europe and beyond
[GRAPHIC] [TIFF OMITTED] T3925A.006

3. Coverage of individual-accounts schemes
    The transition from a public-sector, pay-as-you-go pension system 
into one in which individual, privately managed pension accounts form 
part of the mandatory retirement-income system does not directly affect 
those receiving pensions at the time of the reform. Nevertheless, such 
a reform could affect all current and future workers. A critical policy 
choice, therefore, is whether current and future workers should be 
allowed, encouraged or forced to switch part of their pension provision 
to the new private element. There is a spectrum of possible policy 
options. At one end, all workers, including new labor-market entrants, 
might be allowed choose to stay in the pay-as-you-go system or switch 
part of their contribution to the funded plan. At the other end of the 
spectrum, rights in the old scheme are frozen and all new rights of all 
workers are earned in the defined-contribution, funded plan. In between 
are policies where only some workers must join the new funded element, 
usually defined by age.
    The experience of 19 reforming countries (Table 2) covers the full 
spectrum of possible outcomes. However, this masks some important 
differences. In Mexico, for example, people who contributed to the old 
system can switch back to the public scheme on the day they retire. So 
there is an implicit guarantee that the return on investment in the 
private scheme is at least as large as the (implicit) return on 
contributions to the public plan. As new labor market entrants are not 
offered the same guarantee, Mexico's policy is probably closer to those 
of Chile or Hungary than to those of Bolivia and Kazakhstan. Switching 
back to the public plan is also possible indefinitely in Colombia and 
the United Kingdom and for a limited period in Argentina, Hungary and 
Poland.
Who should be covered by structural pension reform?
    It is readily apparent from Table 2 that most countries have 
focused the pension reform on younger people. Among the Latin American 
countries Chile, El Salvador and Uruguay all required new labour-market 
entrants (and in the last two, younger workers) to switch. Similar 
policies were adopted throughout Eastern Europe and in Sweden.
    There are three main reasons why restricting switching to younger 
people is a sensible policy. First, changing the pension entitlements 
for older workers is difficult, because they have made their labour-
market and savings decisions based on the expectation that the current 
system will remain. They can not retrospectively change these decisions 
to reflect the change in the pension system.
    Secondly, the compound-interest effect means that defined-
contribution pensions put greater weight on earlier years' 
contributions than accruals in earnings-related schemes (such as social 
security). With only a short period for investment returns to 
accumulate, there is less point in older workers switching. This is 
strongly reflected in people's behavior during structural pension 
reforms. In the United Kingdom, for example, around 25 percent of 20-34 
year olds took out a personal pension in 1987/88, compared with 10 
percent of 35-49 year olds and virtually no one over age 50.\6\ There 
was a similar pattern in Latin America, with switching rates of 80-90 
percent among under 35s in Argentina, Chile and Colombia. Among 50 year 
olds, just under half switched in Argentina and Chile and less than 10 
percent in Colombia.\7\ The results from Eastern Europe also confirm 
this.
---------------------------------------------------------------------------
    \6\ See Disney and Whitehouse (1992a,b) and Whitehouse (1998).
    \7\ See Disney, Palacios and Whitehouse (1999) and Palacios and 
Whitehouse (1998).
---------------------------------------------------------------------------
    Thirdly, restricting the switch to a smaller group of workers means 
that it is possible to afford to divert a larger slice of contributions 
into the new individual accounts. With fewer accounts with larger 
balance, the administrative costs can be kept lower.

               Table 2. Rules for voluntary and mandatory switching in structural pension reforms
----------------------------------------------------------------------------------------------------------------
      Country          Mandatory switching    Voluntary  switching        No switching        Option to return
----------------------------------------------------------------------------------------------------------------
                                                  Latin America
----------------------------------------------------------------------------------------------------------------
Argentina                                    entire labor force                             yes, for 2 years
----------------------------------------------------------------------------------------------------------------
Bolivia              entire labor force                                                     no
----------------------------------------------------------------------------------------------------------------
Chile                new entrants            current labor force                            no
                                              (during first five
                                              years of operation)
----------------------------------------------------------------------------------------------------------------
Colombia                                     entire labor force                             yes, indefinitely
----------------------------------------------------------------------------------------------------------------
El Salvador          labor force <36         labor force 36-55       labor force >55        no (yes during first
                                              (f^50) during first     (f>50)                 18 months after
                                              12 months                                      introduction)
----------------------------------------------------------------------------------------------------------------
Mexico               entire labor force                                                     yes, indefinitely
                                                                                             (not for new
                                                                                             entrants)
----------------------------------------------------------------------------------------------------------------
Peru                                         entire labor force                             yes, for 2 years
----------------------------------------------------------------------------------------------------------------
Uruguay              labor force <40,                                ?                      no
                      higher income
----------------------------------------------------------------------------------------------------------------
                                           Eastern Europe/Central Asia
----------------------------------------------------------------------------------------------------------------
Bulgaria             labor force <40
----------------------------------------------------------------------------------------------------------------
Croatia              labor force <40         labor force 40-50       labor force >50
                                              (during first year of
                                              operation)
----------------------------------------------------------------------------------------------------------------
Estonia              new entrants            labor force <61, those  labor force >60, >55
                                              56-60 can join until    after 10/2002
                                              10/2002
----------------------------------------------------------------------------------------------------------------
Hungary              new entrants            entire labor force                             yes, until 12/2003
                                              (during first 20                               (also for new
                                              months of operation),                          entrants of 2002),
                                              <30 again from 01/                             indefinitely in
                                              2003                                           case of disability
----------------------------------------------------------------------------------------------------------------
Kazakhstan           entire labor force                                                     no
----------------------------------------------------------------------------------------------------------------
Latvia               labor force <30         labor force 30-49       labor force >49
----------------------------------------------------------------------------------------------------------------
Poland               labor force <30         labor force 30-50       labor force >50        no
                      (except for             (only during first
                      agriculture)            year of operation)
----------------------------------------------------------------------------------------------------------------
Romania              labor force 20+ years   labor force 10-20
                      before retirement       years before
                                              retirement
----------------------------------------------------------------------------------------------------------------
Slovakia             new entrants            current labor force
                                              (during first 18
                                              months of operation)
----------------------------------------------------------------------------------------------------------------
                                                      Other
----------------------------------------------------------------------------------------------------------------
Sweden               labor force <45                                 labor force <45        no
----------------------------------------------------------------------------------------------------------------
UK                                           entire labor force                             yes, indefinitely
----------------------------------------------------------------------------------------------------------------
Source: Palacios and Whitehouse (1998), European Commission (2003), OECD (2001, 2002, 2005), Chlon (2000) and
  Acuna (2005)

What should the `terms of trade' be for people choosing to switch?
    The terms of trade under which people can exchange pay-as-you-go 
pension rights for contributions to their individual pension account is 
a fundamental design issue.
    The United Kingdom, for example, made a very serious mistake in 
setting these terms of trade, underestimating the incentive given to 
younger workers to switch. This also meant that the government 
seriously underestimated the numbers that would switch.\8\ The 
government forecast 300 000 would take out personal pensions, and a 
contingency plan allowed for a maximum of 500 000. In the end, 3.2 
million people switched in 1987/88. As described above, switching rates 
were strongly related to age, just as the incentive structure would 
suggest.
---------------------------------------------------------------------------
    \8\ See Disney and Whitehouse (1992a,b) and Whitehouse (1998).
---------------------------------------------------------------------------
    The financial implications were substantial. Between 1988/89 and 
1995/96, the government paid #17.7 billion into people's personal 
pension accounts ($32 billion at today's exchange rate). Actuarial 
estimates put the long-run saving on pay-as-you-go benefits at 
9.2 billion. The net cost--8.5 billion, $15 
billion--arises because the government did not adjust the payment into 
personal pensions to reflect different returns at different ages until 
1996. With age-related rebates, the annual net cost was cut from 
1.8 billion to 0.5 billion a year. It is now 
probably around zero.
    However, the opposite risk is also possible: that the terms of 
trade are set so that it is not worth most people switching. This would 
undermine the whole reform. There is a difficult balance to be struck 
between successful reform and financial prudence.
4. Administrative charges for defined-contribution pensions around the 
        world \9\
---------------------------------------------------------------------------
    \9\ This section summarises the analysis of Whitehouse (2000a,b,c, 
2001). See also James et al. (2000) and Shoven (2000).
---------------------------------------------------------------------------
    The issue of administrative charges for defined-contribution 
pensions has become central to pension-reform debates in many 
countries. How can we measure administrative charges? How large are 
they in practice? How can governments keep them low?
Countries' different approaches to charges
    Table 3 summarizes different countries' policies on charges. At the 
top are the systems with the least regulation on charges. Countries 
lower down impose direct regulations on the structure or level of 
charges or regulate industry structure with important indirect effects 
on charges paid.
Measuring charges
    Measuring the price of financial services is more difficult than 
comparing the cost of other goods or services. Providers can levy many 
different kinds of fees. There are examples of both one-off and ongoing 
charges. Some fees are proportional and some are fixed rate. Some are 
levied on contributions, some on the value of assets in the fund, some 
on investment returns.
    These different kinds of charge accumulate and interact in 
complicated ways over the lifetime of membership of a pension plan. 
This leads to the second problem: how to summarize these charges in a 
single number to compare charge levels both between different providers 
in a single country and across countries.
    The measure of administrative charges most familiar to investors 
and policy-makers alike is the `reduction in yield'. This adds together 
all the charges over the lifetime of a pension policy, and expresses 
them all as a percentage of assets. An alternative approach is to 
measure charges as a proportion of contributions. This is the same as 
calculating the charges over the lifetime of the fund as a proportion 
of the balance accumulated at retirement. This second measure is known 
as the `reduction in premium' or the charge ratio.

       Table 3. Strategies on administrative charges for pensions
[GRAPHIC] [TIFF OMITTED] T3925A.007

                  Source: Whitehouse (2000a,b,c; 2001)

International comparisons
    Figure 4 summarizes data on charges for 13 countries with mandatory 
funded pension systems. Even very similar pension systems with similar 
approaches to charges deliver very different levels of fees in 
practice. Among Latin American countries with individual accounts 
systems, the average charge ratio varies from under 15 percent in 
Colombia to nearly 25 percent in Argentina. Looking at all systems, 
average charges range from under 10 percent in Bolivia to 35 percent in 
Australia's retail superannuation funds. As noted above, the three 
cheapest systems offer very limited choice of provider and/or 
investments. As a rule-of-thumb, a charge ratio of 20 percent over a 
40-year pension plan equals a reduction in yield of 1 per cent.

Figure 4. Paying for pensions: the charge ratio for individual accounts 
                            in 13 countries
[GRAPHIC] [TIFF OMITTED] T3925A.008

 Note: charge ratio: total charges over the lifetime of the pension as 
   percentage of accumulated balance at retirement. The calculations 
  assume 40 years' contributions and 3.5 percent annual real return. 
  Australia: `collective': industry-wide funds; `individual': `master 
           trusts' (provided by financial-services companies)

                  Source: Whitehouse (2000a,b,c; 2001)

Charges levied by different providers
    Most studies of administrative fees for pensions look only at the 
average. But the average disguises a huge range of different charge 
levels between different providers. Figure 5 shows the distribution of 
charges in three countries. In the United Kingdom, the cheapest funds 
levying 15 percent of contributions and the most expensive, 35 percent. 
The range in Mexico is 17 to 37 percent. Even in Argentina, with the 
narrowest range, charges vary between 23 and 36 percent, meaning that 
the most expensive fund costs over 50 percent more than the cheapest.
    These large ranges raise a difficult question: why do consumers 
choose expensive funds? Improved levels of service, for example, are 
unlikely to explain such a large differential. There is evidence in the 
United Kingdom that funds with higher charges perform better, but the 
out-performance is insufficient to offset the higher charge burden on 
typical pension policies. Perhaps some consumers fail to take proper 
account of the burden of charges. The most likely reason, particularly 
in Latin America, is excessive marketing (see below).

Figure 5. Distribution of charge ratios across funds: Argentina, Mexico 
                           and United Kingdom
[GRAPHIC] [TIFF OMITTED] T3925A.009

                  Source: Whitehouse (2000a,b,c, 2001)

Policy options for charges
1. No regulation
    An important assumption of the calculations above is that charges 
remain constant until pensions are withdrawn. But pension providers' 
revenues, especially from charges on fund assets, are back-loaded while 
expenses are front-loaded because of set-up costs. Also `learning by 
doing' and the consolidation of the pension fund industry in most 
reforming countries might put downward pressure on costs over time.
    Most mandatory funded pension systems were introduced within the 
last five or ten years. But reforms in Chile and the United Kingdom 
have been in place for longer. Average charges have declined in both 
countries (Figure 6): by almost one half in Chile (from 30 to 15.5 
percent) and one sixth in the United Kingdom (from 27.5 to 23.5 
percent). If other countries follow this pattern of declining charges 
over time, then the charge ratio measures above, which assume constant 
charges, are over-stated.

 Figure 6. Evolution of average pension administrative charges, Chile 
                           and United Kingdom
[GRAPHIC] [TIFF OMITTED] T3925A.010

                  Source: Whitehouse (2000a,b,c, 2001)

2. Improve disclosure
    Measuring the impact of charges on pension fund returns is very 
complicated. The minimum government policy should therefore be a 
requirement for funds to disclose charges in a standard format. This 
will help consumers make informed comparisons between different funds. 
Regulators can make the task easier by producing `league tables' of 
charges. The supervisory authorities in Latin America regularly provide 
comparative information on different pension fund managers, and the 
Financial Services Authority in the United Kingdom has issued data on 
the charges for a wide range of financial products.
    A second step to bring charges to consumers' attention is to levy 
charges on top of (rather than out of) mandatory contributions. This 
encourages shopping around because charges reduce current net income 
rather than future pension benefits. Four Latin American countries have 
adopted this approach. A related issue is ensuring that whoever pays 
the charges makes the choice of pension provider. In Australia, 
employers choose the superannuation fund, but the charges are 
effectively borne by their employees in the form of a reduction in the 
money flowing into their funds. There is a potential `agency' problem 
because employers pick the pension while employees pay the pension 
charges.
    The third policy related to disclosure is educating consumers about 
the effect of charges on their investments. For example, over the life 
of a pension policy, a charge of 1 percent of assets per year adds up 
to a charge ratio of 20 percent. Few investors appear to be aware of 
the major impact that fees can have.
3. Facilitating comparison of charges
    By ensuring all providers stick to a common charge structure, it is 
easier to compare fees between them. Unregulated charging regimes can 
be very complex and confusing. A regulated fee structure, in contrast, 
can mean there is a single `price' that consumers can compare across 
providers. And a single proportional charge, on assets or 
contributions, means that the relative cost of choosing a different 
provider does not vary with earnings or contributions.
    The important policy option for governments taking this route is 
the type of charge to be permitted. There are four features of the two 
charges important in making this choice.
    The first is the time profile of charge revenues. Fees on 
contributions generate more up-front revenues than fees on assets 
(Figure 7). This allows providers to cover their start-up costs more 
quickly. This might boost competition by encouraging more entrants to 
the pension market when the system is established.

   Figure 7. Pension funds' revenue streams under different types of 
                                 charge
[GRAPHIC] [TIFF OMITTED] T3925A.011

                  Source: Whitehouse (2000a,b,c, 2001)

    A second issue is the incidence of the levies across different 
types of consumer. If there are fixed costs per member--and the 
evidence suggests that these are sizeable--then levies on assets 
redistribute from people with large funds to people with fewer assets 
in their plan. Older workers, with larger funds on average, would 
cross-subsidize younger workers, for example. Contribution-based 
charges redistribute from people with high levels of contributions 
(typically higher earners) to people with low levels of contributions.
    Indeed, there would be no revenues from people who do not 
contribute. This might be because they have lost their job, withdrawn 
from the labor force or moved into the informal sector of the economy. 
But pension providers would still have to bear the cost of 
administering these people's funds. Asset-based fees ensure a 
continuing flow of revenues from non-contributors, but this means that 
the fees bear more heavily on people who withdraw from work early.
    Finally, a charge on fund value encourages providers to maximize 
assets, both by attracting funds from other providers and, more 
importantly, by maximizing investment returns.
    The choice between the asset-based and contribution-based approach 
is finely balanced. Unsurprisingly, different countries have taken 
different options. Levies on contributions are the norm in Latin 
America, while the United Kingdom has opted for asset-based fees. The 
government's main arguments were fund managers' performance incentives 
and the continuing revenue stream from members suspending 
contributions.
4. Ceilings on charges
    Quantitative restrictions on charges are rare. Only El Salvador, 
Kazakhstan, Poland, Sweden and the United Kingdom, in the new 
stakeholder plans, have such limits.
    The problem with this approach is the risk that governments set the 
`wrong' ceiling. Too high a limit would be ineffectual. Too low a 
ceiling might mean that fund managers could not cover their costs. This 
will restrict competition and choice. It could even lead to the failure 
of weaker providers, undermining public confidence in the system. 
Ceilings all too often become a de facto minimum charge as well as the 
legal maximum. Price competition, beyond meeting the regulatory 
requirement, would be curtailed.
    The experience with the new stakeholder pensions in the United 
Kingdom has, however, been encouraging. Providers initially said that 
the 1 percent ceiling would be too low. However, a number entered the 
market, a few even undercutting the ceiling.
5. Treatment of low earners
    A common reason for any regulation of charges is to protect low-
income workers. This is particularly important in mandatory funded 
pension schemes. It would be manifestly unfair if low earners saw most 
or even all of their contributions eaten up in charges.
    Regulating charge structures can provide a significant degree of 
protection. Limiting fees to proportional charges (either on assets or 
contributions) means that there are no fixed charges, which bear 
disproportionately on the low-paid. Nevertheless, most countries 
provide a minimum pension guarantee, a universal flat-rate pension or 
social assistance incomes in retirement. People with persistently low 
earnings are unlikely to build up a funded pension above the minimum 
level.
    A sensible solution is to exempt low paid workers from the 
requirement to contribute to a funded pension or to allow them to opt 
out. The United Kingdom, for example, will aim the new stakeholder 
schemes at people earning more than 55 percent of average earnings. 
Australia excludes workers on less than 15 percent of average pay, and 
has plans to allow people earning between 15 and 30 percent of the 
average to opt out.
    An alternative approach is to cross-subsidize low-paid workers' 
accounts directly. The Mexican government ensures a contribution of at 
least 5.5 percent of the minimum wage. Coupled with a tax-credit system 
that boosts the incomes of low-paid workers, this encourages Mexicans 
into the formal sector. Together, these policies promote broader 
coverage of the pension system. A second advantage of direct subsidies 
is that they make the redistribution from higher-paid to lower-paid 
workers transparent.
6. Alternative institutional structures
    The pension plans discussed above are mainly decentralized: people 
choose between a range of competing pension fund managers. An 
alternative approach is some sort of collective mechanism.
    Australia's collectively provided industry funds, for example, 
charge just one third of the price of funds that single employers buy 
from financial-services companies. Australian experts have proposed 
that this intriguing gap reflects `a difference in governance, 
historical ethos, institutional practices and industry structure.' 
Industry funds, with a captive membership, have no need for marketing 
or a sales network. And information, services and investment choice 
tend to be more limited in the industry funds than they are in the 
retail sector.
    A step further is to move to a single, publicly managed fund. 
However, research has shown that public management has typically led to 
poor returns. Even with good management, the state as a large 
shareholder raises corporate governance concerns that are very 
difficult to resolve.\10\ Centralized record-keeping (as in Latvia and 
Sweden, for example) can, nevertheless, reduce costs.
---------------------------------------------------------------------------
    \10\ See Iglesias and Palacios (2000) and Palacios (2002).
---------------------------------------------------------------------------
    Another institutional means of keeping costs low is to `piggy-back' 
on existing structures. For example, employer pension plans in the 
United Kingdom have been able to contract out of the public, earnings-
related scheme since it was introduced in the late 1970s. The United 
States already has a large, employer-based pension infrastructure, 
including 401(k)s. Costs might be lower if individual accounts were 
merged with these plans. Such a policy would, however, require careful 
attention to the regulation and supervision of these plans, 
particularly 401(k)s.
7. Restricting choice of funds
    The main cost of strict regulation of charges is the reduction in 
pension members' choice. Low-cost regimes, such as the thrift savings 
plan (TSP) for federal employees in the United States, offer only a 
small range of funds, often indexed to avoid the extra cost of active 
management. (TSP charges are also low because the scheme only deals 
with one employer.) Bolivia offered no choice of fund initially and 
only a choice between two funds after a few years.
    This restriction of choice has a cost. Pension members are unable 
to choose investments that suit their preferences. For example, older 
members might want to invest more conservatively than younger people, 
but both can be constrained by a `one-size-fits-all' fund.
    The counterpart to restricted choice is limits to competition, 
which might result in poorer service and performance than a 
deregulated, decentralized market.
8. Avoid excessive marketing costs
    The Latin American pension reforms have been, to varying degrees, 
plagued by excessive marketing costs. Pension funds have competed 
fiercely to persuade people to switch between them. Given that the 
portfolios of the different funds were, until recently, highly uniform, 
there was little economic reason for this churning of members. More 
recent reformers have sought to avoid this problem. In Sweden, for 
example, the contribution to the new individual accounts is only 2.5 
percent. There was therefore a risk that administrative expenses could 
eat up a substantial proportion of these contributions. Individuals can 
choose to invest there money in any mutual fund. But record-keeping is 
centralized (which might also cut costs) and fund managers do not know 
who their members are (so reducing the inventive for excessive 
marketing expenditure).
9. Promote consolidation
    The potential for economies of scale in managing pension funds has 
important consequences for public policy on charges and industry 
structure. The evidence, unfortunately, is inconclusive. Figure 5 
showed the very broad distribution of charges across providers in three 
countries with mandatory funded pension systems. Despite this 
variability, there is no relationship between fund size and charges.
    Various studies have suggested anything from under 100,000 to 
500,000 members as the minimum to achieve efficient scale. In mutual 
fund markets, which share many of the features of pension markets, some 
studies have suggested that the fall in costs with size comes to a halt 
once funds reach $0.5 billion. Others suggest this could be as high as 
$40 billion.
    Currently available evidence does not demonstrate that highly 
centralized approaches to managing funded pensions will significantly 
reduce costs. And the potential gains must be balanced against the cost 
of stifling competition, which in the medium term should act as a spur 
to innovation and cost control.
Conclusion
    Governments should, at the very least, ensure clear and transparent 
disclosure of charges so that people can compare different companies' 
fees. A program of financial education that spells out the large impact 
charges have on pension values would also be useful. There is a good 
case also for regulation of the structure of charges, which can 
significantly ease comparisons between providers. However, imposing a 
ceiling on charge levels has the risk that limits are set at the wrong 
level, discouraging entry to the pensions market and reducing 
competition.
References
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Primer series, Social Protection Discussion Paper no. 0507, World Bank, 
Washington, D.C.

Chlon, A. (2000), `Pension reform and public information in Poland', 
Pension Reform Primer series, Social Protection Discussion Paper no. 
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Dang, T.T. Antolin, P. and Oxley, H. (2001), `Fiscal implications of 
ageing: projections of age-related spending', Working Paper no. 305, 
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Dilnot, A.W., Disney, R.F., Johnson, P.G. and Whitehouse, E.R. (1994), 
Pensions in the UK: An Economic Analysis, Institute for Fiscal Studies, 
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Disney, R.F., Palacios, R.J. and Whitehouse, E.R. (1999), `Individual 
choice of pension arrangement as a pension reform strategy', Working 
Paper no. 99/18, Institute for Fiscal Studies, London.

Disney R.F. and Whitehouse, E.R. (1992), The Personal Pensions 
Stampede, Institute for Fiscal Studies, London.

Disney, R.F. and Whitehouse, E.R. (1992), `Personal pensions and the 
review of the contracting out terms', Fiscal Studies, vol. 13, no. 1, 
pp. 38-53.

Disney, R.F. and Whitehouse, E.R. (2001), Cross-Country Comparisons of 
Pensioners' Incomes, Report Series no. 142, Department of Work and 
Pensions, London.

Disney, R.F. and Whitehouse, E.R. (2002), Cross-National Comparisons of 
Retirement Income, in Crystal, S. and Shea, D. (eds), Economic Outcomes 
in Later Life: Public Policy, Health, and Cumulative Advantage, Annual 
Review of Gerontology and Geriatrics, vol. 22, Springer, New York.

European Commission (2003), Social Protection in the 13 Candidate 
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Forster, M. and Mira d'Ercole, M. (2005), `Income distribution and 
poverty in OECD countries in the second half of the 1990s', Social, 
Employment and Migration working paper no. 22, OECD, Paris.

Iglesias, A. and Palacios, R.J. (2000), `Managing public pension 
reserves. Part I: evidence from the international experience', Pension 
Reform Primer series, Social Protection Discussion Paper no. 0003, 
World Bank, Washington, D.C.

James, E., Ferrier, G. Smalhout, G. and Vittas, D. (2000), `Mutual 
funds and institutional investments: what is the most efficient way to 
set up individual accounts in a social security system?', in Shoven, 
J.B. (2000).

OECD (2001), OECD Private Pensions Conference 2000, Private Pensions 
Series, Paris.

OECD (2002), Regulating Private Pension Schemes: Trends and Challenges, 
Private Pension Series, Paris.

OECD (2005), Pensions at a Glance: Public Policies across OECD 
Countries, Paris.

Palacios, R.J. (2002), `Managing public pension reserves. Part II: 
lessons from five recent OECD initiatives', Pension Reform Primer 
series, Social Protection Discussion Paper no. 0219, World Bank, 
Washington, D.C.

Palacios, R.J. and Whitehouse, E.R. (1998), `The role of choice in the 
transition to a funded pension system', Pension Reform Primer series, 
Social Protection Discussion Paper no. 9812, World Bank, Washington, 
D.C.

Shoven, J.B. (2000), Administrative Costs and Social Security 
Privatization, National Bureau of Economic Research, Cambridge, Mass.

Whitehouse, E.R. (1998), `Pension reform in Britain', Pension Reform 
primer series, Social protection Discussion Paper no. 9810, World Bank, 
Washington, D.C.

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measurement concepts, international comparison and assessment', Journal 
of Applied Social Science Studies, vol. 120, no. 3, pp. 311-361.

Whitehouse, E.R. (2000b), `Administrative charges for funded pensions: 
an international comparison and assessment', Pension Reform Primer 
series, Social Protection Discussion Paper no. 0016, World Bank.

Whitehouse, E.R. (2000c), `Paying for pensions', Occasional Paper no. 
13, Financial Services Authority.

Whitehouse, E.R. (2001), `Administrative charges for funded pensions: 
comparison and assessment of 13 countries', in OECD, Private Pension 
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Paris.

                                 

    Chairman MCCRERY. Thank you, Mr. Whitehouse. Ms. Coronado.

  STATEMENT OF JULIA LYNN CORONADO, SENIOR RESEARCH ANALYST, 
                     WATSON WYATT WORLDWIDE

    Ms. CORONADO. Thank you, Mr. Chairman. I will be talking 
about Sweden's reform. Like most industrialized nations, Sweden 
has a public pension system that is financed on a pay-as-you-go 
basis. A rapidly aging population implied a projected 
discrepancy between payroll tax revenue and benefit payments 
that was twice the country's GDP in 1996. Prior to reform, the 
Swedish system paid out benefits according to an aggressive DB 
formula, and on average replaced about 75 percent of pre-
retirement earnings at age 65. The primary impetus for reform 
was to achieve a system whose financing was stable given 
demographic uncertainties and economic fluctuations. Given the 
high level of payroll taxes in Sweden, a consensus emerged that 
the macroeconomic implications of balancing the system through 
an increase in the payroll tax were decidedly undesirable. To 
create a sustainable system, policy makers sought to balance 
social protection of the vulnerable with the need for a tight 
link between contributions and benefits, in order to provide 
appropriate economic incentives and to enhance the efficiency 
of the system.
    The new public pension system in Sweden is a DC scheme 
funded mainly on a PAYGO, with a small funded component. A 16 
percent payroll tax funds a notional DC account on behalf of 
each worker. The account is notional in the sense that there 
are not separate accounts for each worker, and benefits are 
funded through current payroll tax revenue. The account grows 
with payroll tax contributions as well, at a rate of return 
that is based, in large part, on the growth rate of average 
wages. Upon retirement, the balance in the notional account is 
converted to an annuity. In addition to the notional account, 
workers contribute 2.5 percent of their wages to an individual 
account administered by the government and through which 
workers can invest in any 5 of over 700 mutual funds of their 
choosing. Upon retirement, the participant can choose to 
convert their balance in the individual account to either a 
fixed or variable rate annuity that is purchased directly from 
the government.
    A number of macroeconomic stabilizers are built into the 
rate at which benefits accrue. If the system is in actuarial 
balance then the accounts are credited annually with the growth 
rate in average wages. However, the growth in average wages 
does not necessarily reflect the growth in the contribution 
base if cohorts are either growing or shrinking. Thus, in the 
event that an actuarial deficit or surplus opens up, 
policymakers have built in the ability to deviate from average 
wage indexation. Upon retirement, the annuity rate will depend 
on the expected survival probabilities for each cohort so that 
participants bear the risk of future improvements in life 
expectancy through lower replacement rates, although the 
government continues to bear the risk for changes in mortality 
after retirement. Thus, the reform transfers much of the 
economic and demographic uncertainties directly into benefit 
levels, leaving the financing of the system remarkably robust 
to changing economic conditions.
    In exchange for this added uncertainty, participants have 
much more flexibility in how they take their retirement 
benefits. Retirement can be taken as early as 61, but 
participants will realize a steadily higher replacement rate 
the longer they work. This is a far more powerful incentive in 
a DB system, as the replacement rate increases not only with 
the actuarial adjustments to benefits, but also with the added 
pension rates earned through more years of contributions and 
returns. Benefits in the notional and individual accounts do 
not have to be claimed at the same time and workers can claim 
full or partial benefits in either, so that retirement in 
Sweden will likely evolve in a much more varied process across 
individuals and cohorts.
    The individual accounts are administered by a new 
government agency that acts as a record keeper, a clearinghouse 
for investment transactions, a broker on investment fees, and 
the sole provider of annuities. The Swedish administrative 
model was designed to avoid the high costs in other public 
pension systems. Once the funds have been allocated to the 
accounts, employees can choose a maximum of 5 from over 700 
mutual funds. Sweden opted for a relatively unrestricted choice 
as a way of encouraging competition, allowing for 
diversification in a relatively small country, and mitigating 
the potential for political interference in investment 
management. In addition to allowing for risk taking, however, 
facing such a vast number of choices is potentially 
overwhelming to investors. Yet, in the first round of 
investment choices made by investments in 2000, more than two-
thirds of participants made active choices choosing on average 
three-and-a-half funds of different types.
    I am running out of time so, let me skip to this. We can 
get to more of the individual details of the individual 
accounts in questions. Just another key point to make is that 
the government negotiates a fee structure with the 
participating mutual funds. On average, this has resulted in an 
expense ratio of 61 basis points of assets. This is much higher 
than the six basis point expense ratio in the TSP, however the 
system is in a startup phase. The system is currently 
projecting an expense ratio of 30 basis points in 10 years. So, 
what can the United States learn from the Swedish experience 
is, at first blush, passing the uncertainty on to benefit 
levels may seem draconian, but it should be kept in mind that 
Sweden had an extremely high level of benefits prior to reform. 
The post reform replacement rates are much more comparable to 
the current U.S. Social Security system. Sweden has also taken 
the approach of partially funding retirement benefits, which 
will have positive macroeconomic ramifications going forward. 
Finally, their design for the individual account tier deserves 
a very detailed examination should the United States pursue 
such a policy. The centralized clearinghouse model balances 
costs with private market incentives and seems to be very 
promising. That concludes my remarks. I will take questions.
    [The prepared statement of Ms. Coronado follows:]
Statement of Julia Lynn Coronado, Senior Research Analyst, Watson Wyatt 
                               Worldwide

     Sweden's Public Pension Reform: Lessons for the United States

Overview of the Swedish Reform Process
    Like most industrialized nations, Sweden had a public pension 
system established in the early part of last century that was financed 
on a pay-as-you-go basis (PAYG), meaning that current payroll taxes 
funded the benefits of current retirees. Such a system was made 
feasible by a growing population in which the generations of young 
outnumber the elderly by a considerable margin. However also in concert 
with most other industrialized nations, Sweden saw a sea change in the 
demographics of its populations in the latter part of the century. As 
shown in Table 1, life expectancies in Sweden have risen considerably 
while birth rates have declined. The ratio of elderly to young has 
already more than doubled as a result. Sweden's population has aged 
more rapidly than the U.S. with a ratio of elderly to young that is 
closer to Japan's. A rapidly aging system places pressure on PAYG 
pension schemes as the working population has to pay higher taxes to 
finance a given level of benefits for the ever larger cohorts of 
elderly.

                        Table 1--Selected Demographic Characteristics Placing Pressure on
                                          PAYG Social Security Systems
----------------------------------------------------------------------------------------------------------------
                                            Life Expectancy  at       Fertility  Rate      Ratio of Elderly  to
                                                   Birth         ------------------------         Youth*
                                         ------------------------                        -----------------------
                                             1950        2010        1950        2010        1950        2010
----------------------------------------------------------------------------------------------------------------
Sweden                                         71.8        81.1        2.21        1.34        0.51        1.34
----------------------------------------------------------------------------------------------------------------
United States                                  68.9        79.2        3.45        1.93        0.37        0.69
----------------------------------------------------------------------------------------------------------------
Japan                                          63.9        83.3        2.75        1.43        0.17        1.62
----------------------------------------------------------------------------------------------------------------
Source: United Nations, World Population Prospects (2000).
*Ratio of people over 60 to people under 20.

    The aging population implied a projected discrepancy between 
payroll tax revenue and benefit payments. In 1996 the projected 
actuarial deficit of the system was estimated at $500 billion, or twice 
the countries GDP. It was projected that the payroll tax would have to 
rise from just under 20 percent to something in the neighborhood of 30 
percent to fund promised benefits. This compares with the current 
projected unfunded liability in the U.S. Social Security system of $11 
trillion over an infinite horizon, or 1.2 percent of GDP. In the 
absence of any changes to the system, the payroll tax in the United 
States would have to rise from the current rate of 12.4 percent to a 
projected 18 percent by 2079.\1\
---------------------------------------------------------------------------
    \1\ 2005 Annual Report of the Board of Trustees of the Federal Old-
Age and Survivors Insurance and Disability Insurance Trust Funds.

         Table 2--Timeline of the Swedish Social Security Reform
------------------------------------------------------------------------
 
------------------------------------------------------------------------
1984               A commission is appointed to study options for
                    reforming the social security system.
------------------------------------------------------------------------
1990               The commission presents its recommendations,
                    including keeping the basic structure of the system
                    intact, raising the retirement age and requiring
                    more years of work to qualify for a full benefit.
------------------------------------------------------------------------
1991               The government changes hands. A new commission is
                    appointed with a mandate for more fundamental
                    reforms.
------------------------------------------------------------------------
1994               The second commission presents its recommendations;
                    essentially a blueprint for the reform eventually
                    enacted. These are approved ``in principle: by
                    Parliament and a working group is established to
                    draft the necessary legislation.
------------------------------------------------------------------------
1998               Parliament passes most of the legislation for the
                    reform.
------------------------------------------------------------------------
2000               The first investment choices by participants are
                    processed for the individual account component of
                    the system.
------------------------------------------------------------------------
Source: Annika Sunden, ``How Will Sweden's New Pension System Work?''
  Center for Retirement Research Issue Brief 3, 2000, Boston College,
  and Edward Palmer, Testimony Before the Subcommittee on Social
  Security of the House Committee on Ways and Means (2001).

    Hence, Sweden was under considerable pressure to address the 
projected shortfall in its public pension system. The process of reform 
began in 1984 with the appointment of a commission to study options and 
issues for achieving balance. This commission reported its findings to 
Parliament in 1990. The report favored keeping the basic defined 
benefit framework intact while reducing benefits through increasing the 
retirement age and requiring more years in the labor force for a full 
benefit. In 1991, however, the government changed hands and the new 
coalition government favored more fundamental changes to the system. A 
new commission was appointed to review the situation, and this group 
presented its recommendations to Parliament in 1994. These were passed 
``in principle'' and a working group was named to write the necessary 
legislation. The main package of legislation required to establish the 
new system was passed in 1998. The lengthy reform process in Sweden 
reflected the need for broad political support to reform such a 
comprehensive system.
The Swedish Social Security System Prior to Reform
    Prior to the reform, the system was financed through payroll taxes 
and paid out benefits according to a progressive defined benefit 
formula. Taxes were collected and benefits paid out in a two-tier 
structure that separated the social insurance and retirement saving 
functions of the system. The first tier was a non-means tested flat 
benefit that was designed to provide a basic floor of support and was 
funded through a nearly 6 percent payroll tax levied on employers. This 
first tier was fairly generous providing a benefit in 1995 that was 
equal to roughly 18 percent of the average wage rate. The second tier 
of benefits was explicitly earnings-related and was meant to function 
as retirement saving by replacing a similar fraction of pre-retirement 
earnings above the first tier of benefits. It was based on a 
participant's highest 15 years of earnings and required 30 years of 
earnings to qualify for a full benefit. It was financed by a 13 percent 
payroll tax on employers. Taken together, the two tiers of benefits 
implied a progressive benefit structure since the first tier replaced a 
higher fraction of earnings for lower income workers. On average the 
system replaced over 70 percent of pre-retirement earnings.
    The primary impetus for reform was to achieve a system whose 
finances were stable given demographic uncertainties and economic 
fluctuations. Given the high level of payroll taxes in Sweden, a 
consensus emerged that the macroeconomic implications of balancing the 
system through an increase in the payroll tax were decidedly 
undesirable. To create a sustainable system, policymakers sought to 
balance social protection of the vulnerable with a need for a tighter 
link between contributions and benefits in order to provide appropriate 
economic incentives and enhance the efficiency of the system. Along 
these lines, a number of other inequities and inefficiencies were 
identified that policymakers sought to address through the redesign of 
the system. Two perceived shortcomings of the system are of note in 
comparing the Swedish reform to the situation in the United States.
    The first of these were problems associated with the fact that 
benefits in Sweden were indexed to prices rather than wages. The result 
of price indexing was volatility of replacement rates through economic 
cycles when wages grew either more slowly or more rapidly than prices. 
In addition, because benefits were paid up to a ceiling that was also 
indexed to prices, over time real wage growth implied that the system 
was evolving into a flat benefit system and the link between taxes paid 
and benefit received was eroding. It is worth noting that current 
proposals for price indexing benefits in the United States would also 
likely result in volatility in replacement rates and lead the system 
toward a flat benefit structure.
    The second perceived shortcoming of the Swedish social security 
system prior to reform worth noting is that the system, which features 
a formula designed to result in a progressive replacement rate, was not 
considered to be as progressive in practice. This owed largely to the 
use of the 15 highest earning years in determining the benefit level, a 
formula that redistributes from those with long working lives and flat 
earning profiles who are typically lower wage workers, to those with 
shorter work histories and steeper earnings profiles.\2\ Such 
capricious redistribution has also been noted in the current U.S. 
social security system by the President's Commission to Strengthen 
Social Security. A number of research papers have shown that, owing to 
the spousal benefit and the lack of distinction between households and 
individuals, the current system in the U.S. does more redistribution 
between high and low earners within households than across 
households.\3\ Policymakers in Sweden made transparency of 
redistribution a priority in the reform effort.
---------------------------------------------------------------------------
    \2\ See Annika Sunden, ``How Will Sweden's New Pension System 
Work?'' Center for Retirement Research Issue Brief 3, 2000, Boston 
College.
    \3\ Interim Report of the President's Commission to Strengthen 
Social Security, August 2001.
---------------------------------------------------------------------------
The Swedish Public Pension System Post Reform
    The new public pension system in Sweden is a defined contribution 
scheme funded mainly on a PAYG basis with a small funded component. A 
16 percent payroll tax levied equally on employers and employees funds 
a notional account (NDC) on behalf of each worker. The account grows 
with payroll tax ``contributions'' as well as a rate of return based in 
large part on the growth rate of average wages. Upon retirement the 
balance in the NDC is converted to an annuity using an assumed 1.6 
percent real average salary growth rate and the expected life 
expectancy for the cohort. After retirement benefits will be adjusted 
for salary growth that differs from 1.6 percent. In addition to the 
NDC, workers contribute 2.5 percent of wages to an individual account 
administered by the government and through which workers can invest in 
any 5 of over 650 private investment funds of their choosing. Upon 
retirement the participant can choose between a fixed or variable rate 
annuity that is purchased directly from the government.
    A number of macroeconomic stabilizers are built into the rate at 
which benefits accrue. If the system is in actuarial balance then the 
accounts are credited annually with the growth rate in average wages. 
However the growth in average wages does not necessarily reflect the 
growth in the contribution base if cohorts are growing or shrinking. 
Thus, in the event that an actuarial deficit or surplus opens up, 
policymakers have built in the ability to deviate from average wage 
indexation. In addition, balances are adjusted upward each year to 
credit surviving members of a cohort with the balances of the deceased 
and downward for administrative costs. Upon retirement, the annuity 
rate will depend on the expected survival probabilities for each cohort 
so that the beneficiaries bear the risk of future improvements in life 
expectancy through lower replacement rates, although the government 
continues to bear the risk for changes in mortality after retirement. 
Thus the reform transfers much of the economic and demographic 
uncertainties directly into benefit levels leaving the financing of the 
system generally quite robust to changing economic conditions.\4\
---------------------------------------------------------------------------
    \4\ The central government does bear risk through the pension 
subsidy for lower wage workers and earnings credits granted to stay at 
home parents and unemployed, both of which are financed with general 
revenues and can fluctuate with changing demographic and economic 
conditions.
---------------------------------------------------------------------------
    In exchange for this added uncertainty, participants have much more 
flexibility in how they take their retirement benefits. Retirement can 
be taken as early as 61 but participants will realize a steadily higher 
replacement rate the longer they work. This is a more powerful 
incentive in a defined benefit system as the replacement rate increases 
not only with the actuarial adjustment as in a defined benefit system, 
but also with the added pension rights earned through more years of 
contributions and returns. Benefits in the NDC and the individual 
accounts do not have to be claimed at the same time and workers can 
claim full or partial benefits in the both the NDC and from the 
individual accounts so that retirement will likely evolve into a much 
more varied process across individuals and cohorts.
    The individual accounts are administered by a new government agency 
that acts as a record-keeper, a clearinghouse for investment 
transactions, a broker on investment fees, and the sole provider of 
annuities. The Pension Premium Agency takes requests for allocations 
and trades, aggregates them and submits them in bulk to the 
participating mutual funds much as private pension plans in the U.S. 
currently manage their defined contribution accounts. The mutual funds 
thus do not have any information on individual participants. The 
Swedish administrative model was designed to avoid the high costs in 
other public pension systems with individual accounts such as Chile and 
the U.K.\5\ Contributions are collected through the government tax 
authority so as to minimize the burden on employers. Employers remit 
the entire payroll tax and the money is allocated to individuals 
accounts approximately 18 months later when income tax statements are 
filed and reconciled. In the interim the funds are invested in a 
government bond fund.
---------------------------------------------------------------------------
    \5\ See discussion in Edward Palmer ``The Swedish Pension Reform 
Model: Framework and Issues'' (2001).
---------------------------------------------------------------------------
    Once the funds have been allocated to the accounts, employees can 
choose a maximum of five funds from over 700 funds representing 85 fund 
companies currently registered to participate in the Swedish system. 
Some of these funds are highly specialized in particular sectors or 
countries allowing for substantial risk taking by participants. Sweden 
opted for relatively unrestricted choice as a way of encouraging 
competition, allowing for diversification in a relatively small 
country, and mitigating the potential for political interference in 
investment management.\6\ In addition to allowing for risk taking, 
however, facing such a vast number of choices is potentially 
overwhelming to investors. Yet in the first round of investment choices 
made by investors, more than two thirds made an active choice with the 
average participant selecting 3\1/2\ funds of different types. In 
addition, surveys have indicated that many of those who did not make an 
active choice did so intentionally as they preferred to invest in the 
default fund.
---------------------------------------------------------------------------
    \6\ See R. Kent Weaver ``Design and Implementation Issues in 
Swedish Individual Accounts'' Social Security Bulletin vol 6 no 4 
(2004).
---------------------------------------------------------------------------
    Such a high level of active participation was facilitated by a 
massive media campaign by both the government and private mutual fund 
companies. Investors received, and will receive annually, a catalog of 
all the funds and their characteristics as well as educational 
materials on investing. Subsequent years have featured substantially 
lower levels of active participation. This is part because the new 
participants are generally young new entrants to the labor force, but 
is also possibly influenced by the very poor stock market returns of 
recent years combined with the relatively positive performance of the 
default fund and the lack of intense media focus.\7\ Because the agency 
that administers the funds must pass the cost of investor education on 
through higher fees, it does not have the incentive to provide 
extensive education materials. While participants receive the catalog 
of funds and a personal statement each year, the level of information 
in the media has declined substantially years following the start-up. 
This raises the broader issue of who should be responsible for 
financial education in a system where all members of society are 
required to participate in financial markets.
---------------------------------------------------------------------------
    \7\ Weaver (2004).
---------------------------------------------------------------------------
    Another key issue in an individual account system is the design of 
the default fund. In Sweden the default fund is a broadly diversified 
equity fund. If active choices by new entrants remain low, this fund 
will manage an increasingly large pool of assets. This fund was set up 
to have an independent professional staff and has achieved competitive 
returns at low costs to date. However the fund decided independently to 
refrain from investing in particular companies based on international 
labor and environmental concerns and politicians have publicly 
criticized the fund for its lack of Swedish investments so that the 
potential for political influence on investment choices is already 
apparent.
    Among private funds, the government negotiates a fee structure with 
participating mutual funds that is designed to discourage participation 
by high fee funds and encourage the selection of low fee funds by 
participants. Participants to date have paid administrative fees of 22 
basis points of assets and investment fees averaging 39 basis points of 
assets for a total expense ratio of 61 basis points. Expenses are thus 
quite a bit higher than the 6 basis point expense ration the Federal 
Employee Thrift Savings Plan which is frequently cited as a potential 
model for the U.S. in administering individual accounts. Nor does it 
represent a substantial improvement over the Chilean and British 
models. However the system is in its start-up phase and so expense 
ratios will decline as a fraction of assets under management as 
balances increase. In year 2020 the administrative fee is projected to 
be 5 basis points and the asset management fee 25 basis points. The 
Swedish experience does indicate that the first generations in the new 
system of individual accounts can disproportionately bear the start-up 
costs.
Lessons for the United States
    If people continue to retire at the same ages they have in recent 
decades, the combination of longer life expectancies and lower 
fertility rates imply the likelihood of slower rates of improvement in 
our standards of living. Changes to PAYG public retirement programs 
become the mechanism for allocating the resulting economic 
disappointment.\8\ Sweden faced the fiscal challenges of its aging 
population head on through a massive scaling back of benefits. While at 
first blush this may seem draconian, it should be kept in mind that 
Sweden provided an extremely high level of benefits prior to reform, 
providing replacement rates at age 65 upwards of 75 percent. Through 
the process of reform Sweden created a system with a much clearer link 
between contributions and benefits that eliminated disincentives for 
labor supply at older ages. In the future, the likely outcome of 
Sweden's system is that people will postpone retirement in order to 
maintain their standards of living. This increase in labor supply will 
have positive implications for macroeconomic stability. One concern is 
that such a reduction in benefits should be clearly communicated as 
such. The Swedish government does send out a yearly statement, ``the 
orange envelope'' giving all individuals a forecast of their future 
pension. It is important in a pension program that benefit generosity 
is clearly understood by participants in order that they can make their 
personal saving decisions accordingly. Nearly 90 percent of Swedes are 
covered by employer-sponsored pensions and so most participants already 
have a vehicle for any additional saving they wish to undertake. It 
also remains to be seen whether the automatic stabilizers that ensure 
the financial stability of the system through adjustments in benefits 
will be politically sustainable in the long run.
---------------------------------------------------------------------------
    \8\ Steven A. Nyce and Sylvester J. Schieber, The Economic 
Implications of Aging Societies: The Costs of Living Happily Ever 
After, Cambridge University Press (2005).
---------------------------------------------------------------------------
    Sweden has also taken the approach of partially funding retirement 
benefits in the public system through the establishment of individual 
accounts. This will also have positive macroeconomic ramifications 
going forward. The costs of the public system will be reduced over time 
as benefits will be partially funded through compound interest and more 
capital will be channeled into productive use in the private sector.
    Sweden's design for their individual account tier is certainly 
worth a detailed examination should the U.S. pursue such a policy. The 
centralized clearinghouse model has much to recommend it in terms of 
cost efficiencies over the long run. It is difficult at this early 
stage in the Swedish system to draw conclusions about the investment 
choices of participants, however issues surrounding the design of 
default options and investor education are not easily resolved and the 
Swedish example may provide valuable lessons about what policies are 
and are not effective. Indeed the Swedish government recently appointed 
an inquiry to review ways to reduce the number of funds, evaluate 
communication and administrative and investment costs among other 
elements of the system. They will submit their final report this fall.

     Table 3--Comparison of Swedish and U.S. Social Security Systems
------------------------------------------------------------------------
                               Sweden
              ----------------------------------------   United States
                   Pre-Reform          Post-Reform       Current System
------------------------------------------------------------------------
Taxes          19% payroll         16% payroll for
                                    notional defined
                                    contribution
                                    account
 
                                                       12.4%
------------------------------------------------------------------------
Benefits       Non means tested
                flat Benefit
                equal to roughly
                18 % of average
                wage rate
 
 
                                   Benefits based on
 
 
                                                       Progressive
 
 
------------------------------------------------------------------------
System         Payroll tax rate    Payroll tax fixed.  Payroll tax will
Finances        would have to       Benefits and        have to rise to
                rise to             general revenue     roughly 18
                approximately 30    contribution        percent to fund
                percent to fund     fluctuate to        currently
                promised benefits   balance system.     legislated
                                                        benefits.
------------------------------------------------------------------------


                                 

    Chairman MCCRERY. Thank you, Ms. Coronado. Mr. Vasquez.

STATEMENT OF IAN VASQUEZ, DIRECTOR, PROJECT ON GLOBAL ECONOMIC 
                    LIBERTY, CATO INSTITUTE

    Mr. VASQUEZ. I appreciate the opportunity to testify today 
about the Chilean private pension system, especially because it 
has become the model for countries doing the same thing around 
the world or considering doing such reform. In 1981, Chile 
became the first country in the world to replace its bankrupt 
PAYGO pension system with an investment-based privately managed 
system of individual retirement accounts. Chile's pioneering 
reform created a fully funded system whose principal features 
are individual choice, clearly defined property rights, and the 
private administration of accounts. By linking effort and 
reward, the reform offers proper investment and work 
incentives, and that has contributed to Chile's impressive 
rates of growth. It is said that the reform itself is probably 
responsible for up to a quarter of the increase in the growth 
rate and up to a third of the increase in savings rates in the 
country. Today, 95 percent of Chilean workers have joined the 
system. The pension funds have accumulated assets of some $58 
billion, which represent about 75 percent of Chilean GDP, and 
the average real rate of return on the pension funds has been 
10.24 percent.
    The way the system operates is clear and simple. Every 
month workers deposit 10 percent of the first $22,000 of earned 
income in their own individual pension savings accounts, which 
are then managed by specialized fund administration companies 
of their choice. These companies invest the workers' savings in 
a portfolio of bonds and stocks that are subject to 
regulations, and at retirement, use the funds in their accounts 
to purchase annuities or make programmed withdrawals, or they 
can take a combination of the two. 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.
    The reform itself had clear and simple rules when it began. 
Workers already in the labor force were given a choice to join 
the new system or to remain in the old. Those who chose to 
switch to the private system were given ``recognition bonds'' 
that reflected past contributions to the public pension program 
and that are paid by the government when the worker retires. 
New entrants into the labor force were required to join the new 
pension system, thus eventually ending the unsustainable PAYGO 
system. The benefits of those already retired were not 
affected. In the new private system, workers have become owners 
of the means of production, or ``worker capitalists,'' as Jose 
Pinera, the architect of the program, likes to say. This is a 
real paradigm shift in Chile because it reflects a move from a 
consumption-based system to an investment-based system, and has 
depoliticized a large part of the Chilean economy.
    Critics of the system, however, often point to high 
administrative costs, the lack of portfolio choice, low 
participation rates, and so on. Some of these criticisms are 
misinformed. Some are highly misleading. Some were a reflection 
of over-regulation within the system itself. For example, 
administrative costs in Chile are 0.66 percent of assets under 
management, and this compares favorably to the U.S. mutual fund 
industry, where the costs are more than 1 percent. Another 
criticism sometimes heard is that the coverage under the new 
system is low. In fact, in Chile about 30 percent of the 
working population is self-employed and not required to join 
the system. By any measure, coverage in the new system is more 
complete than coverage under the old system, as I show in a 
graph in my written testimony.
    As the system has matured, Chilean authorities have taken 
important steps to liberalize the pension system further. The 
most important structural reform of recent years has been the 
introduction of multiple investment funds. The pension fund 
companies now can offer five different funds to each worker 
that range from very low risk to high risk, and this has the 
advantage of allowing workers to make prudent changes to the 
risk profile of their portfolios as they get older. Other 
reforms have taken place to continue to improve the system, and 
I think others can be introduced. One of the most important 
reforms to the system that I would suggest is liberalizing the 
commission structure even more, so that pension fund companies 
can charge different rates to different customers. In summary, 
the Chilean private pension system is a success story by any 
measure and deservedly continues to be the model for rich 
countries and poor countries around the world.
    [The prepared statement of Mr. Vasquez follows:]
Statement of Ian Vasquez, Director, Project on Global Economic Liberty, 
                             Cato Institute
    Mr. Chairman and members of the Subcommittee, I appreciate the 
opportunity to testify today on Chile's private pension system, 
especially since it has become the model for countries around the world 
that have reformed their public pension systems or are considering 
doing so.\1\
---------------------------------------------------------------------------
    \1\ I thank Jacobo Rodriguez from whose work I have borrowed 
liberally and with permission.
---------------------------------------------------------------------------
    In 1924 Chile was the first country in the hemisphere to implement 
a state-run retirement system. In 1981, Chile became the first country 
in the world to replace its bankrupt pay-as-you-go pension system with 
an investment-based privately managed system of individual retirement 
accounts. The problems that are currently putting pressure on workers 
and public retirement programs in so many countries also plagued 
Chile's government-run system, ultimately making it fiscally unviable: 
payroll taxes were high and saw large increases, the implicit debt of 
the public system was over 100 percent of GDP, the ratio of workers to 
retirees saw a significant and continuous decline, and the government 
was contributing to more than a third of the public pension system's 
revenues.\2\
---------------------------------------------------------------------------
    \2\ Jacobo Rodriguez, ``Chile's Private Pension System at 18: Its 
Current and Future Challenges,'' Cato Institute Social Security paper 
no. 17, 1999, p. 3.
---------------------------------------------------------------------------
    Chile's pioneering reform addressed the above problems by creating 
a fully funded system whose principal features are individual choice, 
clearly defined property rights, and the private administration of 
accounts. By linking effort and reward, the reform offers proper 
investment and work incentives, and has contributed to Chile's 
impressive growth rates.
    Since the private pension system was implemented, labor force 
participation, pension fund assets, and benefits have increased. Today, 
95 percent of Chilean workers have joined the system; the pension funds 
have accumulated assets of some $58 billion, amounting to more than 75 
percent of Chilean GDP; and the average real rate of return on the 
pension funds has been 10.24 percent.\3\
---------------------------------------------------------------------------
    \3\ For detailed statistics of the Chilean pension system, see the 
website of the Superintendencia de AFPs, the Chilean government 
regulator of the private pension system, www.safp.cl.
---------------------------------------------------------------------------
The Chilean Private Pension System
    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.(There are currently six competing pension fund companies 
in Chile.) 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. Fund 
managers can invest up to 30 percent of the portfolio overseas, a 
measure that allows workers to hedge against currency fluctuations and 
country risk. 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); or a worker can choose temporary programmed 
withdrawals with a deferred lifetime annuity.
    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 small--about 
0.1 percent of GDP.\4\ (Of course, that cost is not new; the government 
also provided a safety net under the old program.) Those who have not 
contributed for 20 years and have not accumulated sufficient funds to 
meet the minimum pension can apply for a lower welfare-type pension.
---------------------------------------------------------------------------
    \4\ Ministry of Finance, Chile.
---------------------------------------------------------------------------
    When the reform began, workers already in the labor force were 
given a choice to join the new system or remain in the old. Those who 
chose to switch to the private system were given ``recognition bonds'' 
that reflected past contributions to the public pension program and 
that are paid by the government upon a worker's reaching the legal 
retirement age. New entrants into the labor force were required to join 
the new pension system, thus eventually ending the unsustainable pay-
as-you-go system. The benefits of those already retired and receiving a 
pension at the time of the reform were not affected.
    The transition to the private system was financed in a number of 
ways. It should be noted that the net economic costs of moving from an 
unfunded pay-as-you-go system to a fully funded system are zero. That 
is to say, the total funded and unfunded debt of a country does not 
change by moving from an unfunded system to a funded one. There is, 
however, a cash flow problem when moving toward a fully funded 
retirement system. In the case of Chile, transition costs can be broken 
down into three different parts. First, there is the cost of paying for 
the retirement benefits of those workers who were already retired when 
the reform was implemented and of those workers who chose to remain in 
the old system. That makes up by far the largest share of the 
transition costs at present. These costs will decline as time goes by. 
Second, there is the cost of paying for the recognition bonds given to 
those workers who moved from the old system to the new in 
acknowledgement of the contributions they had already made to the old 
system. Since these bonds will be redeemed when the recipients retire, 
this cost to the government will gradually increase as transition 
workers retire (but will eventually disappear). It is worth stressing 
that these are new expenditures only if we assume that the government 
would renege on its past promises. The third cost to the government is 
that of providing a safety net to the system, a cost that is not new in 
the sense that the government also provided a safety net under the old 
pay-as-you-go system.
    To finance the transition, Chile used five methods. First, it 
issued new government bonds to acknowledge part of the unfunded 
liability of the old pay-as-you-go system. Second, it sold state-owned 
enterprises. Third, a fraction of the old payroll tax was maintained as 
a temporary transition tax. That tax had a sunset clause and is zero 
now. Fourth, it cut government expenditures. And, fifth, pension 
privatization and other market reforms have contributed to high growth 
in Chile, which in turn has increased government revenues, especially 
those coming from the value added tax.
    In sum, the transition to the new system has not been an added 
burden on Chile because the country was already committed to paying 
retirement benefits. On the contrary, the transition has actually 
reduced the economic and fiscal burden of maintaining an unsustainable 
system.
    In the new private system, workers have become owners of the means 
of production, or ``worker capitalists,'' in the words of Jose Pinera, 
Chile's former minister of labor and social security who implemented 
the reform.\5\ This paradigm shift from a consumption to an investment-
based system has positively impacted the country's political economy by 
reducing class conflict and depoliticizing a large part of Chilean 
economy.
---------------------------------------------------------------------------
    \5\ See Jose Pinera, ``Liberating Workers: The World Pension 
Revolution,'' Cato's Letter no. 15, 2001.
---------------------------------------------------------------------------

            Commonly Heard Criticisms of the Chilean System

    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. Some of those criticisms are misinformed. For example, 
administrative costs are less than 1 percent of assets under 
management, a more favorable figure than management costs in the U.S. 
mutual fund industry. Other criticisms are highly misleading. To the 
extent the criticisms are valid, shortcomings in the private system 
typically result from 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 or 4 percentage 
points, depending on the type of fund, or 50 percent below the 
industry's average real return in the last 36 months). That regulation 
forces the funds to make 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.
    The following is a closer look at some of the more frequently heard 
criticisms of Chile's private pension system.
``The Administrative Cost are Too High''
    Critics often claim that the commissions that workers pay to the 
pension funds are exorbitant. 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 2.37 percent of taxable wages, 
by the total contribution (10 percent plus the commission). This 
calculation fails to take into account that the 2.3 percent includes 
the life and disability insurance premiums (about 0.95 percent of 
taxable wages on average \6\) that workers pay, which are deducted from 
the variable commission, and thus overstates administrative costs as a 
percentage of total contributions.
---------------------------------------------------------------------------
    \6\ Ruben Castro, ``Seguro de Invalidez y Sobrevivencia: Que Es y 
Que Le Esta Pasando,'' Documento de Trabajo no. 5, Superintendencia de 
AFP, May 2005, p.12.
---------------------------------------------------------------------------
    The proper way to measure administrative costs is as a percentage 
of assets under management. In Chile, the administrative costs of the 
private pension system are 0.66 percent of assets managed.\7\ The 
Chilean pension fund administrators' association calculates that the 
commissions the industry charges are 0.63 percent of assets under 
management, far lower than such fees charged by other fund managers 
including U.S. mutual funds that charge about 1.38 percent.\8\
---------------------------------------------------------------------------
    \7\ Superintendencia de AFP, The Chilean Pension System (Santiago: 
Superintendencia de AFP, 2003), p. 154.
    \8\ Asociacion AFP, ``The AFPs Charge Lower Commissions Than Other 
Institutions, Both Local and Foreign,'' Research Series paper no. 42, 
June 2004, available at www.afp-ag.cl.
---------------------------------------------------------------------------
    Prior to the above findings, others have calculated similarly low 
administrative costs. Chilean economist Salvador Valdes 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.\9\ 
The Congressional Budget Office estimated in 1999 that the 
administrative costs of private retirement accounts in Chile ``can be 
equivalently expressed as 1 percent of assets.'' \10\ When 
administrative costs are compared to the old government-run system, the 
criticism is even less convincing. 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.\11\
---------------------------------------------------------------------------
    \9\ Salvador Valdes, ``Las Comisiones de las AFPs oCaras o 
Baratas?'' Estudios Publicos, Vol. 73 (Verano 1999): 255-91.
    \10\ Congressional Budget Office, Social Security Privatization: 
Experiences Abroad, sec. 2, p. 7 (January 1999).
    \11\ Raul Bustos Castillo, ``Reforma a los Sistemas de Pensiones: 
Peligros de los Programas Opcionales en America Latina.'' In Sergio 
Baeza and Francisco Margozzini, eds., Quince Anos Despues: Una Mirada 
al Sistema Privado de Pensiones (Santiago, Chile: Centro de Estudios 
Publicos, 1995), pp. 230-1. 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.
---------------------------------------------------------------------------
    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.
``The Coverage Under the New System is Low''
    Critics also say that some 30-40 percent of Chilean workers are not 
participating in the private system. Although the number of Chileans 
participating in the private system is actually greater than the work 
force (some Chileans affiliated to the private system have left the 
work force), only about 61 percent of those participating in the 
employed work force regularly contribute to their private accounts. 
According to the Chilean pension fund regulatory agency, that method of 
calculation underestimates real coverage because it counts only workers 
who have contributed in a particular month even though other workers 
who made contributions in previous months will also receive benefits 
from the system. Including workers who have contributed within the past 
year, coverage in the private system amounted to 69.7 percent of the 
work force, which is greater than that of the previous public system in 
the four years prior to the reform. From 1976-1980, coverage under the 
old system ``averaged 67 percent of the workforce, with a clear 
downward trend.'' \12\
---------------------------------------------------------------------------
    \12\ The Chilean Pension System, pp. 120-23.
---------------------------------------------------------------------------
    Others have also found that coverage in the private system is 
greater than that of the old system. Measuring coverage as those who 
contribute on a regular monthly basis, the percentage of the employed 
work force covered in the private system (more than 60 percent) is 
superior to the coverage of the old system before reform (54 percent in 
1980) and it has been increasing. See graph below.\13\
---------------------------------------------------------------------------
    \13\ Asociacion AFP.
---------------------------------------------------------------------------
    Several factors explain why coverage is not higher in Chile. The 
self-employed, who represent about 30 percent of the work force, are 
not required to participate in the private system. Only about 6 percent 
of the self-employed contribute on a regular basis. Workers who are 
unemployed also do not contribute to the system (the unemployment rate 
has been between 8-10 percent in Chile in the past five years.) 
Moreover, of the 3.4 million people affiliated with the private pension 
system, 1.44 million--including students or women who have stopped 
working to care for children, for example--are not currently in the 
work force.\14\ There is also a large informal economy, which is 
typical of developing countries. Lastly, the evidence suggests a strong 
relationship between economic development and the level of coverage 
around the world (higher per capita incomes correlate with higher 
coverage).\15\
---------------------------------------------------------------------------
    \14\ Ibid.
    \15\ Robert Holzmann, Truman Packard, and Jose Cuesta, ``Extending 
Coverage in Multipillar Pension Systems: Constraints and Hypotheses, 
Preliminary Evidence and Future Research Agenda,'' in Robert Holzmann 
and Joseph E. Stiglitz, eds. New Ideas About Old Age Security 
(Washington: World Bank, 2001), p. 454; and Asociacion AFP.
[GRAPHIC] [TIFF OMITTED] T3925A.012

    In short, the level of coverage under the system does not reflect 
negatively on the private pension system itself. To the extent that 
coverage could improve, factors not inherent to the private system, 
such as rigidities in the labor market and the size of the informal 
economy, would have to be addressed by other public policies. In 
addition, only beginning around the year 2025, when the first 
generation of workers who have contributed during their entire working 
lives begins to retire, will it be fair to compare the private system 
with the old system.
``Too Many Workers Will Depend on the Minimum Pension and the System 
        Will Impose Large Costs''
    The Chilean finance ministry estimates that the average number of 
minimum pensions that it will be supplementing per month in 2005 will 
be 65,000. The costs of doing so are minimal and currently stand at 0.1 
percent of GDP. Part of the reason that the cost is low is that the 
government does not provide the full amount of the minimum pension 
since a worker has some assets in his/her account. On average, the 
government provides 20-30 percent of the capital needed to finance the 
minimum pension. Indeed, the public cost of financing pensions, most of 
which is made up of meeting the obligations of the old system, is 
projected to continue falling (see Table 1).\16\
---------------------------------------------------------------------------
    \16\ Ministry of Finance and Asociacion AFP, ``The AFP System: 
Myths and Realities,'' August 2004, available at www.afp-ag.cl.

                                 Table 1: Civil Social Security Deficit Forecast
----------------------------------------------------------------------------------------------------------------
                                         Recognition                          Minimum  AFP
       Year         Public  Pensions        Bonds        Welfare  Pensions      Pensions             Total
----------------------------------------------------------------------------------------------------------------
2002               3% GDP             1.2% GDP           0.4% GDP           0.1% GDP          4.7% GDP
----------------------------------------------------------------------------------------------------------------
2010               2% GDP             1.2% GDP           0.4% GDP           0.27% GDP         3.87% GDP
----------------------------------------------------------------------------------------------------------------
Difference         ^1% GDP            0% GDP             0% GDP             0.17% GDP         ^0.83 GDP
----------------------------------------------------------------------------------------------------------------
REDUCTION OF FISCAL SPENDING ON PENSIONS: ^0.83% OF GDP
----------------------------------------------------------------------------------------------------------------
(Source: Ministry of Finance: Budget Department, Macroeconomic Aspects of the Draft Law for the Public Sector,
  2002; and Asociacion AFP)

    It is estimated that the percentage of members affiliated to the 
private pension system that will receive government supplements for the 
minimum pension (only those who have contributed 20 years are eligible) 
will vary between 1.9 and 10.5 percent depending on the rates of 
return.\17\
---------------------------------------------------------------------------
    \17\ Asociacion AFP; the rates of return assumed are 3 percent, 5 
percent, and 7 percent.
---------------------------------------------------------------------------
``Workers Change Pension Fund Administration Companies Too Frequently''
    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. 
Transfers have since fallen to about 228,000 per year.

            Liberalizing the Chile's Private Pension System

    It is clear that some of the regulations mentioned above have 
become outdated and may negatively affect the future performance of the 
system. Fortunately, Chilean authorities have taken some important 
steps in addressing the challenges of a more mature system.
    The most important structural reform in recent years is the 
introduction of multiple investment funds. Up until 2000, the pension 
fund management companies could only manage one fund. That year, the 
regulatory framework was changed to allow the AFPs to offer a second 
fund, invested only in fixed income instruments. That reform proved to 
be insufficient, as very few workers decided to switch their savings 
from the diversified fund to the fixed-income one. Indeed, consumer 
demand for the fixed-income fund was negligible. What was needed was to 
let pension fund management companies manage more than one variable-
income fund.
    Chilean authorities finally adopted this reform in early 2002 when 
they instituted a rule that mandated AFPs to offer 5 different funds 
that range from very low risk to high risk. One advantage of having 
several funds administered by the same company is that that could 
reduce administrative costs if workers were allowed to invest in more 
than one fund within the same company. This adjustment also allows 
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. Table 2 shows the maximum percentages of equity 
investment allowed in each fund:

                                 Table 2
------------------------------------------------------------------------
                          Maximum Percentage        Mandatory Minimum
                               Allowed                  Percentage
------------------------------------------------------------------------
Fund A                80%                        40%
------------------------------------------------------------------------
Fund B                60%                        25%
------------------------------------------------------------------------
Fund C                40%                        15%
------------------------------------------------------------------------
Fund D                20%                        5%
------------------------------------------------------------------------
Fund E                Not Allowed                Not Allowed
------------------------------------------------------------------------

    The introduction of a family of funds is an important step and 
consumers are behaving as one would expect--that is, by diversifying 
their investments across the menu of funds. Other steps that have been 
taken in the recent past include:

      The lengthening of the investment period over which the 
minimum return guarantee is computed to 36 months from 12 months and 
the widening of the band from 2 to 4 percentage points for some type of 
funds;
      The further liberalization of the investment rules, so 
that workers with different tolerances for risk can choose funds that 
are optimal for them; and
      The expansion of consumer choice with the signature of a 
bilateral accord with Peru that allows workers from those two countries 
to choose the pension system with which they want to be affiliated.

    Other specific steps that Chilean regulators should take to ensure 
the continuing success of the private pension system include: 
Liberalizing 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); letting other 
financial institutions, such as banks or regular mutual funds, enter 
the industry; \18\ giving workers the option of personally managing 
their accounts through the world wide web; and reducing the moral 
hazard created by the government safety net by linking the minimum 
pension to the number of years (or months) workers contribute.
---------------------------------------------------------------------------
    \18\ 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.
---------------------------------------------------------------------------
    Those adjustments would be consistent with the spirit of the 
reform, which has been to adapt the regulatory structure as the system 
has matured and as the fund managers have gained experience. In 
summary, the Chilean private pension system, despite minor 
shortcomings, is a success story by any measure and deservedly 
continues to be the model for rich and poor countries around the world 
that are considering reforming their retirement systems.

                                 

    Chairman MCCRERY. Thank you, Mr. Vasquez. Mr. Harris.

STATEMENT OF DAVID O. HARRIS, MANAGING DIRECTOR, TOR FINANCIAL 
          CONSULTING, LIMITED, SUFFOLK, UNITED KINGDOM

    Mr. HARRIS. Thank you, Mr. Chairman, for the opportunity to 
testify before you and your colleagues today on the Australian 
pension model and the lessons that can be learned by the United 
States in respect of the continued examination of Social 
Security reform and options around the world. As a former 
resident of the Washington area in the late nineties who has an 
interest in Social Security, I am heartened that Social 
Security is again a prominent issue for the Administration and 
Congress to consider.
    Mr. Chairman, achieving Social Security reform in the 
United States, as you and your colleagues would be aware, is 
not an easy problem to resolve. In the UK, where I am now a 
resident, Prime Minister Blair and his cabinet equally grapple 
with the fundamental need to engineer successful pension 
reforms to their first and second pillars, which my friend 
David John from the Heritage Foundation will elaborate on. 
Grasping the thorny nettle of Social Security or pension reform 
is largely driven by the sobering reality that, in the future, 
legislative bodies will have to either increase taxes or cut 
benefits to maintain Social Security and pension promises. Yet, 
for Australia, a longtime friend of the U.S. whose citizens 
share much in common, the need and implementation of major 
Social Security reforms has already occurred as a priority. It 
is interesting to note it was promoted by trade unions and the 
Social Democratic Labor Party then in government who embraced 
in the eighties the need to compel its work force to save a 
certain percentage of their income for retirement purposes.
    It is important to note that in 1993 only 40 percent of the 
work force was covered by some voluntary retirement saving, 
with only $32 billion Australian dollars held in pension 
assets. In effect, the second pillar pension retirement system 
in the mid-eighties was transformed through contributions 
partly funded by centralized wage deferrals. Individual 
retirement accounts blossomed out of a landscape where many 
workers simply did not have access to retirement accounts. 
Today, 26.2 million individual retirement accounts exist for 
the 9.2 million workers.
    Under the first pillar of the Australian retirement model, 
individuals are provided with Social Security, which is 
equivalent to 26 percent of my mother's average total weekly 
earnings. My mother's view of retirement: if she paid her taxes 
she would be entitled to an old-age pension. In the eighties 
the government, in an effort to contain the future costs of 
pensions, introduced an income to assets test and, with the 
combination of compulsion, began to address the issue of 
fundamental Social Security reform. Three percent was 
considered by the then Labor government as simply not enough. 
An expansion of the compulsory contribution system was managed 
eventually, in 1992 and 1993, through the taxation system. The 
then government proposed a system whereby employers would 
contribute 9 percent, individuals 3 percent, and government 
would provide a 3 percent uplift for lower income workers.
    In 1996, the Labor government moved into opposition and the 
new Conservative Liberal Coalition retained only the policy of 
seeing employers contributing nine percent of individual 
salaries into retirement accounts. Today, Australians, on top 
of making contributions of 9 percent on a compulsory basis, 
contribute two to three percent of their salary on a voluntary 
basis in retirement accounts. As Trevor Matthews, chief 
executive officer of Standard Life UK, who, as an Australian, 
formerly ran a leading life insurer, said, Australian pension 
reforms were achieved through working with political, economic, 
and commercial realities in order to solve Australia's aging 
population. Achieving consensus among stakeholders was critical 
to its success.
    There are many myths that surround the Australian 
retirement model, Mr. Chairman, which I have highlighted in my 
written testimony. Simply put, Australia moved away, like Chile 
and Switzerland, from voluntary retirement savings to 
compelling and providing limited incentives to workers to save 
for their retirement. Today $495.4 billion U.S. dollars are 
held in pension assets for over 9 million workers. Seventeen 
percent of these assets are invested abroad, with the primary 
source of investment being in the United States.
    Yet, no international pension model is perfect. Australia 
needs to address a plethora of individual retirement accounts 
that have grown up. Every worker has nearly three individual 
accounts on average. With respect to taxes, the contributions 
are taxed, the investment returns on the fund are taxed, and 
the fund flows going out of the retirement account are taxed. 
This approach is unique to Australia, and some of your 
colleagues may consider rather immoral. In conclusion, some of 
the lessons the United States can learn from Australia include 
her Labor and trade union support for Social Security reform, 
the need for incentives to low-income workers and the self-
employed, an effective communication and education campaigning 
transition, but also a cost effective regulation, and the 
ability to contain administrative cost structures for the 
growth in individual retirement accounts. Once again, thank you 
for the invitation from this Generation Xer to appear before 
you today.
    [The prepared statement of Mr. Harris follows:]
    Statement of David O. Harris, Managing Director, TOR Financial 
 Consulting Limited, 1996 AMP Churchill Fellow, Suffolk, United Kingdom
    Mr. Chairman, I am very pleased to appear to discuss social 
security reform in Australia. As each year passes the need for reform 
becomes more pressing for many countries as populations rapidly age. 
Moreover, generous promises linked with social security programs will 
make it inevitable that radical reforms will have to be considered. 
This may mean cutting benefits or increasing retirement contributions 
via taxation. I've described compulsory retirement saving as being the 
equivalent to the great white shark for those who know they have to 
deal with the rising tide of ageing. They don't want to confront 
compulsion but they know that it is `out there'. Only three countries 
rely heavily on private mandatory saving policies for retirement, these 
include Australia, Switzerland and Chile.\1\ Australia faced the 
challenge 13 years ago. Not only did we survive, we succeeded. The 
Australian retirement model offers clear proof that radical pension 
reform can be achieved and benefit an entire nation. Women, minority 
groups and 'blue collar' workers, in particular, have seen significant 
benefits flow to them from having the ability to manage their own 
retirement savings.
    The U.S. has had its own success in generating capital through 
individual saving. But it has not avoided the current questions around 
retirement saving: what will be `sufficient' and what financial 
instruments will provide it? No-one in the past, when economic and 
social systems were being formed, could have anticipated the rapid 
ageing of populations throughout the world.
An overview of Australian retirement system
    Australia and the UK stand out as countries that have faced up to 
the discomfort of significant retirement reforms. Both have taken the 
route of a more fully funded, defined contribution system but their 
approaches have differed in terms of politics, or government and the 
role of organized labor and business. These three vested interests, 
individually or combined, can encourage or discourage reform.
    This fact was well understood when Australia reformed its 
retirement system in 1987 and 1992. In 1983 the Australian Labor Party 
led by 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 a 
significant reduction in wage growth.
    The ALP is fundamentally a social democratic party based on largely 
collectivist principles. It has strong links with the trade union or 
organized labor movement through the Australian Council of Trade Unions 
(ACTU). Superannuation was provided through traditional employer-
sponsored plans on a voluntary basis. Surprisingly perhaps it was the 
trade union movement which began the momentum for changing Australia's 
retirement system. They saw increasing superannuation coverage as a 
major priority.
    The Old Age Pension was seen as an important source of income for 
retirees who have limited resources to sustain themselves in 
retirement. Its impact on Australia's GDP is seen in Table 2. Many 
older Australians who retired in the past failed to build up sufficient 
retirement savings; a common perception was that they were entitled to 
an old age pension after paying taxes all their working life and this 
view was encouraged by many governments. In the 1980s, however, the 
Commonwealth Treasury and the Federal Government were not happy with 
the direction of expenditure on the first pillar of Australia's 
retirement framework. This concern was compounded by the demographic 
picture for the next century where the percentage of the population 
aged over 65 was expected to rise from 15% of the population to 23% by 
2030 and the percentage aged over 85 was expected to more than double 
from around 2%.
    The newly elected Federal Government began by ensuring the long-
term viability of the Old Age Pension at its then current level. 
Maximum payments, by the mid 1980s, were determined through a 
comparatively stringent income and asset tests. The full pension 
payment now 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. This 
shift required a strong political resolve. More through timing than 
luck, though, a popular Federal Government with trade union support was 
able to convince the nation of the problems Australia would confront in 
the future if it did nothing about addressing its aging population. 
This 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.\1\
---------------------------------------------------------------------------
    \1\ Australian Bureau of Statistics, 1998 Year Book Australia 
(Canberra, Australia: AGPS, 1998), p215.
---------------------------------------------------------------------------
    Before the introduction of mandated, second pillar, superannuation 
accounts, the coverage of superannuation was limited to roughly 40 
percent of the Australian workforce. Typically, those covered were 
employed in middle class, `white collar' jobs where women and people 
from minority groups were under-represented. 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. 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 pay. By the mid 1980s the 
union movement had shifted its stance whereby it would play a more 
direct and active role in the day-today operations of superannuation, 
via industry funds. These industry funds, grouped around a particular 
economic sector of the Australian economy, brought union and employer 
representatives together as trustees to manage the administration and 
investment of many thousands of individual retirement accounts. The 
increasing involvement of the union movement challenged some industry 
participants' views that administration and investment decisions would 
be distorted in favor of policies that stressed mutuality rather than 
economic reality.
    There was another reason for the trade union movement's interest in 
pensions. Between August 1986 and August 1996, the level of trade union 
membership declined from 46 percent to 31 percent. This coupled with 
the decline in traditional union-based industries, such as heavy 
manufacturing, reinforced the unions' enthusiasm for reforms they felt 
would increase their profile and relevance.
    By 1986 circumstances were ideal for the introduction of a 
widespread employment-based retirement incomes policy. The government 
insisted that it was in the ``public-interest'' to have a national, 
compulsory, employment-related retirement income scheme in place \2\ 
Award superannuation, set at 3% of an individual's yearly income, was 
introduced. This 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, sponsored by 
employer and employee organizations in one or more industries, were 
established to receive the 3% award contributions.
---------------------------------------------------------------------------
    \2\ 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), p5.
---------------------------------------------------------------------------
    A further 3% round of award superannuation was made in 1990-91 
before the government acted more decisively on reform. In August 1991 
the Government's indicated its intention to introduce a Superannuation 
Guarantee Levy from July 1 1992. 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 reforms was 
substantial, some opposition was expressed by then Australian Democrats 
(a minor `left leaning' political party) leader Senator Kernot who 
favored a single, government-controlled, national portable system, 
similar to that of a national provident fund. But the Government's 
proposed legislation quickly generated wide acceptance through working 
in `partnership' with organized labor, business interests and industry 
associations.
    The use of government inquiries or private sector research helped 
to highlight the inadequacies of Australia's level of retirement system 
provision. These inquiries were seen to be delivering independent views 
or recommendations and the Federal Government felt vindicated in 
implementing a mandated retirement system.
    Another means by which the Federal Government was able to engineer 
significant change to the retirement system was through an effective 
public education campaign in 1994-1995, co-ordinated by the Australian 
Taxation Office. The total cost of the campaign was $AUS 11 million and 
the message was that the new retirement system would not only benefit 
the individual but the nation as a whole. 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 
used by the government to hear, interpret or receive objections to the 
planned reforms and this encouraged a spirit of `consensus' to be 
generated amongst many stakeholders of differing political ideologies.
    Finally the 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 consequences of proposed reforms could be simulated and 
understood by superannuation industry participants and bureaucrats 
alike. Unlike in Chile, where individual retirement account reforms 
created a totally new financial infrastructure, much of the 
superannuation infrastructure in Australia already existed under the 
voluntary system. 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.
    Australian business saw the reforms in terms of nurturing the 
capital market and the 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 that 
increased costs would be levied on employers as contributions lifted 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, but small business strongly opposed the 
reforms arguing principally that the increased cost burden linked with 
an expanded retirement provision would cause many business failures. In 
fact business played only a moderate role in supporting the 
government's reform agenda and this was co-ordinated, in part, by large 
financial providers who would develop or modify the financial 
infrastructure of such mandated retirement accounts.

  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 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 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 salary on retirement.
The impact of compulsion
    The criticisms levelled at Australia's pension system, usually by 
those who are looking at it from the outside, belong to what I've 
called the 7 Myths. Typically these run along the lines of:

    1.  Compulsion in Australia started a recession;
    2.  Australia had a successful voluntary second pillar pension 
framework (so why move to compulsion?);
    3.  After compulsion net savings fell;
    4.  The industry made free with fees and charges;
    5.  Australians make free with their retirement savings--spend the 
lot and then fall back on the State pension;
    6.  Compulsion was introduced for ideological reasons by the a 
union backed Labor Government rather than as an answer to socio-
economic need;
    7.  The second pillar savings level of 9% is insufficient to 
replace income.

    None of these myths is borne out by the facts. In fact pension 
adequacy has been improved in the second pillar and Australia has been 
proofed against future demographic change. Expensive Defined Benefit 
plans, the supposed gold standard of some politicians and Employee 
Benefit Consultancies (EBCs) have become all but extinct. At September 
2004 the breakdown of benefit structures included 297,327 accumulation 
funds, 182 defined benefit plans and 309 hybrid plans. At the same time 
superannuation coverage of all workers has been maintained at a level 
of 88%.
    Compulsion has dramatically raised retirement savings and improved 
the future prospects of baby boomer and Generation X retirees. 
Comparatively low administration costs, wide investment choice and 
minimal mis-selling have protected consumers from detriment.
    One of the reasons why Australia has been so successful in keeping 
administrative costs low and 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. 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, in part, to returns being maximized and 
administrative fees being minimized.
    Sound regulation, transparency and significant improvements in the 
competency levels of distributors eg. financial advisers and financial 
planners, has raised public confidence in the retirement system and 
nurtured a steady increase in the level of voluntary contributions made 
into superannuation accounts. The Australian government has announced 
that it will encourage lower income families and workers to bolster 
their retirement savings via government co-contributions by widening 
the eligibility criteria for the Government's co-contribution scheme 
(whereby the Government matches an eligible member's after-tax 
superannuation contributions dollar for dollar, up to a prescribed 
annual maximum, and subject to an income test).
    Total superannuation assets held by 9.2 million workers now stand 
at nearly $649 billion \3\ ($US495.4) for just over 9 million workers 
compared with $32 billion in 1993. A large percentage of them are 
invested in equities (49%), interest bearing securities (16%) and 17% 
or $108 billion are invested in overseas equities.
---------------------------------------------------------------------------
    \3\ Statistics, Superannuation Trends September 2004 Australian 
Prudential Regulation Authority.
---------------------------------------------------------------------------
    Administration costs do 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. An authoritative survey, conducted by the Association of 
Superannuation Funds of Australia (ASFA), estimated that an average of 
$1.28 ($US0.97) per member per week was made for overall administration 
costs in 1999-2000. It should be noted that this figure has declined 
from $1.66 ($US1.27) per week two years earlier. Expressed in another 
way, costs as a percentage of assets in June 2000 were calculated to be 
1.29%.

                   Table 2: 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
----------------------------------------------------------------------------------------------------------------
UK                                                    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).

What we could have done better
    Australia has pursued an independent line on taxation of 
superannuation and one I find hard to agree with. Contributions are 
taxed at a rate of 15 percent, along with possible additional taxation 
of 15 percent for members earning over a certain threshold. A further 
15 percent is levied on the investment income of each superannuation 
fund and finally the benefits can be subjected to varying tax treatment 
of between 0-30%, depending on timing of the contributions. As you can 
see the Commonwealth Treasury's faith in the politicians getting 
taxation revenues back from retirees' retirement nest eggs was very low 
when this taxation approach was adopted in 1992. Continual change to 
the way superannuation is taxed has caused much confusion for plan 
participants and trustees and industry associations are pushing for a 
comprehensive review.
    Another negative feature is the sheer volume of accounts. Workers 
have an average of three, I have four. A new plan for a new job has 
created unnecessary duplication and administrative cost. Many funds are 
now seeking to streamline the transfer process by administration 
protocols.
    It has to be said that the system has not delivered benefits to 
current pensioners whose circumstances have deteriorated over the past 
10 years. A state pension indexed to prices and pegged at 26% of male 
total average weekly earnings has reduced their purchasing. The full 
benefit of compulsory superannuation reforms will not `crystalise' 
until well into this century.
What next?
    Around 30% of employees in Australia already have fund choice and 
the Choice of Fund Act 2004 will give a further 40% of employees this 
freedom from 1 July 2005. Employers can meet their obligations under 
the Act by entering into a certified agreement with their employees. If 
workers do not choose a fund, employers must make contributions to a 
fund that satisfies the requirement to offer a minimum level of life 
insurance cover. The level of insurance premiums will not be regulated. 
Employers will give their workers a standard choice form which will 
provide basic information and highlight what should be considered 
before a fund is selected such as: level of fees and charges and the 
type of investments a fund offers.
    The Howard government's reason for choice of funds is partly 
ideological in my view but is described as providing a more flexible 
and adaptable retirement system--one of the benefits should be 
portability--and more appropriate for flexible workplace arrangements 
which allow workers to reduce their hours as they approach retirement 
and to work beyond 65. The new legislation will allow people to access 
their superannuation from their preservation age without having to 
retire and it will allow them to develop strategies in transition to 
retirement for example working part-time and supplementing their income 
with some of their superannuation. It is not intended to enable people 
to dissipate their superannuation savings before retirement, however, 
and the Government is taking measures to ensure that savings are drawn 
down in a regular and orderly way.
    The government has announced further measures to encourage lower 
income families and workers to bolster their retirement savings via 
government co-contributions which match after-tax superannuation 
contributions dollar for dollar up to a prescribed annual maximum and 
subject to an income test.
Lessons for the U.S.
    As indicated, lessons do exist for the U.S. in regard to how 
Australia has addressed its ageing populations and they can be 
summarised in five major points:

      Partnership with the trade unions
      Incentives for low income workers and the self-employed
      Information and education
      Cost effective regulation
      Contained administrative costs under the creation of 
numerous individual retirement accounts

And, finally, persuading all stakeholders that change had to happen and 
that it was for the benefit of the nation as a whole.

                                 

    Chairman MCCRERY. Thank you, Mr. Harris. Dr. Baker, you 
must feel a little bit like General Custer, but I invite you to 
wade in. I assure you, you will survive the hearing.

  STATEMENT OF DEAN BAKER, PH.D., ECONOMIST AND CO-DIRECTOR, 
            CENTER FOR ECONOMIC AND POLICY RESEARCH

    Dr. BAKER. Well, thanks. I appreciate the opportunity, but 
given the relative merits of the argument I figure it is a 
balanced panel.
    Chairman MCCRERY. So did General Custer.
    Dr. BAKER. I expected better. I would like to make four 
main points about the lessons I can get from various efforts of 
privatization around the world: first, that we could say it 
increases risk as opposed to the guaranteed benefits product by 
current systems. Second, the universal experience has been that 
of it increasing administrative costs by a factor or 20, 30 or 
40, so, very huge increase in administrative costs. Thirdly, 
the programs are not popular with workers, and the evidence on 
this that I am looking to is the increase in participation 
rates, or I should say lack of increase of participation rates 
in the developed world in response to privatization, which was 
the main purpose of the reforms, and that turns out to have 
been very limited, if any at all. Fourth, transition costs are, 
in fact, borrowing. We can't tell the functional market. What 
we can tell them, but they won't believe, is that it will be 
repaid with later benefits in 30 or 40 years, and there is 
evidence on that.
    So, to go through each of those in turn, first off, the 
increase in risk. This is sort of straightforward. We have two 
basic types of risk we can talk about. One is bad investment 
choices. The best example here is probably in England where we 
had the mis-selling scandal there in early 1990, where a lot of 
financial companies made promises they couldn't deliver on. You 
also have the problem that in many cases people take too little 
risk which, say, under President Bush's proposal, would 
guarantee they would lose because they would not compensate 
themselves for the money they would put into those accounts. 
What has been proposed as a counter by many people is that they 
will educate workers, as in Chile. For example, they actually 
have education classes on their accounts in their high school. 
As an economist, we ordinarily like to think there is an 
opportunity cost in time. I don't know that is the best use of 
a single mother's time in the evening to be studying Chile's 
accounts rather than spending time with her kids, or if we are 
talking about in schools, I don't know if it is better they 
spend time studying their accounts rather than learning math, 
science, or language competency. That is a judgment that would 
have to be made.
    The second type of risk, of course, is timing risk. Markets 
have ups and downs, nothing we can do the about that. In Chile, 
one of their government ministers actually suggested people 
delay their retirement for a few years because the market had 
temporarily depressed accounts. President Bush's proposal says 
we will shift people out of stocks into bonds at 55. I am sorry 
to say this, but that just changes the risk that the market 
will be down when you are 55 rather than when you are 65. Same 
story, so, there is no way around that.
    The second point, the cost. Lots of evidence on this. The 
administrative costs of these accounts are 15 to 20 percent of 
the money that goes into them. There is a really big confusion 
on this. President Bush's commission said that they could do it 
for 30 basis points, 30 cents. It is important to understand it 
is 30 cents, three-tenths of 1 percent, of the stock. A dollar 
might be in that account for 40 years. If your taxes or 
administrative costs are three-tenths of a cent on that dollar, 
after 40 years that is 12 percent. Okay, so, the average 
administrative costs any administrator would get would still be 
6 percent, about 12 times the cost of the current system. So, 
as I say, the existing cost, if we look at systems that exist 
in the world, are in the order of 30 to 40 times, 15 to 20 
percent of the money that is put into the system. I should also 
point out that annuities have a cost estimated at 15 to 20 
percent. These are very large expenses. If we applied them to 
the U.S. system, we would be talking about somewhere in the 
order of $75 billion a year being wasted on administrative 
expenses, if the whole system were done through a privatized 
system like that in Chile. President Bush's commission said 
that a government run system could be much more efficient than 
the market. Perhaps that is true, but even then we are still 
talking about a system that would cost us 10 to 15 times as 
much as the current system.
    My point about the systems not being popular, again, if we 
look at participation rates in the countries that did reforms, 
World Bank did a study on this. In Latin America, in most 
cases, there were very low increase in participation rates. The 
other point, very interesting on this, in Chile where we have 
the best model, as you heard here, a very high percentage of 
the workers appear to be targeting the minimum benefit. That is 
very interesting because most workers are voting with their 
feet for a DB system in the middle of a DC system. I take this 
as evidence it is not terribly popular.
    The last point I want to make is, that financing transition 
costs is borrowing. President Bush has argued, or his staff has 
argued, that it is okay that we run large deficits to finance 
the transition because they will be repaid 30 or 40 years out 
with lower benefits. We could look around the world. No country 
has attempted to finance this transition purely through 
borrowing. We had the model of Chile where they actually ran 
very large surpluses, 4 percent of GDP. That would be 
equivalent of $500 billion a year in the United States. Perhaps 
the closest example to President Bush's model is Argentina 
where they did not make adequate cuts in other expenses or 
adequate increases in other taxes, and as you may remember, 
Argentina defaulted on its debt in 2001. It is worth pointing 
out that if Argentina had not privatized its system and that 
money had continued to go to the government, Argentina would 
have had a balanced budget in 2001, the year it defaulted. So, 
long and short, I will summarize by saying, I don't think the 
record is terribly successful. I think we do have a very 
successful system here, and I would suggest that we use great 
caution too in looking into any reform. Thank you.
    [The prepared statement of Mr. Baker follows:]
 Statement of Dean Baker, Ph.D., Economist and Co-Director, Center for 
                      Economic and Policy Research
Mr. Chairman and Members of the Subcommittee:

    I want to thank the Subcommittee for inviting me to testify on the 
experiences of other countries who have privatized their Social 
Security systems. At this point there are a large number of countries, 
mostly in the developing world, who have partially or completely 
privatized their Social Security systems. There are four basic 
generalizations that can be made based on the experiences of these 
countries:

    1)  Privatization invariably increases risks for workers. These 
risks take three forms: the timing of the worker's retirement, the risk 
associated with the worker's choice of assets, and the risk of having a 
low income during a working lifetime. The latter point refers to the 
fact that most traditional Social Security systems, including the 
system in the United States, are designed to be redistributive to low-
wage earners. A system based strictly on individual accounts is not 
redistributive, although redistributive features can be added to the 
system.
    2)  Privatized systems vastly increase the administrative costs of 
operating a Social Security system. The most efficient privatized 
systems have annual administrative costs for the retirement program 
that are 30 to 40 times as high as the current system in the United 
States. When the costs of annuities are included, financial 
intermediaries can take as much as 30 cents of every dollar placed in 
the system.
    3)  Privatized systems have not proved very popular with the 
workers they are supposed to benefit. One of the main reasons for 
introducing defined contribution systems in developing countries is 
that a privatized system was supposed to extend coverage to the large 
segment of the workforce employed in the informal sector, most of whom 
were not covered by the traditional Social Security system. There has 
been little change in participation rates in the countries with 
privatized Social Security system. In most cases, the vast majority of 
workers have voted with their feet against the privatized systems by 
opting not to participate.
    4)  Financial markets view borrowing to cover transition costs as 
real borrowing. The Bush administration has argued that the transition 
costs associated with switching from the current Social Security system 
to a system of private accounts should not be viewed as real debt, 
since the borrowing would be associated with lower Social Security 
benefits in the future. The evidence from other countries is that 
financial markets focus on current balance sheets, not speculation 
about benefit levels in the distant future. Every country that has 
privatized their Social Security system has attempted to at least 
partially fund the transition with a combination of tax increases and 
spending cuts. Argentina, which defaulted on its debt in 2001, is the 
most prominent example of a country that failed to take adequate steps 
to offset the cost of the cost of its transition.

    I would also add the additional observation that private accounts 
do not by themselves increase national wealth. This is important in the 
context of promoting private accounts as a way to increase returns to 
retirees. Since private accounts do not actually increase wealth, at 
best they can be a mechanism for redistributing money from the working 
population to retirees. If Congress intends to redistribute money from 
workers to retirees, then there are arguably more efficient mechanisms 
to accomplish this goal.
    I will elaborate on each of these points in turn.
Risk
    Countries that have privatized their Social Security systems have 
subjected retirees to all three forms of risk noted above, the risk of 
market timing, the risk associated with asset choice, and the risk of 
low income during a working lifetime. In the first case, it is a basic 
fact about financial markets that they are volatile. Even if the 
average return on equities exceeds the return on riskless assets, there 
is considerable variation in this return. In Chile, the longest 
standing experiment with a privatized system, a government minister 
recommended that workers delay their retirement for a few years after a 
downturn in the national stock market.
    There is no way to avoid this market timing risk. The Bush 
administration's suggestion that workers be forced to switch out of 
stocks approximately 10 years before retirement does little to change 
the story. If the market plunges just before a worker reaches this 
switch date, then he or she is almost as bad off as if the plunge 
occurred just before his or her retirement.
    A second sort of risk is associated with the choice of asset. This 
risk can result from a worker either being too conservative or taking 
too much risk with their accounts. Many workers are ill-informed about 
financial markets and may only feel comfortable holding very safe 
assets with low returns. In the case of the proposal President Bush 
outlined in his State of the Union Address, this could result in 
workers losing money on their individual accounts, since they would 
lose more from their Social Security benefit than they would gain from 
the investments in their accounts.
    Workers can also engage in speculative investments that end up 
losing money. This happened to some extent in England where there was a 
``mis-selling scandal'' in the mid-nineties. Many financial firms had 
sold accounts to workers by promising returns on the accounts that 
workers would not actually realize. The British government eventually 
forced these firms to make good on these promises. In some cases, where 
firms had gone out of business, the government was forced to pick up 
itself the cost of fulfilling these promises.
    These risks can be minimized by restricting choice. If the 
government gives workers a very narrow range of options, then the risk 
of bad asset selection is reduced. (Of course, this assumes that the 
government knows better than individual workers how best to invest 
their money.)
    In principle, insofar as workers are too conservative with their 
investment choices because they are ill-informed about financial 
markets, the problem can be addressed with better education. However, 
this raises two additional problems. First economists usually believe 
that time has an opportunity cost. Time that workers spend learning 
about financial markets is time that they could have spent with their 
children or on other activities. If we are designing a system that 
requires that tens of millions of workers get additional education on 
financial markets, then we have decided that this is the best use of 
their time. (In Chile, the schools now have sessions that teach people 
about the retirement system. This means that time that could have been 
spent developing math, science, or language skills is instead being 
used to teach people how to manage their Social Security accounts.)
    The other problem with trying to educate workers on their 
retirement investments is that it is not clear who should be doing the 
educating. Many of the country's top financial advisors were 
recommending that people invest in stock even at the peak of the 
nineties bubble. It is not clear that advice from such experts would be 
beneficial to most workers.
    Finally, a system of private accounts, by itself, is not 
redistributive to low wage workers. This means that if a mechanism is 
not put in place to ensure that workers who put little into these 
accounts because of low earnings, still have an adequate retirement 
income, then many low wage earners could end up as losers. While most 
countries with privatized systems have put some sort of minimum benefit 
in place, this is not universally the case. For example, Peru does not 
have a minimum benefit in its system.
    It is also important to realize that putting a redistributive 
mechanism in place today, does not guarantee that it will be there 
twenty or thirty years in the future. Any redistributive mechanism 
attached to private accounts will always be subject to political risk. 
The intention of the designers of the system will matter little if 
political support does not exist to retain redistributive mechanisms in 
the future.
Expenses
    There is now a large body of research that shows that the 
administrative costs of a privatized system of individual accounts 
vastly exceeds the costs of a centralized defined benefit system like 
the one in the United States. The administrative costs of the Chilean 
system have averaged close to 15 percent of the money placed in the 
accounts each year, while the cost of the British system have averaged 
close to 20 percent. Administrative costs are much greater in these 
systems because of the costs associated with servicing an individual 
account, the costs associated with marketing to individuals, and the 
profits of the firms who administer these accounts.
    In addition to the annual costs associated with operating these 
accounts, there are also costs associated with turning the accounts 
into annuities at retirement (which is not generally required). 
Research indicates that insurance companies charge between 10 and 20 
percent of the value of a sum to convert it to an annuity. Roughly half 
of this fee is associated with the adverse selection that results when 
annuitization is not mandatory. (Only relatively long-lived individuals 
are likely to buy annuities.) The other half is due to the 
administrative costs and profits of the financial firms that issue 
annuities.
    A single centralized system of accounts (which does not exist in 
any of the countries that have opted for privatization) could in 
principle lower costs, especially if it minimized workers' choices in 
selecting investments and switching between investments. President 
Bush's Social Security commission estimated that a bare-bones 
centralized system would cost roughly ten times as much as the current 
system. (There has been considerable confusion about this point because 
of how the commission framed its cost estimate. The commission 
estimated that the administrative cost would be 0.3 percent of the 
stock of money in an account. This means that the fee on a dollar 
placed in an account would be 0.3 percent for each year that dollar is 
in the account. Some dollars will be in an account for forty years, 
while some dollars placed, in the account just before a worker 
retirees, will be there for just a short time. If a dollar is a 
worker's account for an average of twenty years, then this 0.3 percent 
fee will be paid twenty times, making a total administrative cost of 
6.0 percent, compared to a cost of just 0.5 percent on the dollar 
placed in the Social Security system.)
    President Bush's commission also argued that a centralized 
government run system can radically reduce the cost of issuing 
annuities. While a centralized system may in principle be vastly more 
efficient than the current market system, there would still be a 
problem of adverse selection in any system where buying annuities is 
optional, as President Bush has proposed. This means that a worker with 
an average life-span could expect to lose between 5 and 10 percent of 
their money under such a system, compared to what they would receive 
with an actuarially fair annuity.
Popularity
    The World Bank recently completed a study of the privatized Social 
Security systems in Latin America.\1\ One of the main criticisms of 
these systems is that they have not substantially increased 
participation over the rates achieved under the traditional defined 
benefit systems. The argument that these systems would increase 
participation claimed that workers view their current Social Security 
contribution as a tax, whereas they would see their contribution to a 
private account in a different light. The fact that participation has 
changed little after privatization, in some cases not even growing more 
rapidly than what would have been expected if past trends had 
continued, indicates that workers do not view contributions to these 
accounts very differently than they do contributions to the traditional 
defined benefit system.
---------------------------------------------------------------------------
    \1\ Gill, I, T. Packard, and J. Yermo, 2005, Keeping the Promise of 
Social Security in Latin America, Stanford, CA: Stanford University 
Press.
---------------------------------------------------------------------------
    It is worth noting that in Chile, the most developed system, a 
large percentage of the workers target the minimum benefit. This 
minimum benefit allows any worker who has been in the system for twenty 
years to turn over their account to the government, and then get a 
guaranteed benefit that is tied to the value of the minimum wage. In 
effect, these workers are voting with their feet for a defined benefit 
system.
Transition Costs
    In the short-term, the switch from a traditional pay-as-you-go 
Social Security system to a defined contribution system implies a large 
increase in the government deficit, since the same benefits must still 
be paid to current retirees, even though the government is collected 
much less in Social Security contributions. Every country that has 
opted to privatize its Social Security system has attempted to at least 
partially cover these transition costs by reducing its deficit, or 
building up a surplus, with some combination of tax increases and 
spending cuts. For example, the Chilean government increased the size 
of its annual surplus to 4 percent of GDP (the equivalent of a surplus 
of $500 billion in the United States in 2005) at the point where it 
implemented its privatization plan.
    They felt the need to cut their deficits or increase their 
surpluses precisely because these governments did not believe that the 
financial markets viewed their implicit commitments to pay Social 
Security benefits in the distant future as being the same as actual 
government debt. The one important example of a government that did not 
take sufficient steps to offset the borrowing needed to finance its 
Social Security privatization was Argentina. In 2001, it was paying 
real interest rates of more than 20 percent on its debt, because 
lenders did not have faith in the government's ability to pay off its 
debt.
    By contrast, in 1994, the year Argentina put its privatization plan 
in place, the country was generally regarded as one of the most 
creditworthy countries in the developing world. Had it not been for the 
privatization of its Social Security system, Argentina would have been 
running balanced budgets between 1994 and 2001.
    The United States is approaching the question of Social Security 
privatization at a time when it faces much larger deficits than any of 
the other countries that have gone this route. The experience of 
Argentina suggests that it is likely to face a very high price in 
financial markets if it does not couple privatization with large tax 
increases and/or spending cuts.
National Wealth and Privatization
    No economist believes that the United States would be increasing 
national wealth if it borrowed $200 billion a year and invested this 
money in the stock market. It is possible that this will reallocate 
income, as the government can benefit from the gap between the return 
on equities and the interest paid on government bonds, but this is not 
creating additional wealth for the country as a whole. Similarly, it 
cannot increase national wealth if it borrows $200 billion a year and 
hands $2,000 a year to 100 million families and tells them to invest it 
in the stock market. This would simply be changing the allocation of 
national income.
    This is important to recognize because one of the goals often 
claimed by proponents of privatization is increasing the rate of return 
on Social Security contributions. Insofar as the money is simply 
borrowed, as President Bush has proposed, then any increase in the rate 
of return due to privatization is simply coming at the expense of the 
rest of the population. This could be seen fairly directly in the case 
of Chile where accounts earned double-digit real rates of returns 
through the eighties. The main asset of Chile's private accounts in the 
eighties was Chilean government bonds, which paid double-digit real 
interest rates. In effect, Chile's workers received high returns on 
their accounts because Chile's taxpayers paid high interest rates on 
the money their government borrowed to finance the accounts. It may 
have been desirable to transfer money from Chile taxpayers to Chile's 
retirees, but this could have been done without going the route of 
privatization.
    In short, it is important that policy makers recognize the 
distinction between using private accounts as a way to redistribute 
income--which they may be to some extent--and a mechanism to increase 
national wealth, which they surely are not.
    (There is a separate issue of whether private accounts in the 
United States will be able to earn the rate of return claimed by 
proponents of privatization. Stock returns come from either capital 
gains or dividend payouts. No analyst has yet passed the ``No Economist 
Left Behind Test,'' which asks for a set of dividend payouts and 
capital gains, consistent with the Social Security trustees profit 
growth projections, that add to the 6.5-7.0 percent returns assumed in 
analysis of Social Security privatization. Given current price to 
earnings ratios and low projected profit growth, there is no plausible 
set of dividend yields and capital gains that will produce 6.5-7.0 
percent real stock returns.)
    Mr. Chairman, this concludes my testimony and I would be happy to 
answer any questions from you or other Members of the Subcommittee.

                                 

    Chairman MCCRERY. Thank you, Dr. Baker. Mr. John.

  STATEMENT OF DAVID C. JOHN, RESEARCH FELLOW, THOMAS A. ROE 
 INSTITUTE FOR ECONOMIC POLICY STUDIES, THE HERITAGE FOUNDATION

    Mr. JOHN. Thank you for having me, and also for looking at 
this rather important set of experiences around the world. I am 
going to concentrate on the UK's experience. Let me start by 
just--I think it is obligatory for conservatives dealing with 
the UK to quote Winston Churchill, so, I have to do my Winston 
Churchill quotes, which is that he reminded us that the United 
States and UK are two people, separated by a common language. 
This is especially true in pensions. We have similar wordings 
of terms in areas of pension reform, and in the United States, 
we actually do deal with some specific issues that are very 
similar to what the UK has, but each of the countries' systems 
has been shaped by very special national circumstances and by 
past experience. Eight years ago, many conservatives wrote that 
the UK would serve as a perfect model for a U.S. system of 
Social Security accounts. Frankly, we were wrong. More 
recently, a group of more liberal writers have been writing say 
that the United States, UK experience proves that any form of 
personal retirement accounts cannot work in the slightest, and 
that is wrong also. One of the key things to remember again is 
that the UK has special circumstances. There has been 
reference, for instance, to a mis-selling scandal in the UK 
pension plan. The mis-selling scandal did happen, and it was 
extremely serious. However, it actually resulted from a very 
specific example and circumstance in the UK marketplace; 
namely, that they did not have a retail market in mutual funds 
and similar investments. Therefore, these investments were sold 
by ill-trained insurance agents who did an exceedingly good job 
selling insurance but, not a good job selling investments.
    Most of the poor advice actually had to do with whether an 
individual would redirect a portion of their Social Security 
taxes into a personal account, thereby losing employer-matched 
contributions, or stay in an employer account where they would 
take advantage of these additional contributions. The net 
result was that the UK very sharply increased its retail 
regulation, and it also required these companies to make 
repayments. Now the UK system is also different in that they 
tied their pension system to an employer system, which was 
predominantly a DB system similar to United Airlines, Bethlehem 
Steel, and so forth, at precisely the time that that type of 
pension system was essentially failing due to a variety of 
circumstances that actually have nothing to do with Social 
Security. This has affected the results in the UK market. 
Nevertheless, there are six lessons that the United States can 
learn from the UK--and the actual system itself is described in 
my written testimony. Number one, if you build it they will 
come, works for baseball, especially in Iowa, but it doesn't 
necessarily work for a pension plan. In the UK, the government 
set up something called stakeholder pensions, which are 
relatively simple, low-cost pensions that were required to be 
offered by small businesses that had more than four employees.
    Unfortunately, the administrative costs were relatively low 
and probably too low, with the net result that 350,000 
employers did set up this type of pension plan. Better than 80 
percent of the pensions are empty without having any 
contributions in the slightest. About half of the money that 
went into the stakeholder pensions has actually been 
transferred from other existing accounts. The UK Trade Union 
Congress has charged that the stakeholder pension experience 
has actually been more of a boon for upper income workers 
seeking additional tax shelters than anything else.
    Second, simplicity is essential. Adair Turner, who heads up 
the UK Pension Commission, which we will be reporting this 
fall, recommending changes in their pension system, points out 
that the UK system is probably one of the most complex in the 
world. The net result of that is that a recent poll showed that 
precisely 6 percent of the UK population feels that they 
understand the pension system that is out there very well. It 
is a matter of great concern, however, to the average worker. A 
poll in October, in advance of the election that was held in 
May, showed that the question of pensions was number one on 
workers' minds at that point. Second, they have a pension 
credit, which is means tested, which must be applied for. It is 
not a simple delivery system. The net result is that only 60 
percent of those people who are eligible actually receive this 
pension credit. For the most part, the 40 percent who do not 
are the ones who need it the most, the most elderly, and the 
most poor.
    Number three, programs can have unintended motivational 
consequences. The pension credit is means tested, and it 
requires a 40-percent penalty on existing savings, with a net 
result that 20 million workers in the UK who have incomes 
between 16,000 and 65,000 have stopped saving. This is 15 
percent, roughly 20 percent of the overall problem in the UK. 
Fourth, index pricing requires a minimum benefit. The basic 
State pension was price indexed 25 years ago. The net result is 
that most people who only receive that, about 12 percent of the 
work force, are actually living in poverty. There are two very 
positive mentions to this. Number one, accounts do work. Even 
with the serious problems that the UK experience, the UK has 
pension savings equal to 70 percent of their GDP, which is the 
most in Europe. The overall cost of their public pension system 
is one of the lowest in the world. Second, this is key, the UK 
governments, both Labor and Conservative, when they have found 
programs that promised more than they could deliver, changed 
the benefits. They actually went through and reduced benefits. 
There have been a number of instances in the last 25 years 
where the State benefits have been altered.
    Now, in October 2005, just to conclude here, the Pension 
Commission is going to report. The expectation is that they are 
going to require more savings, perhaps in the form of an 
Australian mandatory system, rather than less. The expectation 
also is that they are going to come up with a comprehensive 
approach rather than a continued bit by bit by bit, which has 
proved to have rather serious problems. The key lesson is that 
the UK is fixing their system while the United States is still 
working on it. The UK is likely to have a consensus by the end 
of this year or early next year. The question is whether we are 
strong enough to do the same. Thank you.
    [The prepared statement of Mr. John follows:]
 Statement of David C. John, Research Fellow, Thomas A. Roe Institute 
          for Economic Policy Studies, The Heritage Foundation
    I appreciate the opportunity to appear before you today to discuss 
what we in the United States can learn from the United Kingdom's 
experience with public pension reform. This is an extremely important 
subject, and I would like to thank both Chairman McCrery and 
Representative Levin for scheduling this hearing. Let me begin by 
noting that while I am a Research Fellow at the Heritage Foundation, 
the views that I express in this testimony are my own, and should not 
be construed as representing any official position of the Heritage 
Foundation. In addition, the Heritage Foundation does not endorse or 
oppose any legislation.
The crisis faced by the UK public pension system
    In 1997, just eight years ago, reforms made to the United Kingdom's 
pension system under both Conservative Party and Labour Party 
governments were regarded as a model for avoiding the fiscal problems 
caused by the imminent retirement of millions of baby boomers. Studies 
by international organizations and a variety of think tanks showed that 
rather than the huge increase in retirement-related costs that threaten 
to engulf most Social Security systems, the UK faced a future where 
these costs would be relatively stable in terms of the percent of GDP 
that would be devoted to paying for retirement benefits. The 
combination of reductions in government paid benefits and generous 
incentives for workers to finance their own benefits through personal 
or work-related pension plans looked like a complete success.
    This impression did not fade quickly. As recently as four years 
ago, testimony about the UK system by a leading British insurance 
executive to this subcommittee was entitled: ``Pensions: A British 
Success Story.'' \1\ However, the last few years have been hard on the 
UK pension system. Due to poor planning, constant government tinkering, 
the closure of many corporate pension plans and other factors, all 
political parties recognize the need for a comprehensive pensions 
overhaul. A UK government pensions survey to be issued this week is 
expected to reveal that only one out of every six private sector 
employees can expect to have a ``decent'' pension when they retire \2\
    The British pensions system has become a national issue. As a 
result, a late October 2004 poll showed that UK voters regarded their 
pension system as the number one issue that needed to be addressed in 
the May 2005 general election. A total of 54 percent of those polled 
listed pensions as one of the top four issues, above such usual 
political concerns as health care, crime and immigration. While in 
fact, pensions played a small role in the election, public concern 
remains high, and pension reform is expected to be a major issue in the 
coming year.
    As a partial response, the government of Prime Minister Tony Blair 
established a blue ribbon Pensions Commission under former 
Confederation of British Industry head Adair Turner that is charged 
with issuing two reports. The first, issued in October 2004, paints a 
gloomy picture of the current system, while the second, scheduled for 
fall 2005 elections, will propose solutions.
Two nations separated by a common language: the relevance of the UK 
        experience to the U.S. Social Security debate
    The British pension experience does have significant lessons for 
the American Social Security debate. However, those lessons are 
different from recent claims made by opponents of President Bush's 
proposed changes to the American Social Security system. Although there 
are superficial similarities between personal accounts in the UK system 
and those proposed for the American Social Security system, a closer 
examination shows major differences.
    First, the accounts in the UK mainly invested in either employer-
sponsored defined benefits pension plans or to individual investment 
plans similar to the American IRA. The American proposal, on the other 
hand, is completely separate from any employer-sponsored pension plans, 
and would be limited to investment through a centralized, government-
managed investment platform similar to the Thrift Savings Plan (TSP), 
which is only open to U.S. government employees and to military 
personnel.
    Further, the accounts did not cause most of the problems faced by 
British pension system. Instead, the overall UK situation closely 
parallels the problems faced by U.S. defined benefit pension plans such 
as those recently turned over to the Pension Benefit Guarantee 
Corporation by United Airlines and Bethlehem Steel.
    Finally, to the extent that personal accounts are a significant 
problem in the UK, this is mainly due to design flaws and poor planning 
that were present from the beginning, misguided short-term fixes that 
had unforeseen consequences, and the bursting of the late 1990's stock 
market bubble. While the British experience shows mistakes for 
Americans to avoid, it does not prove that adding personal retirement 
accounts (PRAs) to the American Social Security system will be a 
failure.
The structure of the UK public pension system
    The UK pension system is extremely complicated. There are two 
levels of state pensions, which are supplemented in some cases by two 
additional programs aimed at increasing the state pensions of lower 
income retirees. In addition, there are a variety of employer-related 
and personal pension plans. To make matters more confusing, workers 
have the ability to shift a portion of the taxes that fund the second 
state pension into either their employer-provided pension plan or a 
personal account. Finally, different governments over the past twenty 
years have revised and re-named various parts of the state pension 
system, changing benefit levels, tax treatment of pension 
contributions, and even account structures seemingly at random. The 
result is a constantly changing array of programs that are confusing to 
the British and can bewilder foreign observers.
    The Basic State Pension: The most basic level of public pension 
benefits in the UK is the Basic State Pension, which pays a flat-rate 
pension to all workers who have both worked and paid taxes for at least 
a minimum period. Currently, women are allowed to retire at age 60, 
while men are only allowed to retire at age 65. The retirement age for 
women will increase to 65 between 2010 and 2020 starting with women 
born in April 1950. Approximately one in eight retirees receives only 
the Basic State Pension.
    Currently, the Basic State Pension pays single people GBP 82.05 
($148.50) per week and couples GBP 131.20 ($237.50) per week. This 
equals $7,722.50 per year for single people and $12,348.50 annually for 
couples. As a comparison, the U.S. Social Security system paid 
individual retirees an average of $11,460 annually as of December 2004. 
Benefits are indexed to the change in prices, and are adjusted every 
April.
    In order to qualify for the Basic State Pension, men must work and 
pay taxes for at least 44 years, and women must work and pay taxes for 
at least 39 years. However, workers who are unemployed, unable to work 
due to illness, or who stay home to care for a family member may 
receive credits that can replace some of the required earnings years. 
U.S. Social Security benefits are based on the worker's highest 35 
years of employment, and do not give any form of credit for these 
situations.
    The State Second Pension (formerly SERPS): Since 1978, the UK has 
also had a second level of public pension that is based--at least in 
part--on past earnings. Starting in 2007, this pension level will also 
pay a flat rate benefit. Prior to 2002, the State Second Pension (S2P) 
was known as the State Earnings-Related Pension Scheme (SERPS), and 
paid benefits that are much more directly linked to earnings than the 
new S2P is to be.
    Workers receive credit towards their S2P benefits for income earned 
between 15 percent and 110 percent of national average earnings. 
Overall, they pay National Insurance Contributions (NIC) (which help to 
fund several different benefits including the Basic State Pension) 
equal to 11 percent on income between about GBP95 per week ($172 per 
week or about $8,941 annually) and GBP 625 per week ($1,131 per week or 
$58,825 annually) and 1 percent on incomes above that level. In 
addition, employers pay 12.8 percent on all income above GBP 95 per 
week. Both the income levels and tax rate are subject to change 
annually, and if the employee has contracted out of the S2P, taxes 
rates are different.
    Workers have the ability to ``contract out'' of this pension level 
and re-direct a portion of their taxes into either their employers' 
pension plan or a personal plan. In the case of an employer pension, 
the tax level is reduced, while for an individual pension plan, the 
government pays a portion of taxes directly into the plan. If a worker 
contracts out, he or she receives credit for those benefits only on a 
prospective basis; benefits already earned are not affected.
    Since 1978, the UK has changed benefits payable under both SERPS 
and S2P several times. These changes are more fully reviewed below, but 
the mixture of changes combined with the ability of workers to jump in 
and out of this pension level have resulted in some workers gaming the 
system, and make it very hard to determine benefits. The S2P is 
intended to improve benefits to low and moderate income workers, and 
gives workers who earned under GBP 12,100 annually (about $21,900) 
credit for earning that level.
    Means tested benefits: In addition to these two public pension 
levels, low income workers can qualify for additional means tested 
benefits. The Pension Credit is intended to ensure a minimum retirement 
income of at least 30 percent above that paid by the Basic State 
Pension. These benefits are reduced by 40 pence for every pound that an 
individual receives above the Basic State Pension level, and must be 
applied for. In addition, low income retirees are eligible for non-cash 
benefits that mainly rebate some or all of the local (``council'') 
taxes they pay and a portion of their rent payments.
    Employer and personal pension plans: As mentioned above, UK workers 
have the ability to re-direct a portion of their NIC into either their 
employers' pension plan or a personal pension plan. The UK had a highly 
developed defined benefit (DB) pension system, but it has been hit with 
a series of reverses similar to those that have hit DB plans in the 
U.S. As a result, the majority of these private sector plans have been 
closed to new entrants and replaced with less favorable defined 
contribution plans.
    Stakeholder Pensions: Since October 2001, employers (including 
small businesses with more than 4 employees) that do not offer workers 
another pension plan have been required to offer their employees a 
``Stakeholder Pension'' plan. Designed by the government, and intended 
to be a simple and low cost pension system that would especially appeal 
to moderate income workers. Fees for these plans were initially capped 
at one percent of assets under management, and plans were required to 
accept an opening deposit as low as GBP 20 ($36). After initial 
enthusiasm, this plan has widely been regarded as a failure, and in an 
effort to revive it, the UK Department of Work and Pensions increased 
the allowable fee to 1.5 percent of assets under management for the 
first ten years an account is open in December 2004. At the same time, 
it also reduced the regulatory burden (in the form of a required level 
of investment counseling) for certain types of simple investment 
products.
What Americans should learn from the UK public pension system
    Simplicity in program design and administration is essential: The 
UK system is overly complex both in its design and in its 
administration. To some extent, this is the unintentional consequence 
of program changes intended to correct specific problems, but the end 
result is a system that is extremely difficult for even professionals 
to understand.
    As a result, a December 2004 survey found that only 6 percent of 
felt that they understood the pension system very well, while 29 
percent did not know about key tax benefits. Not surprisingly, only 5 
percent of those polled felt that they were ``very confident that they 
would have enough to live on in retirement, and only 3 percent thought 
that state benefits would provide a comfortable income.
    Unfortunately, this complexity also applies to the administration 
of certain benefits. The Pension Credit, a means tested benefit 
intended to improve the retirement incomes of lower income retirees, 
must be applied for, and is not automatic. Retirees are required to 
answer a complex survey in order to qualify, and despite the fact that 
individuals could answer the questions over the phone, many have not 
bothered to apply for the benefits. As of September 2004, 40 percent of 
those eligible had not claimed their benefits. Experts believe that 
most of those who have not claimed the credit are those who need it the 
most--the lowest income retirees. Interestingly, the government had 
assumed that 30 percent would not claim benefits in its planning.
    Programs can have unintended motivational consequences: A side 
effect of the Pension Credit has been to reduce pension savings by low 
and moderate income workers. While the 40 pence per pound of income 
above Basic State Pension levels reduction in this benefit is actually 
significantly lower than the program that it replaced, the net result 
has been a sharp drop in pension savings. A June 2005 study found that 
almost 20 million workers earning between GBP 9,000 and GBP 25,000 
annually ($16,200 to $45,000) are not saving for retirement because 
they fear that a means tested system would penalize them for their 
savings. In the aggregate, the means tested program is estimated to 
reduce annual pension savings by about GBP 3.7 billion a year ($6.7 
billion).
    Constant change increases confusion: Change has been a constant 
feature of the UK public pension system since the 1980's. Programs and 
new benefit levels have been created, revised, and re-named many times. 
A side effect of this has been to increase confusion among UK workers.
    Looking at SERPS alone, the program was created in 1978 and 
promised to pay benefits based on the 20 best years of a worker's 
earnings. In 1986, SERPS benefits were changed to being based on all 
earnings between the age of 16 and retirement, and in 1995, changes to 
the pension formula further reduced benefits. In 2001, SERPS was 
replaced with the S2P, while the benefit formula was made more generous 
to lower income workers, and after 2007, the S2P will become another 
flat-rate pension. In 2002, thousands of workers who had contracted out 
of SERPS and its successor received letters from their financial 
services companies advising them to contract back in, as the amount 
they were savings was unlikely to be enough to equal what the 
government was likely to pay. Even though most benefit credits earned 
prior to these various changes were grandfathered in, workers can be 
excused if they feel completely confused and unsure what their benefits 
will be.
    The availability of individual accounts does not alone solve 
problems: Despite massive publicity and fanfare when they were first 
offered in April 2001, Stakeholder pensions have largely been a 
failure. Even though about 305,000 employers started these pension 
plans for their employees, and that number grew to about 350,000 by the 
end of 2003, 82 per cent of those remained as ``empty boxes'' with no 
members, while only 13 per cent of employer-based pensions have 
contributions from employers. To make matters worse, only about 1.5 
million plans were sold by the end of 2003, and sales have steadily 
dropped annually since then. Even these poor numbers do not indicate 
new savings, for about half of all Stakeholder plans were funded with 
money transferred from another existing plan. In addition, a 
significant number were estimated to be set up by wealthier individuals 
in order to claim the tax benefits of opening such an account.
    Merely designing an ``ideal'' account structure and making it 
available does not guarantee that industry will aggressively sell it--
especially if there is an unrealistic cap on fees. In the UK case, one 
key error seems to have been including marketing charges in the fee cap 
rather that limiting it to fees directly associated with the 
individual's account. Faced with such a limited profit potential, 
companies were unwilling to spend the amount necessary to continue to 
promote Stakeholder accounts. While the December 2004 fee increase may 
help, these plans have been labeled a failure, and are unlikely to 
revive as a significant retirement investment vehicle.
    Price indexing can reduce benefits below poverty: Since 1980, the 
Basic State Pension has been calculated using price indexing rather 
than growth in wages. As a result, the flat rate pension amount has 
dropped to only about 17 percent of average wages (GBP 82.05 ($148.50) 
per week and couples GBP 131.20 ($237.50) per week or $7,722.50 per 
year for single people and $12,348.50 annually for couples). The 
roughly 12 percent of retirees who only receive this pension have 
incomes that are below poverty level. If the wage indexing had been 
retained, the benefit levels would equal GBP 109 a week ($197.29 week--
$10,259 year) for individuals and GBP 174 a week ($314.94 week--$16,377 
year) for couples.
    This is not to say that changing the method of indexing is a 
mistake, but that policy makers must be aware that doing so could 
result in unacceptably low benefit levels. As a result, such a move 
should be accompanied with a benefit floor that guarantees an adequate 
minimum retirement income level.
    Poor planning increases costs: When SERPS was created 1978, the UK 
government failed to conduct accurate longer-term studies of the cost 
that these benefits would impose on their government. Its failure to 
estimate benefit payments after 2007, despite the fact that most 
younger 1978 workers would only be retiring then was a key reason why 
benefits had to be revised in both 1986 and 1995.
    This was also seen after the 1998 SERPS changes that were intended 
to encourage workers to contract out of SERPS and into either an 
occupational or personal pension plan. The government estimated that 
only between 500,000 and 1.75 million workers would take advantage of 
this option, while by 1993, almost 5 million workers (about 85 percent 
of those most likely to benefit from contracting out) actually did.
    A 1990 government study showed that while about GBP 9.3 billion 
(about $17 billion) would be paid by the government in the form of 
rebates and special bonuses into accounts, the cost of paying SERPS 
benefits in the future would only decline by about GBP 3.4 billion 
(about $6.2 billion). Pensions expert Edward Whitehouse has an even 
higher estimate of GBP 12 billion (about $22 billion) revenue lost in 
return for the same level of reduction in future benefit payments.
    A retail-based account system requires close monitoring: The most 
famous problem with the UK system, the so-called ``mis-selling'' 
scandal, is widely misunderstood in the U.S. When individuals were 
allowed to move out of SERPS into personal accounts in 1988, many were 
poorly advised by ill-trained insurance agents, and either moved out of 
employer-based plans that included an employer contribution and into 
personal plans that did not include that employer contribution, or 
failed to make an appropriate level of additional voluntary 
contributions that would be necessary to reach their retirement goals.
    The mis-selling scandal resulted more from a sales force that was 
used to selling conventional insurance products and did not themselves 
understand the products they were selling than from other reasons. The 
fact that the agents' compensation was also tied to commissions 
exacerbated the situation.
    As a result, however, a thorough investigation was conducted, and 
companies where mis-selling had occurred were required to compensate 
their customers. In addition, a new financial regulator, the Financial 
Services Authority, was created from several smaller and weaker 
regulators, and it has, if anything, overly compensated by requiring 
levels of disclosures to individual customers far in excess of those 
required in the U.S.
    For Americans, this problem is interesting, but does not apply to 
Social Security reform proposals. For one thing, the SEC and other 
financial regulators have long monitored sales to individuals and 
require significant consumer disclosures. More importantly, the 
proposed U.S. Social Security reforms are based on a government-managed 
centralized investment system, and neither individual companies nor 
agents and brokers will not be allowed to participate.
Conclusion
    It would be a mistake to assume that the UK pensions experience has 
only been one of failure. The opposite is actually true. The country 
still has a higher level of pension investments, about 70 percent of 
GDP, than any other country in Europe, and the cost of public pension 
benefits is substantially lower than most countries in the world. In 
addition, roughly 50 percent of the workforce is covered by some level 
of private pension.
    While the current UK government is responsible for some of the 
problems in their current system, most notably the Pension Credit that 
has destroyed the incentive to save for many of their workers, others 
have resulted from the collapse of the defined benefit pension system 
and problems caused by mistakes by earlier governments. The current 
government is also responsible for the Pensions Commission, whose 
recommendations are expected to result in an overall reform of their 
system.
    However, their experience teaches Americans that even well 
intentioned individual changes can only make matters worse. In 
addition, it is important to consider the overall structure of the 
complete pension system. The UK has well learned this lesson, and the 
expected October 2005 final report of the Pension Commission is 
expected to give a full picture of proposed changes in light of the 
complete pension system.
    It is important for Americans to remember that much of the UK 
experience results from special circumstances unique to that country, 
and that they do not apply to the United States. In addition, it would 
be a serious error for Americans to assume that the lesson of the UK 
experience is to discourage individual accounts, whether as part of 
Social Security or as part of 401k or other retirement savings options. 
The opposite is rather the case.
    Personal accounts are a source of strength, both in the UK pension 
system and in their economy, and the current government has been 
actively seeking ways to increase the number of workers who have them. 
It would be both ironic and sad for Americans to draw the opposite 
conclusion from their experience at the same time that the UK is 
working to build individual pension savings.
                                 ______
                                 
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---------------------------------------------------------------------------
    \1\ Statement by Keith Bedell-Pearce, Executive Director of 
Prudential, plc to the Subcommittee on Social Security, Committee on 
Ways and Means, July 31, 2001.
    \2\ ``Crisis looms for `private' pensioners,'' Scotland on Sunday, 
June 12, 2005. Available at: http://news.scotsman.com/
index.cfm?id=645242005 (June 13, 2005).

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    Chairman MCCRERY. Thank you, Mr. John. I thank all of you 
for your excellent testimony. Dr. James, in her testimony, 
talked about a mandatory add-on. By that, I took her to mean 
that the government would mandate that everybody have an 
account. It wouldn't be voluntary, it would be a mandatory 
account, and she talked about the government's financing that 
mandatory add-on account through a tax increase, basically, 
funding those accounts with general revenues from the 
government. So, you are saying--well, that is the question I 
want to get into. Let us assume, rather than the President's 
voluntary account proposal, we talked about a mandatory account 
that the government would fund. We wouldn't mandate that the 
taxpayer take another, say, 4 percent of his income out of his 
pocket to fund his account, but it would be funded by the 
government. Obviously, there are three ways to do that. The 
government could issue more debt, general debt, the government 
could cut spending elsewhere, or the government could find a 
new revenue source or increase an existing revenue source, 
increasing the tax take sufficient to fund those accounts. If 
we were to cut spending to fund the accounts or increase taxes 
to fund the accounts, we would automatically increase national 
savings, would we not? Does anybody disagree with that?
    Dr. JAMES. As long as there is no offsetting effect going 
on.
    Ms. CORONADO. By household.
    Dr. JAMES. Government impact would be positive.
    Chairman MCCRERY. Well, it is the same. The people who are 
investing, you are saying there would be a decrease in private 
investment?
    Dr. BAKER. Right. As long as there was no offsetting 
decrease somewhere else.
    Chairman MCCRERY. As long as there is no decrease in 
private investment, there would be a net increase in national 
savings; correct?
    Dr. BAKER. If you assumed that is the definition.
    Chairman MCCRERY. Well, I am trying to get to some basics 
here. Mr. Whitehouse in his testimony said that given the size 
of the U.S. economy and the maturity of our financial markets, 
capital markets, a change such as those that took place in 
South America wouldn't have as big an effect on the economy. 
So, I guess one thing I would like for you to comment on, would 
it be wise for the United States, or would it not make much 
difference, if we were to mandate personal accounts, not take 
the money from the payroll tax, but have the government fund 
those accounts from some other source. Would it be wiser to 
fund it with an increase in general revenues, or an increase in 
debt, or an increase or a decrease in other spending? Any 
comments on that? Let us assume we could do any of those.
    Dr. BAKER. I can give you a typical economist answer. It 
depends on what you are trying to do. Is the point to increase 
national saving, in which case that would have the same effect 
as any other sort of cut and spending or increase in taxes. So, 
if that is how to fund it, yes, that is one point to increase 
national savings.
    Chairman MCCRERY. Is that a good thing to increase national 
savings?
    Dr. BAKER. I do think we need to increase national savings. 
We do have a deficit that is too large. I don't know if that is 
the only way to increase national savings, but that is one way 
to do it. The second idea is, do we have to increase retirement 
security, and then you have to ask if that is the best way to 
do it. The question is, what are the goals here? Then the 
question is--you could advance both of those goods, but the 
question is, is this the best way to advance them?
    Chairman MCCRERY. Any other? Mr. Whitehouse.
    Mr. WHITEHOUSE. As I said in my testimony, the target 
benefit level under Social Security on this level is quite low 
by international standards. I don't see that as a particular 
problem, but it is for most Americans who have to make a 
voluntary provision either on their own, through an Individual 
Retirement Account (IRA), or through their employer. The issue 
for me is people who are not saving enough for retirement. Now, 
the average contribution rate to 401(k)s is 9.5 percent. That 
is, if people maintain that for a full year, going to be enough 
to give them a pretty comfortable retirement. It is the people 
who are not covered by private pensions who concern me and the 
people who are not saving enough in those private pensions. If 
one were to save--to add on to Social Security a mandatory 4-
percent contribution to some form of account--and clearly the 
people who are in 401(k)s already, they are not going to change 
their behavior, but you are going to pick up the people who are 
currently going to be relying solely on Social Security in 
their retirement, and they are not going to have a very 
comfortable retirement.
    Chairman MCCRERY. Well, I didn't understand that last 
comment. If we keep the current system and then add on a 4 
percent account?
    Mr. WHITEHOUSE. The people who are saving already in that 
401(k) are in the company plans. They don't need to change. 
They are doing that already, but there are some people who are 
not saving enough.
    Chairman MCCRERY. Right, but why wouldn't the 4 percent 
add-on account not help those who are not saving enough?
    Mr. WHITEHOUSE. It would make them save. They are not 
saving at the moment.
    Chairman MCCRERY. It would help them.
    Mr. WHITEHOUSE. Yes, it would help them. Those are the 
people who concern me. They are not saving enough. We are 
having this debate in the UK at the moment about how--the 
importance of compulsion in this. I think the United States 
performs very well. Most people are saving enough for 
retirement. People who are currently retired, most of them, are 
in a good position. There is a missing sort of 25 percent of 
the work force who are not saving enough now, and 25 percent of 
pensioners who are on very low incomes.
    Chairman MCCRERY. Dr. James?
    Dr. JAMES. Yes. Just following up, and so I can explain 
what I meant by my comment, if we want to maintain the 
currently scheduled benefit level from the total--from what I 
see as the total mandatory plan--that will require additional 
funding. That is why I thought of a mandatory add-on. The 
question is where should the funding go? Better off going into 
an individual account, in my opinion, than into the Social 
Security Trust Fund. There is a danger if it goes into the 
Social Security Trust Fund that it will be borrowed by the 
Treasury and actually increase Treasury borrowing more than we 
would have otherwise. In that case, the extra money would not 
be increasing national saving, it would leave us with a bigger 
debt at the end. So, that is a rationale for putting the money 
into individual accounts where the money is actually invested 
in productive assets, and does not--is less likely to--increase 
Treasury borrowing. In addition, as Ed Whitehouse said, what 
this really does is to make sure that everyone saves some 
minimal amount. I think the proportion that is not saving 
enough through 401(k)s is probably greater than 25 percent when 
you take into account the amount that they save, the 
consistency of saving through a lifetime, and the likelihood 
that they will keep it in the 401(k) until retirement. I 
believe the proportion with insufficient voluntary saving is 
greater than 25 percent. That is basically the reason for the 
mandate. The people who are already saving through 401(k)s 
might actually reduce that saving if they had to put the money 
into an add-on, which would be a little bit of an offsetting 
factor.
    Chairman MCCRERY. If you took it out of their pockets, yes.
    Dr. JAMES. Yes, if you took it out of their pockets.
    Chairman MCCRERY. There may be an offset, yes.
    Dr. JAMES. Now, your method might have a somewhat different 
effect.
    Chairman MCCRERY. Ms. Coronado?
    Ms. CORONADO. If I could make one general comment about the 
general revenue financing of this. You are sort of weakening--
through that method of financing, you are weakening the link 
between the taxes paid and the benefits received. If one of the 
goals of addressing the aging problem is to strengthen the 
incentives to keep working, and if your work results in higher 
benefits in the future, then that is a good thing for the 
stability of the system. General revenue financing weakens that 
link because it is not if I work more, or if I work harder, or 
if I work a year longer I am going to have more benefits, it is 
just going to come from the government. That sort of financing 
actually creates more of the dependency mentality rather than 
the right incentives for retirement, delaying retirement.
    Chairman MCCRERY. I understand that link, but I also 
understand the current fiscal situation of the United States, 
which is we are taking in more than we need to pay benefits 
right now. The surplus that we are taking in is really general 
revenue. Don't kid yourself. We are spending every penny of it 
for defense, for other things. To me, it doesn't make a whole 
lot of difference whether it is general revenues or payroll tax 
revenues. We are using that money as if it were general 
revenues and have been for quite some time, and will be for the 
next 11, 12, 13 years, depending on whose numbers you believe. 
I am not really hung up on that. I am worried about Mr. 
Whitehouse's concern about providing for a minimum level of 
retirement security for everybody in this country. I don't 
really care how we do it, except I want to do it in a fiscally 
sound way. The Social Security system, as it is currently 
built, is a ticking time bomb. As Dr. James alluded to, if we 
just increase payroll taxes we are just going to add more debt, 
in effect. That is what I want to avoid. That is why, to me, 
this concept of pre-funding through personal accounts is a no 
brainer, as evidenced by the rest of the world that is doing 
this.
    Why is the concept so hard for some to grasp that we are 
going to have to pay the bill now or pay later? The way we are 
financing this thing now, we are costing ourselves money. We 
are paying ourselves interest. We are promising ourselves to 
pay ourselves interest over time. That is swell if you are 
prepared to raise taxes enough to cover the bill. The rest of 
the world has seen that if we take advantage of capital 
markets, if we take advantage of the private sector to pay us 
interest over time, that is going to help us pay our bills for 
this minimum security that we want to provide for the people in 
the United States. What is wrong with that analysis? Dr. Baker, 
I am sure you have some comment.
    Dr. BAKER. Glad you asked.
    Chairman MCCRERY. Frankly, I am anxious to hear you because 
it is unassailable. The rest of the world has reached that 
conclusion, so, what is wrong with it?
    Dr. BAKER. Well, the rest of the world hasn't reached that 
conclusion.
    Chairman MCCRERY. Well, they seem to be headed that way.
    Dr. BAKER. That is not clear. Actually the World Bank study 
of Latin American reform programs suggested that they should 
view these privatized systems as transitions to it moving to a 
system like the United States where you have a well-defined 
benefit system and a well-working voluntary system like our 
401(k) employer-based system. I won't assume that the rest of 
the world is moving toward that at all. The second point you 
asked me what is wrong with the logic. The logic is 
unassailable. The point here is the national savings rate. Now, 
if you are concerned--it strikes me as very peculiar. I don't 
spend that much time on this at all, but the Social Security 
system is a system that is currently running a surplus. It is 
the rest of the budget that is $600 billion in deficit. If the 
Congress is concerned that we have inadequate national savings, 
it could address that tomorrow by doing something about the 
rest of that deficit. That affects how rich we will be 10, 20, 
30 years in the future. It is national savings, it is not 
Social Security, per se. So, you say, okay, we are going to 
give you this add-on, and you say, we are going to finance it 
either--well, if we do it by borrowing, debt is not going to 
affect anything at all. If we are going to do it by raising 
taxes, we could have done it anyhow. We can do it by cuts in 
other programs. That is fine. If you have the programs you want 
on the chopping block.
    Chairman MCCRERY. If we raise taxes now, Dr. Baker, to fund 
something that is going to pay us interest, to me that makes 
more sense than waiting to raise taxes even more to cover the 
interest that we promised ourselves. I see everybody else on 
the panel nodding. I just want the record to reflect that.
    Dr. BAKER. I would go back to the point that Dr. Coronado 
made, however. If you are thinking about raising taxes, I think 
it is better to raise them and put that into the individual 
accounts, so that the individual doesn't think of it as a tax. 
It is actually something that is actually revenue.
    Chairman MCCRERY. Actually, revenue neutral. If we put it 
all back into private accounts for individuals, then it is 
basically a revenue neutral approach. We have given back in the 
form of personal account money, in a personal account, every 
penny that we have raised in taxes. So, it is not really a tax 
increase. It is something that is revenue neutral.
    Dr. BAKER. You do have the administrative taxes though.
    Chairman MCCRERY. We have raised taxes, Mr. Pomeroy, on the 
one hand--don't laugh--and we have given it all back on the 
other hand.
    Mr. POMEROY. Mr. Chairman, I did not mean to snicker.
    Dr. JAMES. Could I just make a point on the administrative 
costs? The administrative costs of this plan would actually be 
lower than the average individual pays today when they save in 
401(k)s or in mutual funds. The plan could be set up to provide 
an opportunity for people to save and invest their savings at 
lower administrative costs than they face now in the voluntary 
market. That is a plus of the system, not a minus.
    Chairman MCCRERY. Thank you. I have taken far too much 
time, but I appreciate the responses of the panel, and I 
appreciate the patience of my colleagues. Mr. Levin.
    Mr. LEVIN. Well, I was going to ask some questions, but I 
think I need to----
    Chairman MCCRERY. You may. You may also take up some more 
time.
    Mr. LEVIN. I would like to say a few things about what you 
said. It is really strange that those who favor replacing the 
Social Security system because of the present budget situation 
are those who have voted for policies that have helped create--
--
    Chairman MCCRERY. Mr. Levin, let me just interrupt here 
because I am not here to defend the President's plan. You keep 
referring to the President's plan.
    Mr. LEVIN. Let me finish.
    Chairman MCCRERY. Well, I just want to make it clear that I 
am prepared to talk with you about not replacing the current 
Social Security system but adding to it, making it better. I 
would love to have that discussion, rather than you continue to 
characterize us as wanting to do away with the current Social 
Security system.
    Mr. LEVIN. That is what the President has proposed.
    Chairman MCCRERY. It is up to the Congress to dispose. The 
President may propose what he wants. It is our job to dispose. 
We can only do that through a dialog.
    Mr. LEVIN. I am all in favor of a dialog, but the President 
set a path in the State of the Union, on a strictly partisan 
basis, to say, ``I want privatization.'' It would diminish 
dramatically the replacement rate that you already say is 
relatively low compared to other plans, and also would create 
massive debt. Now--let me just finish.
    Chairman MCCRERY. Okay.
    Mr. LEVIN. We have made clear that that is unacceptable. We 
will not agree to replace the Social Security system. We will 
not agree to the diminution of the replacement rate. We will 
not agree to this massive borrowing. The President is the chief 
legislator in this country whether he is a Democrat Republican. 
He has the power to propose, and he also has the power to 
dispose. He can veto anything that we pass. It is totally 
misguided to say, all right, the President is out there, let's 
go on, but we have said yes. Once the President of this country 
says that he is willing to set aside the privatization 
proposals, we have always said we are willing to sit down and 
talk about how we shore up the Social Security system. There is 
a shortfall. We want to address it without replacing the 
system.
    The President continues to say that privatization is a 
condition for his acceptance of any plan. He is out campaigning 
saying that today while the American people are telling him 
that is not acceptable. The American people are not willing to 
have privatization of our Social Security system or whatever 
you want to call it. So, it is up to the President to remove 
the barrier to our sitting down and having a discussion as to 
this shortfall. Now, it is interesting you say the Social 
Security moneys are general revenue moneys. When it is your 
policies--I agree there was 9/11. That is part of it. There was 
a recession. We don't have to argue about who caused it at this 
point. There have been a lot of policies, including tax cut 
policies, that have not benefited savings in this country, and 
I think, have undermined this country.
    So, you use these huge deficits as an excuse to replace 
Social Security. They aren't general revenue moneys unless this 
Congress acts as if they were. In the nineties we took steps to 
make sure that we were not going to use Social Security moneys 
for general revenue purposes. We had a projected $5.6 trillion 
surplus not using Social Security moneys. So, you are saying 
because your policies have led us to use Social Security 
moneys, we therefore need to change the system, and that is 
simply not acceptable. It is not acceptable to us. You say--I 
want to say a word about the increasing of savings. Look, you 
can do it through various devices, but there are some program 
cuts that will not increase savings. If you cut education 
programs, or if you cut some other programs and force people to 
use their moneys without any government help, you are not going 
to increase the savings rate. You are essentially displacing 
private savings. If you will have the President say the same 
thing that you will, take them--go beyond the barrier of 
privatization, we will sit down. He created that barrier, not 
the Democrats, he did. You shake your head no. He is the one 
who proposed it. He is the one who continues to insist that 
they must be part of any plan. I was going to ask some 
questions.
    Chairman MCCRERY. Go ahead.
    Mr. LEVIN. Let me just ask one or two, if I might. It 
really reinforces what I have said. We each used this, the 
issue of other countries, I think, to support our own 
positions. Mr. McCrery, you have been very fair in creating 
panels. I think this is kind of an exception to the rule you 
have followed.
    Chairman MCCRERY. Thank you, Mr. Levin.
    Mr. LEVIN. It is kind of a McCrery exception. I kind of 
chuckle when the Heritage Foundation says it doesn't take a 
position on plans. No, I take my hat off to you. You have 
been--as Cato has been--very clear for decades. You want to 
replace Social Security with a private system, or whatever you 
call it. Well, I will quote back what you said and what Cato 
has said. Let me just emphasize this issue of borrowing, 
because you said in your testimony--I will just ask one 
question of Ms. James, Dr. James, excuse me. If we in the 
United States want to use--this is on page four. If we want to 
use pension reform as a way to increase national savings, we 
either must use an add-on or we must come up with a plan for 
transition finance that does not depend heavily on enlarging 
the public debt. The President's proposal, in addition to all 
of its other ramifications, involves massive debt, which it 
said in some cases, including Mr. Shaw's comments, over decades 
would be offset. We just are not willing, and most Members have 
not been willing to accept more massive debt on top of the 
trillions we already have, with the belief that 40, 50 years 
from now that that massive debt will be counteracted. So, I 
think this hearing is serving a useful purpose, and to the 
Chairman, as soon as we have an acknowledgment that private 
savings are not a condition for a discussion of the shortfall, 
we will sit down, that you say we will take it off the table.
    Chairman MCCRERY. Say that again?
    Mr. LEVIN. That we will take it off the table?
    Chairman MCCRERY. Before that.
    Mr. LEVIN. We will sit down.
    Chairman MCCRERY. Before that.
    Mr. LEVIN. What we are saying is the President has made it 
a condition that there be privatization, a diversion of Social 
Security moneys. We are not willing to accept that as a basis 
for negotiation.
    Chairman MCCRERY. Okay. Once again, that is the President's 
proposal to divert money from the trust fund and to finance it 
with debt. Once again, the President may propose all he likes. 
It is up to the Congress to dispose of those recommendations. 
If you would like to sit down, along with some of your 
colleagues, and discuss alternative ways to finance personal 
accounts so that we may pre-fund some of these obligations we 
know we have in the Social Security system, I am perfectly 
willing to do that, as, I believe, are other Republicans in 
Congress.
    Mr. LEVIN. Is it your understanding that either diversion 
of Social Security moneys or borrowing would be part of your 
proposal?
    Chairman MCCRERY. We wouldn't go in with that 
understanding, but we could go in certainly putting that on the 
table, and discussing it and seeing what we can come up with.
    Mr. LEVIN. That is the status quo, that the--it is that 
that has been the barrier, Mr. Chairman, and that the President 
take the barrier away.
    Chairman MCCRERY. Well, let us take the barrier away.
    Mr. LEVIN. Well, you take it away.
    Chairman MCCRERY. I have----
    Mr. LEVIN. Well, you haven't taken it away.
    Chairman MCCRERY. We will try.
    Mr. LEVIN. Take it away and we will go.
    Chairman MCCRERY. In plain words, it is gone. You and I can 
sit down and start from scratch and try to construct something 
that makes enough sense to enough of us so that we can pass 
something to do something very good for future generations of 
Americans as well as current generations.
    Mr. LEVIN. Well, I think the Democratic Party--and I will 
finish--we have always favored strengthening Social Security.
    Chairman MCCRERY. You have.
    Mr. LEVIN. As long as the premise is--as it was in 1983--
strengthening it, not replacing it, if that is the clear 
understanding, we can sit down. That has not been the proposal 
either of the President or from your party.
    Chairman MCCRERY. Well, I appreciate very much your offer 
to sit down, and I will look forward to taking you up on that. 
Mr. Shaw.
    Mr. SHAW. Thank you, Mr. Chairman. I can't help but wonder 
what some of these folks from across the pond must be thinking 
about, some of the things we are hearing here today.
    Mr. LEVIN. They hear more in the House of Commons.
    Mr. SHAW. We see it sometimes on C-SPAN, so, we are doing 
this to sort of make you feel at home, I guess. I would like 
to--I have to use some of my time to set the record straight. I 
do not know of one single time the President of the United 
States has put as a condition to sitting down with Democrats 
that they have to agree with his plan or they have to agree 
with individual accounts. I do know--and you heard it here 
today--that the Democratic leader on the Subcommittee on Social 
Security said that it is--that the President put his plan aside 
as a condition to sit down and negotiate, yet he has no plan to 
bring to the table. How can you negotiate with somebody who has 
no plan? That doesn't make any sense to me. I think the 
President--and the President has made it very, very clear to 
this Congress--that he is welcoming all ideas to save Social 
Security. He has one idea. Quite frankly, my idea is different 
than his. I put mine on the table, and I made him very much 
aware of it. The reason that I support individual accounts, I 
don't know any other way out of this box. Mr. Whitehouse, you 
said that 401(k)s were bringing in an average of 9.5 percent; 
is that correct?
    Mr. WHITEHOUSE. That is the Employee Benefits Research 
Institute--Investment Company Institute surveys of 401(k)s, the 
largest survey, they have average contribution, both employee 
and employer, comes to 9.5 percent.
    Mr. SHAW. Do you think it is reasonable then to assume that 
individual accounts might well throw off the same percentage?
    Mr. WHITEHOUSE. You mean that people would voluntarily 
contribute more than the amount diverted into them.
    Mr. SHAW. I am sorry?
    Mr. WHITEHOUSE. That people would make additional voluntary 
contributions to the account.
    Mr. SHAW. Is the rate of return 9.5 percent?
    Mr. WHITEHOUSE. No, no, no, that is the contribution rate.
    Mr. SHAW. Oh, I am sorry.
    Mr. WHITEHOUSE. That is the amount of earnings that people 
put in.
    Mr. SHAW. What is the rate of return? That is the important 
figure that we are talking about.
    Mr. WHITEHOUSE. I would say that over time that the real 
rate of return on pension funds in the United States is 
probably about 4 or 5 percent, real, over a very long period. I 
don't have the exact numbers, but that would be my guess.
    Mr. SHAW. So, we should probably assume that would be the 
return we will get on the individual accounts?
    Dr. BAKER. Actually not----
    Mr. SHAW. I didn't ask you. If I could--listen I have 
already heard you talk. I know you are an economist, but your 
assumptions are really over the top. Mr. Whitehouse.
    Mr. LEVIN. He is in trouble with the panel.
    Mr. WHITEHOUSE. I wouldn't like to make an over-the-top 
assumption and forecast the future. I am not very comfortable 
with that. In our work at the OECD we tend to assume a 3.5 
percent real rate of return on private funded pensions, which I 
think is a reasonable, conservative sum.
    Mr. SHAW. What is the mix on that? I know that the 
actuaries at Social Security are--I believe that they have come 
in with over 5 percent assumed return, and I think that is with 
about 25 points being paid out.
    Mr. WHITEHOUSE. I think Dr. James here, who was on the 
Commission----
    Dr. JAMES. We used, with a 50/50 portfolio, we used a 4.6 
percent net return. I am assuming that the administrative costs 
would be 30 basis points, that was 4.9 percent minus 0.3, so, 
it came to 4.6. That is for 50/50 portfolio. Of course, it 
depends on what portfolio you assume, as you know, and what you 
assume about the future.
    Mr. SHAW. All right. Mr. Vasquez, you testified on the 
Chile plan. As part of your testimony, you were talking about 
some 30 to 40 percent of the workers are self-employed and do 
not have to pay into any type of an account. What percentage of 
the workers who have employers and are not self-employed, what 
percentage of them opt to go into the personal account?
    Mr. VASQUEZ. Most of the workers are in the personal 
accounts. The issue is the level of contributions, and though 
self-employed have the option of affiliating with the private 
pension system, most of them do. They are not obligated to 
contribute, and that is why you see within the labor force--why 
30 percent of the labor force, which is self-employed, is not 
regularly contributing. They are putting their money into other 
types of investments, like their own businesses and that kind 
of thing. So, you see an increase in the rate of coverage of 
the work force from the time that the reform began, and it is 
now higher than it was before the reform happened under the old 
system. The World Bank just published a study this year that 
found since the reform was introduced, the contribution rates 
of people who were entering the work force after 1981 have 
increased significantly compared to prior to the reform.
    Mr. SHAW. So, what Dr. Baker said, that people are voting 
with their feet and leaving these plans is simply not true?
    Mr. VASQUEZ. No, I totally disagree with that. He used the 
measure of minimum pensions as some sort of an example--today 
there are about 65,000 minimum pensions that are being paid by 
the government. Let us remember that when you talk about a 
minimum pension, the government is not paying the entire 
minimum pension. It is topping up what the people who have 
accumulated money can't make up. So, it ends up paying maybe 20 
or 30 percent of that. That represents about 12 percent of the 
actual pensions that the system is paying. The vast majority of 
people who are in the system getting pensions are, if you want 
to talk about it as voting with their feet, voting in favor of 
the private sector.
    Chairman MCCRERY. Thank you.
    Mr. SHAW. Thank you.
    Chairman MCCRERY. Thank you, Mr. Shaw. Mr. Neal.
    Mr. NEAL. Thank you very much, Mr. Chairman. I also want to 
thank Chairman McCrery for not only the talent and caliber of 
the witnesses, but for the opportunity to address the 
witnesses. I wish that happened more often in the full 
Committee, but I think you have really done a good job with the 
Subcommittee. I am also pleased that he acknowledged a certain 
reality today when he said that the Social Security surplus is 
being used to fund a lot of surplus government expenditures. He 
mentioned defense and he mentioned a number of other things, 
but there is also another reality. It was used to fund the tax 
cuts, $2 trillion worth of tax cuts, over the next 10 years, 
and then to say there is a problem in the Social Security Trust 
Fund? After we ripped $2 trillion out?
    One of the problems of the modern Congress here is this is 
the Stepford Congress. This Congress has abrogated its 
authority. We don't ask questions about Iraq, we don't ask 
questions about changed policy numbers in terms of the Medicare 
debate and prescription drugs. We don't ask questions about 
people who edit reports on global warning. Nobody is dragged 
before this Congress to ask a question. Even in the European 
system or the British system members get up--Prime Minister 
Blair's own party, they resign, they go at it with him. Pretty 
good. That never happens in this Congress.
    To argue that the President doesn't dictate what the 
majority party in Congress does is disingenuous. Whatever he 
says with this Congress, majority, it goes, and everybody knows 
it. They speak with one voice on everything, and you can see 
the disarray in Iraq and across the world now because of it. 
The job of Congress is to ask occasionally, just occasionally, 
maybe a few questions about policy. Let me ask and make a 
couple of points. The witnesses today have extolled the virtues 
of privatization. You have advocated that the U.S. adopt this 
approach. At the same time we have heard some pretty glaring 
facts. There have been, quote, mis-selling scandals in the UK. 
Administrative costs have skyrocketed, eating away at people's 
benefits in many of these countries. When given the option--I 
want to come back to you, Mr. John, because you raised a good 
point about the mis-selling issue. For those of us like Mr. 
McCrery, Mr. Levin, and Mr. Shaw who were here during the 
Savings and Loan debacle, we know that part of the problem was 
that people who weren't qualified to get into that business got 
into that business, and that is something we should be mindful 
of.
    We have also heard that when given the option large numbers 
of workers don't participate in the savings programs in the UK, 
and in Chile. We have also heard that price indexes eroded the 
value of benefits quite significantly. I think that as we focus 
on the benefits of the proposals that have been offered today, 
it is also fair to focus on some of the weaknesses. The idea is 
not necessarily to strengthen capital markets, the idea is to 
provide security in retirement. We have not heard either of the 
witnesses speak to the notion of disability. We haven't heard 
the witnesses speak to the question of survivors' benefits, 
what happens to widows, what happens to children. Maybe we 
could hear from the witnesses--Dr. James you are nodding your 
head, would you speak to that, please?
    Dr. JAMES. Yes, I was actually just in Chile to study 
disability and survivors' benefits. I was there for two weeks. 
In fact, that is been an under-studied topic. If you like, I 
can tell you what their system is. It is a novel system. I 
don't know if you would like to hear the details about that. 
Basically, they use the individual accounts and turn it into a 
DB. They guarantee that a disabled person will get 70 percent 
of his last 5 years average earning. From the point of view of 
the recipient, it is actually a DB, but it is a DB that uses 
the money in the accounts. The pension fund is required to buy 
a group insurance policy that will top up the account enough to 
purchase an annuity of that value, and, because it uses the 
money in the accounts, it costs quite a bit less than most 
other countries. It costs about 1 percent of earnings per year.
    Mr. NEAL. What about survivors' benefit?
    Dr. JAMES. Same for survivors, it is part of the same 
program. I haven't completely analyzed it yet, but that is the 
basic system.
    Mr. NEAL. I know that----
    Dr. JAMES. It is something we need to talk about.
    Mr. NEAL. My time is running out. If I could go back to Dr. 
Baker here. Many of the witnesses have focused on lessons we 
could draw from countries that have had some problems with 
private accounts. They have also extolled those virtues, as I 
indicated a moment ago. What are the best lessons for us to 
learn, you think, as we get down the road in the Social 
Security debate. I meant what I said about Mr. McCrery in terms 
of the witnesses. He really has done a good job with these 
panels.
    Dr. BAKER. Well, just to repeat a couple of points. First 
off, there is no way to escape the risk that we are replacing a 
system of guaranteed benefit with risk. I know it is actually 
the intention of many people to cut benefits, and use the 
privatization as a way to cut benefits. So, you have had the 
problem in England where you are facing a situation where 
future generations of retirees will have much lower benefits, 
at least relative to their wage income, than current 
generations. Thirdly, there is a lot of illusion here about 
rates of return. In Chile you had very high rates of return in 
the eighties primarily because their main asset, Chilean 
government bonds, paid very high interest. That is in one 
pocket, and out the other pocket.
    At the risk of disagreeing with Representative Shaw, I 
raised this issue of stock returns to all the economists in the 
debate, and I have asked a very simple question. If you think 
you will get very high return on stocks, give two numbers--we 
call it the No Economist Left Behind Test--the return on 
dividends and capital gains. That is the only way we get money 
from stocks that add to your assumption on returns, 6.5, 7 
percent. Steve Goss, Chief Actuary at the Social Security 
Administration (SSA), said yes, you could get that if price/
earnings ratios first fell by one-fifth. The fact is, no 
economist can support those numbers. I might be wacky here, but 
I stand by my arithmetic.
    Mr. NEAL. Finally I would say, Mr. Chairman, that President 
Bush did indicate that his proposal for Social Security--and he 
spent a lot of time traveling this country for a guy who 
doesn't have a proposal--would include lower benefits. Thank 
you, Mr. Chairman.
    Chairman MCCRERY. Thank you, Mr. Neal. Mr. Lewis.
    Mr. LEWIS. Thank you, Mr. Chairman. Ms. Bovbjerg, I just 
want to get some respect here on the problem. Just recently, 
David Walker testified before our Committee. I am going back to 
this. I think I brought this up the last time you were here, 
that in about the year 2020, the revenue coming into the 
Treasury will only cover entitlements and interest on the 
Federal debt. There will be nothing left in discretionary 
spending. By 2040, the revenue line just comes in a little bit 
above interest on the debt. There is nothing for the 
entitlements, nothing for Medicare, Medicaid, Social Security. 
We keep hearing that Social Security will--the benefits will 
have to be cut by 23 percent, but looking at that revenue line 
by 2040, there will be no Social Security, there will be no 
Medicare, there will be no Medicaid. There will only be revenue 
enough for interest on the debt. Is that chart accurate that 
you provided for us?
    Ms. BOVBJERG. It is our simulation, and it is based on 
presuming that everything pretty much stays the same in the 
out-years. We use the SSA and Congressional Budget Office (CBO) 
assumptions. We also assume that discretionary spending would 
grow with the economy. We assume that the tax provisions would 
not expire in that particular scenario. It presumes essentially 
that you are going to make up the difference with debt, and I 
know that Mr. Walker has spoken a number of times before the 
full Committee about the economic dangers of continuing on that 
course.
    Mr. LEWIS. When the fact is that the average family is 
paying basically 40 percent of their income in local, State, 
and Federal taxes, how much higher would the taxes have to be 
to cover all of our unfunded liabilities and debt?
    Ms. BOVBJERG. Oh, it would have to really be tremendous. I 
think that one of the things I remember the last time I was 
here is you asked me about a $45 trillion number.
    Mr. LEWIS. Yes.
    Ms. BOVBJERG. I decided, since I wasn't completely sure 
what was in that, I wouldn't comment on that. I looked at that 
number, and that is really kind of mashing together all the 
obligations, the things that we think are going to be coming up 
with in the future. It is arguable whether that is--that is not 
a budget number, that is not a CBO number.
    Mr. LEWIS. Right.
    Ms. BOVBJERG. It would really represent a significant draw 
on our economy. One of the things I was thinking about in terms 
of how you finance certain things is that we don't have a lot 
of slack.
    Mr. LEWIS. Right.
    Ms. BOVBJERG. To finance more things with debt. Just 
remember, we haven't decided yet how we are going to deal with 
the health care problem.
    Mr. LEWIS. Exactly. If we were just dealing with Social 
Security, maybe we could increase taxes to deal with that, but 
when you are dealing with the other entitlements. This is a lot 
bigger problem that just saying, well, we can increase taxes. 
That burden would--when you are looking at a number that is 
four times the size of the American economy, my goodness, 50 
years ago or more the government started on a path of a charge 
account to pay for retirement and health care in this country. 
If you look at Social Security and then the Great Society and 
all of the programs, it is basically a charge account on coming 
generations, and you don't have the assets to back it up with. 
It is going to be a crushing situation if we do don't do 
something, and I think Social Security is the easiest problem 
to fix. That is all. Thank you.
    Chairman MCCRERY. Thank you, Mr. Lewis. Mr. Pomeroy.
    Mr. POMEROY. Thank you, Mr. Chairman. I do want to 
sincerely indicate my appreciation to this panel like the other 
ones that you have had. I think that you have displayed 
constructive leadership in your discussion of issues. I meant 
no disrespect. Let me just--first of all, let me set the stage. 
Ms. Bovbjerg, if I get the essence of your testimony, it is 
that we can learn from one another across the community of 
nations, but in the end we each have our own idiosyncratic 
issues, and we need to tailor our plans to reflect individual 
circumstances ranging from national values to state of the 
economy. Would that be correct?
    Ms. BOVBJERG. Absolutely.
    Mr. POMEROY. Let me move to a line that strikes me from 
your testimony, Ms. Coronado. I found the discussion of the 
Swedish plan to be interesting, but on pages four and five, you 
discuss the way adaptations have been made relative to the 
increasing life expectancies of populations, bottom of page 
four, top of page 5: ``Upon retirement, the annuity rate will 
depend on expected survival probabilities for each cohort so 
that the beneficiaries bear the risk of future improvements in 
life expectancy through lower replacement rates, although the 
government continues to bear the risk for changes in 
immortality after retirement or you retire. If your group is 
living longer, your rate, your pension, is going to go down 
relative to the income replacement rate.''
    Then you say that the reform transfers much of the economic 
and demographic uncertainties directly into benefit levels, 
leaving the financing of the system generally quite robust to 
changing economic circumstances. This is a case to me of us 
fixing the macro problem and ignoring the micro problem, the 
micro problem being the circumstances of an individual's 
finances. Let me just reflect upon changing the--transferring 
the economic and demographic uncertainties directly into 
benefit levels. We have talked a bit about longevity risk and 
longevity indexing. I think we will talk about it some more. It 
is a very interesting concept that I have some very serious 
concerns about, depending on how you address it. One way I 
wouldn't want to address it is one that reduces benefits 
because people are living longer, because as people are living 
longer you are going to have more years in retirement to have 
to deal with elevating costs. I think you made an honest 
statement there, but I don't think we want that to be a guiding 
principle of ours. I think we want to, in the end, come up with 
a reform proposal that holds micro right at the forefront of 
what we are trying to do, because we don't want to have 
people----
    Ms. CORONADO. Keep in mind----
    Mr. POMEROY. We don't want to have a healthy system on the 
one hand, and people that are old and broke on the other. So, 
we have to figure that out. In the next paragraph you talk 
about how they have structured this in a way that also 
encourages work while people can work, and moves them into 
interesting notions of phased retirement that we could probably 
learn from.
    Ms. CORONADO. Right.
    Mr. POMEROY. The core is how do we protect an adequate 
benefit over the long-term. Frankly, I have some concerns about 
this. Chilean statistics that have concerned me, Mr. Vasquez, 
are that women, especially older women, are disproportionately 
falling on the minimum guaranteed rate. Their earning power is 
less for accumulated and private accounts. Then, their years of 
receiving payment are longer. So, if you are--something like 65 
percent of women, depending on the minimum State pension--I am 
raising a concern of where that replacement rate is. What is 
the replacement rate? What is the minimum rate in terms of a 
dollar and a cent per month?
    Mr. VASQUEZ. Currently it is about $120 or so.
    Mr. POMEROY. It is $120 a month. Sixty-five percent of 
women are depending on that minimum rate?
    Mr. VASQUEZ. This is an improvement.
    Mr. POMEROY. It may be an improvement, but it is no guiding 
light for the United States to aspire to for this kind of $120 
minimum payment for elderly women.
    Mr. VASQUEZ. Chile is much poorer----
    Mr. POMEROY. Let me just ask you something across the 
panel. I will start with Dr. Baker. My time is so short. I 
don't mean to unfairly cut you off. I got what I was asking for 
with that question. It seems to me that longevity risk--the 
heart of providing a pension program that works over the long 
haul--entails keeping people in a pool so that we have a mix of 
life expectancies, and so that those that are dying earlier, in 
the end, are not drawing upon the system nearly to the extent 
of someone who lives long, so, you have a cross subsidy. You 
operate a risk pool, a longevity risk pool.
    Now, I do not understand how you run a private account for 
everybody. We are not in a pool any more. I got mine, you got 
yours, we are all individual, and you have that kind of risk 
sharing on longevity risk. So, I think one of the reasons we 
are so opposed to the private account going in is it is 
antithetical, in my opinion, to making sure that people have 
adequate benefits in their old age. Especially in times of 
increased life expectancy. That is terribly problematic. Mr. 
Chairman, I don't know if you want to allow me time to go 
across the panel, but I am done talking and I would like a 
response to that question.
    Chairman MCCRERY. Sure. If anyone would like to respond.
    Dr. JAMES. If I could answer your question about the 
Chilean minimum benefit. It is 25 percent of the average wage. 
You have to take into account the average wage in the country. 
For someone over the age of 75, it is actually 28 percent of 
the average wage. We don't have a minimum benefit like that in 
our own country currently.
    Mr. WHITEHOUSE. This is around 19 percent worth of average 
earnings. So, the minimum safety net level for all people in 
the United States is below----
    Mr. POMEROY. I would hope we could do better than 25 
percent replacement rate in terms of longevity risk protection. 
Let us get to that question. Dr. Baker.
    Chairman MCCRERY. Wait.
    Mr. POMEROY. Okay. Across the panel.
    Chairman MCCRERY. Across the panel.
    Mr. POMEROY. Longevity risk protection.
    Ms. CORONADO. May I say something?
    Mr. POMEROY. Longevity risk protection in private accounts. 
How do these two interact?
    Dr. JAMES. People buy annuities. At the point they buy the 
annuities the longevity risk is pooled, and the vast majority 
of people in Chile buy annuities.
    Mr. POMEROY. Private insurance, not social insurance.
    Dr. JAMES. It is through the private annuity market. They 
get back--studies of what they get back indicate they get back 
their full premium when you discount at the risk-free rate. It 
is privately provided, but it is a pretty good deal. It is 
price indexed.
    Mr. WHITEHOUSE. Sweden is not alone in having these 
longevity adjustments. Germany just introduced one. You have 
the same sorts of things in Italy and Poland. The idea is that 
the benefit will fall as life expectancy increases. I think the 
designers of the system hope that people will, as a result work 
longer, and so, they will retire later in these programs. As 
life expectancy increases they will work longer, and get the 
same benefit.
    Mr. POMEROY. To offset the falling benefit by working 
longer.
    Mr. WHITEHOUSE. Absolutely, that is the incentive.
    Ms. CORONADO. That is the incentive of the system. In 
Sweden, it is still the government that is sole provider of the 
annuities. It isn't even going to the market to deal with load 
factors. The government is providing the annuity. It is very 
low cost, therefore, and you are pooling risk across the entire 
population, it is just that you are doing it on a cohort-by-
cohort basis. So that as trends continue, and we don't know 
whether people are living longer and longer or whether that 
will sort of ameliorate a bit. Somebody has to pay for that.
    Mr. POMEROY. We are all victims of the notch baby issue. I 
think that cohort-by-cohort would raise some interesting 
political issues here.
    Mr. VASQUEZ. I would just emphasize that the minimum 
pension in Chile is greater as a share of the average wage than 
it is here, in the United States. Also, that studies have shown 
that women are doing much better now under the new system than 
they were under the previous system.
    Mr. POMEROY. Chile, old Chile to new Chile.
    Chairman MCCRERY. Any other members of the panel want to 
make a brief comment?
    Mr. HARRIS. I would just make a comment with regard to 
Australia, Congressman. There is a bedrock that all Australians 
will get, that is 26 percent of male total average weekly 
earnings, if they need it. Now I probably won't need it when I 
retire, hopefully I have saved enough through thrift so that 
that safety net will not come into operation due to the income 
and assets test. I think it is important to share with you that 
it was the trade unionists and social Democrats in Australia 
who said you have to give the individual the ability to save, 
and that is important in an IRA-oriented system.
    Chairman MCCRERY. Final word, Dr. Baker.
    Dr. BAKER. On the question of annuities. If you allow 
people to opt out, as President Bush proposed, invariably, 
adverse selection occurs, which reduces benefit by 10 percent. 
Also, in the Chilean system, many workers don't work enough to 
get the benefits. So, to compare apples to apples, that would 
be conservatively less than 25 percent for those who don't get 
the minimum benefit.
    Chairman MCCRERY. Mr. John, very briefly.
    Mr. JOHN. Very brief. I would just like to point out that 
my 19-year-old daughter is guaranteed to lose about 28 percent 
of her Social Security benefits due to the fact that she will 
retire 10 years after the U.S. trust fund expires, and that is 
not exactly risk free.
    Chairman MCCRERY. Mr. Ryan.
    Mr. RYAN. All right. Thank you. Two questions, but first I 
just want to make an observation based upon what we have been 
talking about here. There is one area where I think all of us 
have reached consensus, both sides of the aisle. It is a 
statement I hear politicians from left and the right making. 
That is, whatever we do, we are not going to change benefits 
for people over the age of 55. I think that is the number we 
use these days, those who are in or near retirement. We have 
all come up with the notion that we are going to figure out a 
way to make sure that those benefits are locked in, guaranteed, 
dependable for people aged 55 and above. That leads us to the 
rest of us, the rest of the country. Mr. Harris, you called 
yourself a Gen-Xer, what is a Gen-Xer? I don't know where that 
age break is.
    Ms. CORONADO. It is 1964.
    Mr. HARRIS. Those born between 1964 and1972.
    Mr. RYAN. Thank you. I didn't even know that. So, I am a 
Gen-Xer then.
    Mr. HARRIS. You're welcome.
    Mr. RYAN. My generation is expected, at best, to get a 1-
percent rate of return on our payroll taxes when we retire. 
Now, when I retire, we may or may not have the money to pay our 
benefits. My three children are expected at best to get a 
negative 1-percent rate of return on their payroll taxes. When 
80 percent of the American people pay more in payroll taxes 
than they pay in income taxes, this is a big deal. We should be 
asking ourselves, can't we do better for our money? When we 
hear from the other side, take off the table any idea of pre-
funding your retirement, of utilizing capital markets to get 
ahead, and then we will talk, that just sounds ridiculous to 
me, especially when we are not even bringing another 
alternative to the table. It is basically saying we will either 
raise taxes or cut benefits to fix this problem.
    That means that negative 1 percent rate of return that my 
kids are getting, and we are $4 trillion short of paying them 
their benefits, is going to go less than negative 1 percent 
rate of return. You are telling my generation that the 1 
percent rate of return I hope to get, future generations will 
get less than that. To me that is not fair. We should talk 
about how to make this system not just fair today, but fair for 
all generations. That is a point I want to make that is lost in 
this room every time we have these hearings. Now, Dr. Baker, I 
had a couple of questions I want to ask you. First, I went 
through your testimony here. You make some interesting points. 
You argue that Social Security's financing shortfalls are 
exaggerated and the system is in far better shape than most 
perceive, it is not a crisis. Am I paraphrasing fairly 
accurately?
    Dr. BAKER. I don't think that is my testimony, but I will 
stand by the statement.
    Mr. RYAN. I read it in one of your papers here. Then you 
argue that the slower economic growth projected by the Social 
Security trustees implies lower returns in market investments 
like stocks and bonds. In your paper, which I have here in your 
binder, you argue that a 4.6 rate of real return on stocks is 
consistent with the trustees' economic growth projections, 
which is a lot lower than their 6.5-percent growth projections 
by the SSA actuaries; therefore, you argue that personal 
accounts wouldn't be a very good deal.
    That is a very interesting point, but I am not sure they 
are consistent with one another, because you also argue in your 
paper that as stock returns fall, so do bond returns. I think 
you say that bond returns would go from 3 percent to about 2.1 
percent. If bond returns are low, then a couple of things have 
to happen. First, personal accounts invested in stocks wouldn't 
be such a bad deal after all, because what matters most is 
premiums paid to stocks over bonds. Second, any debt incurred 
in transition financing would have a lower interest rate and, 
therefore, bear a lower cost. Third, a lower bond rate in this 
country would mean that the current system's deficits would be 
much bigger than we are currently projecting. The 75 year 
actuarial deficit would grow about 30 percent, and the infinite 
rise in deficit we had calculated would about double if you go 
to a 2.1 percent bond rate.
    It seems to me if we accept your argument regarding 
economic growth and investment returns, then personal accounts 
are still a good deal; relatively speaking, transitional costs 
are more affordable and the current system's problems become 
much, much larger than we are now calculating them to be.
    Dr. BAKER. Well, let me point out a couple of things. 
First, in terms of calculating the current system's problems, 
people like to put this in a way to make it very dramatic and 
scare people. Very frankly, I don't think there is anybody in 
this room, probably anybody in the country, that really has a 
very good sense of numbers like a $4 trillion deficit or $11 
trillion over an infinite horizon, or the $44 trillion number 
we heard here. I like to express things as a share of GDP. Now, 
if you use a lower discount rate, GDP rises as well, so that 
$44 trillion we expect as the share of future income would be 
about 6 percent. You would still end up with about 6 percent, 
as a share of future income. Now, you get a more dramatic 
number in terms of trillions if you use a lower discount rate, 
but that doesn't change the nature of the economic problem.
    In terms of how individual accounts stack up if you have a 
lower return on stocks and also a lower return to bonds, I am 
very skeptical of what sort of return you will have on bonds 
and what sort of return you will have on stocks, but again, 
given the gross assumption of the trustees--those are not my 
assumptions, they are their assumptions--the return we could 
expect on stocks is about 4.5 percent. I am more agnostic on 
bonds. I coauthored that paper; I will just say that. I am, for 
the moment, willing to say 3 percent, but if you want 2.1 
percent, fair enough. The point is, that gaps about 2.4 
percentage points. The gap that is currently assumed by the CBO 
and by the actuaries in analyzing individual accounts, is on 
the order of 3.5 to 4 percentage points. If your gap is just 
2.5 percentage points, 2.4 percentage points, you assume that 
50-50 mix, whatever mix you want, and then you would assume 
administrative costs. Therefore, you are ending up with a very 
small premium.
    Mr. RYAN. It sounds like a self-defeating argument if you 
are saying the trend is that bonds will be lower, then 
transition costs are lower, returns are better for stocks 
relative to bonds, but more importantly, our projected problems 
get higher. Let's just say it is--2.1 percent from 3 percent. 
It doesn't seem like a big difference, but that doubles the 
infinite-horizon forecast and adds 30 percent to the 75-year 
window.
    Mr. BAKER. It also doubles our income, those horizons do. 
So, it is proportional. The share of our income doesn't change. 
That would be the relevant measure.
    Mr. RYAN. You are saying the notion that we should measure 
Social Security's finances in and of itself is a notion we 
shouldn't use?
    Mr. BAKER. Well, it is not terribly meaningful. Again, it 
is relative to our income. If Botswana had a debt of a trillion 
dollars, it is devastating. Us having a debt of----
    Mr. RYAN. Do you think it is meaningful that DB plans are 
measured, in and of themselves, as to their health and 
financial safety and security?
    Mr. BAKER. They aren't measured in and of themselves. They 
are measured relative to their future contributions.
    Mr. RYAN. So, with reference to Bethlehem Steel's DB plan, 
it is irrelevant whether we measure that one on its own or in 
the context of the broader economy?
    Mr. BAKER. No. I am saying it is measured relative to its 
contributions. If you expected more money coming in, then 
whatever liabilities it had today would be of less consequence.
    Mr. RYAN. Anyone else wish to comment on that? I think I 
still have a second. I can't see from here, but administrative 
costs--again, I am using that excuse.
    Mr. LEVIN. One advantage of being a senior Member.
    Mr. RYAN. That is why Mr. Rangel chooses to sit down here, 
because he can't see the light.
    Chairman MCCRERY. You are two and a half minutes over, Mr. 
Ryan.
    Mr. RYAN. I am hopeful we will have a second run. I want to 
ask you about administrative costs. Literally, I want to 
understand how you come up with $75 million per year 
administrative costs.
    Chairman MCCRERY. You can be thinking about that as we go 
to the next Member. Ms. Tubbs Jones.
    Ms. TUBBS JONES. Thank you, Mr. Chairman, and thank you, 
ladies and gentlemen, for coming this morning, now this 
afternoon. Mr. Ryan and I are in the same class. Fortunately, I 
am 55, and so, supposedly I am guaranteed a benefit. I am not 
confident that I am guaranteed a benefit if, in fact, we decide 
to go to individual accounts. I couldn't sit here--Mr. Ryan, 
you are my good friend and colleague. What was ridiculous in my 
mind was the tax cut for the top 1 percent, which put us in a 
situation where we could not fund many of the programs that the 
people in the country are relying on, like education.
    Mr. RYAN. Would my friend from Ohio yield for a second, 
ma'am?
    Ms. TUBBS JONES. Absolutely not. So, seeing how you thought 
it was ridiculous, I just wanted to put something that I 
thought was ridiculous on the record. Let me, first of all, ask 
each one of you, what is happening with health care for seniors 
in the countries? I am going to leave you out, since you have 
been with us so many times already, Ms. Bovbjerg.
    Ms. BOVBJERG. I am not much offended.
    Ms. TUBBS JONES. Dr. James, what is happening with health 
care in the country that you looked at?
    Dr. JAMES. Well, I looked at the world.
    Ms. TUBBS JONES. You testified today--I don't have but 5 
minutes, so, you can't tell me about the world.
    Dr. JAMES. Every country--if you are asking about health 
care costs, every country faces the problem of high and rising 
health care costs. There is a wide variety of solutions and----
    Ms. TUBBS JONES. For example, our seniors right now are 
faced with a significant problem of having to pay a lot of 
money for prescription drugs. Many of our seniors are using 
more, or most, of their Social Security benefit to pay for 
their prescription drug benefit. I am just curious about what 
is happening around the world, because as we talk about 
retirement security, the lack of health care for the seniors 
that are in retirement is a significant issue. If we will just 
go down the line--again, I don't have but 5 minutes and can see 
the light, so, I have to be guided by the light.
    Dr. JAMES. Let me just say that health care is much more 
complicated than Social Security, as I am sure you know.
    Ms. TUBBS JONES. Mr. Whitehouse.
    Mr. WHITEHOUSE. I will answer about the UK, as that is 
where I am from, even though I do live in France now.
    Ms. TUBBS JONES. I should say, Bon jour, comment allez-
vous?
    Mr. WHITEHOUSE. Merci, tres bien. We are very wedded--great 
political consensus on that--to our system of the National 
Health Service, which many Americans describe as socialized 
medicine. We are very happy with that because it is a system 
which delivers a pretty reasonable level of health care. It is 
not that wonderful, but it gives a pretty reasonable level of 
health care, and it is extraordinarily cheap. We are probably 
spending, possibly half of the percentage of GDP on health 
care.
    Ms. TUBBS JONES. Do you buy prescription drugs in bulk?
    Mr. WHITEHOUSE. We have a very complicated pharmaceutical 
pricing regulation system. For seniors, prescription drugs are 
free, as they are in France, as well.
    Ms. TUBBS JONES. Ms. Coronado, before I go to your answer 
on health care, I read with interest a paragraph on page three 
of your statement. It says, ``The first of these problems 
associated with the fact that benefits in Sweden were indexed 
to prices rather than wages. The result of price indexing was 
volatility of replacement rates through economic cycles when 
wages grew either more slowly or more rapidly than prices.'' 
You go on to say, ``It is worth noting that current proposals 
for price indexing benefits in the United States would also 
likely result in volatility in replacement rates and lead the 
system toward a flat benefit structure.'' Expand on that for me 
for a moment, if you would.
    Ms. CORONADO. The pressures that these systems face require 
either raising taxes or cutting benefits, and price indexing is 
proposed as a way of phasing in basically a reduction in 
replacement rates over time. It is associated because, 
ultimately what we are worried about in retirement is replacing 
a certain fraction of pre-retirement income and maintaining a 
standard of living. Price indexing has some problematic 
characteristics when you are trying to achieve that.
    Ms. TUBBS JONES. Do you suppose that is why now the 
administration has created this new term called progressive.
    Ms. CORONADO. Progressive price indexing just basically 
puts a floor on that, but you are still going to have the same 
problems in the middle and upper tiers when the real value of 
benefits is basically going to be declining over time as a way 
of achieving balance.
    Ms. TUBBS JONES. Let me ask Mr. Vasquez about health care.
    Mr. VASQUEZ. Well, I don't pretend to be an expert on 
health care. In Chile, I can only say that, to the extent that 
people who are retiring today in Chile are better off, they are 
going to be able to deal with their health care needs in a 
better way. The whole discussion about health care is something 
much more----
    Ms. TUBBS JONES. Do you know whether or not people pay for 
their own health care? Is there a Medicare kind of program? 
Prescription drugs?
    Mr. VASQUEZ. Yes, but I don't pretend to be an expert on 
that. There was some limited reform, where people contribute 
their own money to a private account. Again, that was a reform 
that was far more limited than the pension reform.
    Ms. TUBBS JONES. Mr. Harris, I would love to ask you and 
Dr. Baker and Mr. John, but I am out of time. Maybe somebody 
else will ask the same questions. I thank you all of you for 
your responses and your presentations today. Thank you, Mr. 
Chairman.
    Chairman MCCRERY. Thank you, Ms. Tubbs Jones. I would 
advise all Members that assuming we don't have--we are not 
interrupted by votes--I will allow a second round of 
questioning if anybody has any other questions and our 
panelists are agreeable to staying. Mr. Brady.
    Mr. BRADY. Thank you, Mr. Chairman. I think this hearing 
has been really helpful from the standpoint of your goals to 
try to build an educational base. As we tackle this problem, 
learning from other countries, the consequences of ignoring a 
growing retirement mass and some of the impacts of the 
decisions that are made to address the retirement, I think is 
very helpful. I am going to spare the panel a question, from 
the standpoint of, we are fortunate, as we look at solvency and 
sustainability, and can we grow the money in the United 
States--we are fortunate that we can also look at some proven 
models right in our own communities and neighborhoods.
    The Galveston plan, for example, has been in existence a 
quarter of a century. They invest only in interest-bearing 
accounts, and throughout that quarter of a century had an 
average return of about 6.5 percent. The TSP that many of us 
are putting our precious payroll dollars into over the years 
has averaged a 7.5 percent return. Our Texas teachers, which is 
a very large group--that plan has operated now over half a 
century, and the average return here is, in the last decade, 
about 10 percent--even through Enron, even through the 
recession in the dot-com bust a good, solid return. When I talk 
to average people in those plans, and I tell them, you are in a 
risky scheme, you are in a guaranteed gamble and you really 
need to come under Social Security instead, they look at me 
like I am crazy, because they have real accounts with real 
assets that have grown gradually and steadily, never in a 
direct linear way, there is risk in everything, but in a very 
good, solid way--and as a result, their retirement checks are 
much, much, much larger than Social Security. I think Mr. 
Chairman, it is really helpful from a global perspective, to 
see the experiences that this panel has outlined and then to be 
able to translate that, meld that with some proven models that 
are right around us in this room. The combination of the two, I 
think are very helpful, so, I will yield back my time.
    Chairman MCCRERY. Thank you, Mr. Brady. Mr. Becerra.
    Mr. BECERRA. Thank you, Mr. Chairman, and thank you for 
also indicating that we could have a second round. I think that 
is generous and also lends itself to meaningful discussion. I 
would also point out, as some of my colleagues have, that while 
this has been a phenomenal panel and we appreciate your 
testimony, it is undeniably an unbalanced panel because of the 
private witnesses, not including the government witness; six of 
the seven have either written or spoken in support of 
privatization. While I think it is important to have a full 
discussion, it would also be helpful to be able to air all 
perspectives, to be able to come up with meaningful policies. 
So, I do thank you for your testimony.
    Chairman MCCRERY. Mr. Becerra, I won't count this against 
your time. That is the second time we have had that comment, 
and I appreciate it because you are right, you are accurate. We 
did offer your staff the opportunity for more witnesses to 
express your point of view. Dr. Baker, and he is a mighty 
force, but he is the only one that they chose. I appreciate 
your observation. It is not my--by our that it turned out that 
way.
    Mr. BECERRA. I see our staff chattering in the back, so, I 
won't try to dispute what the Chairman has said, only to say 
that I think it is important to try to have as ample a 
discussion as possible. I do appreciate, Mr. Chairman, that I 
think you have been, and you have made every effort to try to 
be, fair and have good discussion, so, that is not a concern. I 
do believe that when we finally have a chance to sit down--and 
I think we will get there, especially if someone like the 
Chairman is helping conduct those opportunities--we will want 
to have heard from as many people as possible, from every 
perspective.
    Chairman MCCRERY. Absolutely.
    Mr. BECERRA. As we sit here and look at this panel, while 
it is great to have six perspectives and only one to counter, 
at least to provide a different perspective, it does make it 
difficult to get a full sense of what is out there. Again, be 
that as it may, you have been very generous in doing these 
hearings. I thank you for that, and I thank you for not 
counting that against my time. Just a quick point on budget 
perspective because we are seeing this discussion about how we 
don't have the money to deal with Social Security, therefore we 
have to replace it with privatization. Ms. Bovbjerg, you 
responded to some degree about that. I don't know if you know 
the numbers, but if you take the tax cuts that the President 
has proposed and, as you indicated in your assumptions, you 
project them out as if they were permanent. If you were to take 
those tax cuts that went mostly to wealthy folks and extended 
them out, the cost of those tax cuts, isn't it correct, are far 
more than the cost of making sure Social Security is solvent 
for that same period of time?
    Ms. BOVBJERG. Mr. Becerra, I don't know what those numbers 
are. I believe we might have provided something like that for 
the record, perhaps before the full Committee. I will check 
and----
    Mr. BECERRA. You can check, but I can tell you right now 
that everybody that has done an estimate on this will tell you 
the cost of the tax cuts that went mostly to wealthy people 
were somewhere between three to five times greater than the 
cost of providing solvency for Social Security for that same 
period. If we want to talk about being fiscally responsible--in 
fact, if you want to talk about being fiscally responsible, you 
can avoid extending tax cuts that are going mostly to wealthy 
folks at a time when people are saying ``the sky is falling'' 
for Social Security. Indeed you could probably take only the 
tax cuts that went to the wealthiest 1 percent of Americans, 
and with that, just with that, you have almost enough to take 
care of any solvency problems that Social Security has in the 
long term. Going back to the whole issue of Social Security and 
privatization that we have seen throughout the world, please 
tell me if I am wrong, but in every case where we talk about 
the mistakes in some of these privatization systems, the losers 
have either been the retirees or the taxpayers. When a 
mistake--the euphemism ``mistake'' is used whether it is 
because somebody got charged a lot in fees or because bad 
investment advice was given, the mistakes have cost either the 
retiree, because he or she will have less money in his account, 
or the taxpayers, who have to bail out the system to correct 
that.
    Dr. JAMES. Not exactly correct, no. In the UK, I believe 
there is a lawsuit which has resulted in about an $11 or $12 
billion settlement.
    Ms. BOVBJERG. It is $20 billion.
    Dr. JAMES. That will come from the companies.
    Mr. BECERRA. Well, Dr. James, you made my point: $11 
billion is going to go back to the retirees, because the 
companies took the money from the retirees.
    Mr. WHITEHOUSE. They are not retired yet. They are the 
workers.
    Mr. BECERRA. You made the point that I was trying to 
express, and that is that the ones that are contributing the 
money when so-called ``mistakes'' are made, are the ones most 
likely to lose, unless they, of course, happened to be 
successful in some litigation. I guarantee you that if you tell 
the American seniors that that is what they have to rely on, 
going to court so they can get their retirement benefits, I 
suspect, Dr. James, you are going to have a hard time passing 
this in Congress. Dr. Whitehouse, you mentioned rate of returns 
in private pensions average somewhere around 3.5 percent, real 
rate of return, about 3 percent. Have you examined the rate of 
return for the thousands of Enron employees in this country who 
saw Enron go bankrupt?
    Mr. WHITEHOUSE. Minus 100 percent would be my guess of 
that.
    Mr. BECERRA. What about the United Airlines employees who 
today are relying on a bankruptcy court to determine how much 
they are going to get out of their retirement?
    Mr. WHITEHOUSE. That is a DB plan. The 401(k)s do have some 
of those problems, and I believe this House is addressing these 
issues of large quantities of money in employer stock. The 
optimal employer stock in your pension plan is zero because 
your future welfare already depends on the success of that 
company, your earnings in that company. So, the way 401(k)s 
have been structured have not been regulated perhaps as they 
should have been in the past.
    Mr. BECERRA. Let me ask you one last question, as I see the 
light is red, and I know the Chairman has said we will have a 
second chance for questions. Mr. Vasquez, in the case of the 
Chile privatization model in 1981, when the military 
dictatorship decided to scrap the old DB system that was in 
place, that had a lot of problems because of abuse and 
underfunding and so forth that had occurred, and replaced it 
with a privatization system, they didn't include themselves in 
that privatization plan, did they?
    Mr. VASQUEZ. The military was not included and that was a 
big mistake. Today, they are having financial difficulties and 
they are facing the same sorts of problems as public pension 
systems.
    Mr. BECERRA. They still haven't included themselves in 
that?
    Mr. VASQUEZ. The architect of that program, Jose Pinera, 
always said it is a mistake for the military to be left out and 
they have a deficit in their public pension.
    Mr. BECERRA. Having recognized that mistake--24 years 
later, having recognized that mistake, have they now included 
themselves in the privatization plan?
    Mr. VASQUEZ. No, and that is a political problem.
    Mr. BECERRA. That is--the test of any plan that you propose 
is, are you willing to be part of it, and in this case, it 
seems that some of the leaders aren't.
    Mr. VASQUEZ. The Chilean Minister of Labor is part of it, 
and he was advocating the military to take part in it.
    Mr. BECERRA. Mr. Chairman, why don't I stop there, and if 
you have a second round, if we have any further questions, I 
will ask it.
    Chairman MCCRERY. Thank you, Mr. Becerra. Mr. Rangel, 
distinguished Ranking Member of the full Committee, do you have 
any questions you would like to ask the panel?
    Mr. RANGEL. No, but I do want to compliment you, as other 
Members have, for the selection of such qualified panelists to 
assist us to see how this has worked in other countries; and 
just once again, say publicly that I don't doubt that we all 
want to reach the same end and make certain that we provide the 
President with a bipartisan bill. So, therefore, Mr. Chairman, 
at some point we are going to have to make a political judgment 
in terms of what we can do with this information that we are 
getting, so that in the parts of the bill that we are agreed 
on, we will be able to have the pros and cons of the different 
approaches to this serious problem. I really think that you 
have made a great first effort as the Committee moves toward 
trying to reach a solution. I hope we can enjoy that same 
activity in terms of the political questions that we will have 
to face when we seriously face the problem. Thank you so much.
    Chairman MCCRERY. Thank you, Mr. Rangel. Now, are there any 
Members that would like to have a second round of questioning? 
Mr. Ryan, you may proceed.
    Mr. RYAN. Mr. Baker, I just wanted to ask you, you 
mentioned $75 billion. Where did that number come from? How did 
you come up with that? What you said at the end of the 
testimony sort of caught me off guard.
    Dr. BAKER. Sorry. Very, very simple calculation. What I was 
saying was, suppose the United States were like Chile, where 
our entire system was funded through individual accounts.
    Mr. RYAN. You said whole 12.4 percent payroll tax.
    Dr. BAKER.If you just look at the benefits that we are 
taking, roughly $500 billion a year in benefits. In Chile, the 
administrative costs are roughly 15 percent of what goes into 
the system; 15 percent of $500 billion is $75 billion a year.
    Mr. RYAN. That is an interesting computation. What if you 
added the rate of return that you would get by going to--did 
you add the rate of return, say that 4.6 percent the actuaries 
use, or the 5.2 percent on a different blended stock? Did you 
change that, or did you adjust for an increased rate return 
that would be attributed to bonds and stocks versus the current 
system?
    Dr. BAKER.I was just saying, given that amount of payout, 
given that you had 500 billion a year in payout, given 
administrative expenses that are roughly equal to 15 percent of 
what gets paid in, paid out each year that gets you $75 billion 
in administrative fees.
    Mr. RYAN. Are you saying 15 basis points or 15 percent?
    Dr. BAKER. Fifteen percent. Again, there is a confusion 
here. A lot of people have exploited, I think, and misled a lot 
of people on this. This President's commission expressed their 
cost as 30 basis points of the stocks. If I have a dollar in 
that account for 40 years, I am paying three-tenths of a cent 
for 40 years. Over that 40-year span, I have paid a cost of 12 
cents, 12 percent. Now, these systems actually have much higher 
costs. In Chile, it is around 1 percent which--you take that 
over 40 years, that would be 40 percent. Now, most money isn't 
in there for 40 years, but if you just take an average--say it 
is in there 15 years--that gets you the 15 percent.
    Mr. RYAN. I have a lot of questions. I see everybody 
shaking their heads as well. I will let Mr. Vasquez and Mr. 
John and anybody else who wants to comment on that.
    Mr. VASQUEZ. I will quickly say that the proper way to 
measure administrative costs is costs, fees, as a percentage of 
assets managed. In Chile that is 0.66 percent, and that is 
better than the mutual fund industry here in the United States. 
So, if you are going to be worried about administrative costs, 
we should also be worried about all the mutual funds here in 
the United States. We might as well propose nationalizing and 
monopolizing that. The issue in Chile is that Chileans have 
control over their Social Security, control over their 
retirement, and that is something that gets lost in technical 
analysis about administrative costs, even though the 
administrative costs are very, very low in Chile.
    Mr. RYAN. Mr. John?
    Mr. JOHN. Twelve percent over 40 years, that assumes there 
is $1 in the account and there is only that $1 in that account 
for the entire 40 years. The one advantage of any account, 
whether it is TSP or 401(k), or just a plain old Christmas 
account, is that it is joined by lots and lots of friends that 
come along as the account grows. Therefore, you especially have 
more friends joining those dollars toward the end of the 
period, and they are only in there for a very brief period of 
time.
    Dr. BAKER. It is less than 5 percent.
    Mr. JOHN. Three-tenths of 1 percent is actually an 
incredibly low amount. You are talking in terms of 30 cents per 
$100, and that is just an astonishingly good deal.
    Dr. BAKER. Ten times the cost of the current system.
    Ms. BOVBJERG. May I jump in on administrative costs for a 
minute? We did a report for this Committee several years ago on 
the range of administrative costs and how those compounded over 
a working lifetime. The range that we developed came from 
talking to a lot of people with different proposals and looking 
at a lot of different ways to think about individual's 
accounts, and it ranged from one-tenth of a percent to 3 
percent. Now, admittedly, the 3 percent maximum assumed that 
the accounts were in a very decentralized system. When we 
looked at the difference between one-tenth of a percent and 
even 1 percent over a long, working lifetime, a 45-year working 
lifetime, it was a 22 percent difference in the administrative 
costs that came out of an individual's account. My point here 
is that account administration matters a lot. This is something 
that has not always been done well in other countries, and 
something I did want to say in my testimony.
    Mr. RYAN. It has been very beneficial to hear from 
everybody on how to do this and how not to do it. Mr. Harris.
    Mr. HARRIS. There has been a lot of talk, probably too much 
talk, on that. There is a correlation between high 
administrative costs in individual accounts. I have been flying 
7,200 miles in last the 24 hours. By the time I get back to the 
UK, I think it is important to clear up this inaccuracy. I 
think it is important to note that in Australia an average 
member of a plan pays 97 cents per member, per week. Expressed 
in another way, the cost as a percentage of assets in June 2000 
were calculated as 1.29 percent of assets in the management, 
and that has fallen to 1.03 percent. In the UK, there is a 
stakeholder pension account which has a maximum administrative 
cost for everything--originally at 1 percent, now set at 1.5 
percent. The correlation between high administrative fees and 
charges or costs in individual accounts is a fallacy.
    Dr. JAMES. Could we just put the administrative cost issue 
in context, that this money is being saved, it is being 
invested, it is earning a rate of return? So, some of the 
benefits that are paid at the end come not directly from the 
dollar of contribution that was paid at the beginning, but from 
the rate of return that was earned all along the way, which far 
exceeds the 30 basis points that we are talking about; and 
therefore, as compared with the PAYGO system, you should be 
able to get the same benefit at the end for a lower initial 
contribution. I think----
    Mr. RYAN. That is the point I was hoping to make, Dr. 
James. I will just conclude.
    Chairman MCCRERY. Mr. Whitehouse.
    Mr. WHITEHOUSE. We had this implicit comparison of the 
administrative expenses of running funded systems and on the 
old PAYGO systems. I just did a check on the laptop, earlier, 
on the data I have on administrative expenses in Latin America. 
The PAYGO schemes were costing something like 30 percent of the 
benefit expenditure in administration. So, the old systems that 
were in place before that were probably more inefficient than 
the new systems are now. So, as Dr. James says, there are extra 
services you are getting for those contributions, but it is not 
true to say that they are necessarily, vastly administratively 
more inefficient.
    Mr. RYAN. Thank you, Mr. Whitehouse. Let me conclude with 
this. We heard mentioned three times that if we just repealed 
the tax cuts for the top 1 percent we could fix all these 
problems. I am not exactly sure what tax cuts are being 
referred to, but I am assuming that marginal income tax rate 
cuts--and one thing that occurred in the tax cut, we brought 
the marginal income tax rate--remember, over two-thirds of 
those who pay that are small businesses, Subchapter S 
corporations, Limited Liability Companies, we brought their tax 
rate down to the level that large corporations pay, the 
corporate tax rate.
    What is more important is, contrary to the projections that 
we were giving in Congress as to what those would, quote, 
unquote, ``cost,'' we have actually exploded those projections. 
Last year, receipts coming from those individual tax rates grew 
at double-digit rates. This year, just this quarter, receipts 
from individual income tax rates are up 16 percent. The 
corporate tax rates are up 47 percent this year from these 
lower tax rates. So, it is a matter of fact that the 
projections that estimated that, quote, unquote, ``cost'' to 
revenue lost to the tax cuts did not materialize and, more 
importantly, we are receiving higher revenues from those lower 
tax rates. So, to try and extrapolate the, quote, unquote, 
``cost'' to revenue lost from tax cuts based on old 
projections, which have already been disproved as a means to 
try and pay for Social Security, is just a comparison that now 
current history, current facts, have disproved. With that, I 
would like to yield.
    Chairman MCCRERY. Thank you, Mr. Ryan. Mr. Becerra.
    Mr. BECERRA. Thank you, Mr. Chairman. Thanks again for the 
second round. Just to comment on my friend from Wisconsin's 
comments, if indeed that is the case, that we have seen such 
great returns from the corporate tax, income taxes that are 
being paid, I would hate to see what condition we would have 
been in if, we are suffering from an over $600 billion deficit, 
as it is. If that is what we are getting, and this is as good 
as it gets with a $600 billion deficit, woe is the day we get 
into another recession with corporations having helped us 
with----
    Mr. RYAN. If the gentleman will yield, it helped reduce the 
deficit since the tax cuts passed by $150 billion. So, our 
deficit would have been higher.
    Mr. BECERRA. That is a number that can be used, but when 
you take into account the trillions of dollars the tax cuts 
have cost, it is going to be a matter of balancing things out. 
I think many of us believe that had we not gone the route of 
cutting taxes so heavily and so skewing it toward the wealthy, 
that we could have still got some of these returns done, some 
things that would have helped the business community without 
having cost the Treasury so much money, which now we will be 
paying for quite some time in deficit interest payments.
    Chairman MCCRERY. We would urge both Members to confine 
your questions to the subject at hand because these panelists 
have spent an awful lot of time here.
    Mr. BECERRA. Let me do that then. Going back to Chile, Mr. 
Pomeroy pointed out that 65 percent of women who are retiring 
fall within this minimum benefit for retirement under this 
privatized plan in Chile; and in many cases, they are receiving 
this minimum amount not because they have earned it 
necessarily, but because their actual private account would 
have paid them less, but because there is a minimum account 
amount that the government says you are entitled to, the 
government then has to make up the difference. Here we would 
call that welfare. So, we are making sure that--or, Chile is 
making sure that its retirees, regardless of their condition 
and regardless of the wisdom of their investment or the 
production of their investment, they will receive a minimum 
benefit, as minimal as that might be $140, $145.
    In many cases those individuals who are receiving that 
minimum benefit would be receiving even less were they to rely 
solely on their private account return; and only because the 
government is guaranteeing them the $140 to $145 a month 
pension are they able to receive even that. I am not sure if 
those calculations are made to determine the costs through a 
welfare system for retirees, that taxpayers have to pay for now 
that they are retired, that didn't earn enough out of these 
private accounts. I would be interested in--perhaps in writing, 
if you could supply figures--because we are short on time, if 
you could provide some remarks on what has been done to deal 
with the fact that in some cases the governments have had to, 
in essence, put seniors on welfare in order to get them a 
minimum payment.
    The other point I wanted to make--and you can comment if 
you wish on this--we put in the abstract all the time, a number 
of stories have been written about the Chile privatization 
model. An example was provided for in, I believe, the New York 
Times. A gentleman by the name of Dagoberto Sain, who is a 66-
year-old laboratory technician who was planning to retire 
because of a recent heart attack, he earns about $950 a month 
and he had been told by his pension plan that after nearly 24 
years of contributions, that he will be able to receive a 20-
year annuity. It will pay him, until he is 88, a total of $315 
a month.
    His comment was--I am quoting from the article--
``Colleagues and friends with the same pay grade, who stayed in 
the old system, meaning the Social Security tax system, people 
who work right alongside me, are retiring with pensions of 
almost $700 a month, good not until they are 86, but until they 
die. I have a salary that allows me to live with dignity,'' and 
all of a sudden when he prepares to retire, ``I am going to be 
plunged into poverty all because I made the mistake of 
believing the promises they made to us back in 1981''--and 
1981, of course, is the date that they started their 
privatization system.
    I know there are a number of concerns that are being raised 
by people in many of these countries, and I know there are 
aspects that need to be explored, as well, where some people 
have done very well. I think the difficulty for us is, how do 
we make sure that we don't have the hills and valleys for 
seniors after 40 years of work in this country, and make sure 
that everyone knows that they will be able to retire in 
dignity. So, with that, I will allow anyone who wishes to 
comment, but understanding my time is quickly expiring.
    Mr. VASQUEZ. First of all, on the minimum pension--yes, 
that is a minimal welfare type of program in Chile; and that 
costs about 0.1 percent of GDP, and it is minimal. That is a 
superior and far more efficient way of providing welfare than 
the previous system. As far as the anecdote that you provided 
from the New York Times, in my view it is----
    Mr. BECERRA. It is not an anecdote. It is a real-life case 
of an individual.
    Mr. VASQUEZ. It is an anecdote of a person that is very 
difficult to analyze because there is not enough information in 
the article as to how many years prior to it he was working. 
Was he working for the government before and then he switched? 
There are many people in Chile who were working for the 
government, and when they switched into the private system, the 
government didn't pay them the full recognition bond that other 
people in the private sector got because the government had 
been under-reporting their wages. Those people have suffered 
from the move to the private system precisely because the 
government didn't pay them the full amount, and the way to fix 
that is, get the government to pay them the full amount that 
they were owed. I suspect he may have been one of those people, 
but there is no way of telling from the article.
    Dr. JAMES. The article also contains obvious factual 
errors. For example, he could not have gotten a 20-year 
annuity; that is not one of the allowable payouts in Chile. He 
would have to have gotten a lifetime annuity, so, he may have 
colloquially said, It is a 20-year annuity, but in fact it 
could not have been. Perhaps it was a life annuity that 
promised to pay his estate for 20 years if he died early, but 
it would continue to pay him for as long as he lived. If you 
look at the replacement rate--that is, the ratio between the 
benefit that he gets and his initial wage; I don't remember the 
exact numbers there, but I think if you go back to it, you will 
find it is actually a pretty good replacement rate for 20 years 
of contributions, probably quite a bit higher than he would get 
for 20 years of contributions in the United States as a 
replacement rate.
    Mr. BECERRA. Again, you could be right, but that goes 
contrary to what he said he would be receiving, a $358 pension 
instead of a $700 pension.
    Dr. JAMES. The article was factually incorrect.
    Dr. BAKER. Just on the point about the welfare program, 
obviously, systems of accounts are not redistributive; they are 
neutral. If on top of that you have some guaranteed minimum 
benefit, that is a form of redistribution, conceivably a form 
of welfare; and that will presumably enjoy the same political 
support as other welfare programs do in this country.
    Mr. BECERRA. Mr. Chairman, thank you.
    Chairman MCCRERY. Thank you, Mr. Becerra. I think one 
lesson we have learned from this hearing today is you can't 
believe everything you read. Mr. Lewis.
    Mr. LEWIS. Thank you, Mr. Chairman. This is for the whole 
panel. Among the countries that have undertaken reform, 
primarily have solely by reducing benefits and raising taxes. 
What is the financial status of their Social Security system, 
right now? Will they have to go back and make more significant 
changes in benefits and taxes in the foreseeable future?
    Ms. BOVBJERG. It depends on how sustainable their changes 
have been. By the way, this country would be included as a 
country that has made changes to the PAYGO system, and of 
course, we are revisiting the changes. One of the things that I 
have been really struck by in looking at 31 countries is how 
normal it seems for governments to go back and revisit these 
changes. Pension reform is a work in progress in most places, 
depending on how sustainable the changes are.
    Dr. BAKER. If I can make a quick comment on that, how we 
think about this. It is not clear it is desirable to put in a 
system and then never re-examine it, because it is basically a 
fundamental democratic issue. How much money do we want to put 
aside during our working lifetime to support us at what level 
of income during our retirement? At what age do we want to 
begin to collect those benefits? Whatever we might think is a 
good idea in 2005, people might think very differently about in 
2025 or 2040. So, the fact that they might revisit that at some 
future point, to me at least, is not an obvious indictment of 
the system.
    Mr. LEWIS. Do you think this is the time we need to address 
this issue with Social Security?
    Dr. BAKER. Let me put it this way: There are a lot of other 
issues that present much more immediate problems.
    Mr. HARRIS. In Australia, Congressman, there is a 
fundamental need that an acknowledgement exists for consensus. 
This is a very important point to establish--that both major 
political parties realize that consensus is important to drive 
through pension reform, Social Security reform. They 
acknowledge that 9 percent compulsory contributions is simply 
not enough, and the Labor Party, if you like, still remains wed 
to the idea of 15 percent contributions by the individual in 
the second pillar. It is important also to note is that the old 
age pension increasingly is becoming less and less important 
for Australians as more and more people leave that program 
through the income and assets test.
    Mr. LEWIS. Let me add another question to that. Is there a 
way to--if you take personal accounts off the table, is there a 
way to fix our Social Security system for the long term? Any 
ideas on that?
    Mr. WHITEHOUSE. By contribution rates would be an obvious 
solution, which other the countries have adopted. If you look 
at the fiscal position of Social Security versus all the other 
OECD countries, the spending is already among the lowest among 
OECD countries, about 4.5 percent of GDP. The average for the 
OECD countries is about 8 percent of GDP. You have Italy there 
at the top already spending 14 percent of GDP on pensions, and 
that is forecasted to rise, even though they have had some 
fundamental reforms there. The answer, I am afraid, on the 
other side of the pond has been a mixture of tax writers, 
contribution writers, and benefit cuts.
    Dr. JAMES. In addition to that, one of the things that 
happens in the very long run is that conditions never turn out 
to be what you predicted initially. So, no matter what you do 
now to fix it, 10 or 20 years down the road, there will be 
surprises. So, I think it would be useful to think about what 
kinds of built-in stabilizers you can put into the system so 
this Committee doesn't have to hold hearings every 5 or 10 
years to fix it again. One of the surprises always comes from 
longevity increases, which are often greater than predicted. 
So, we have talked about indexing benefits to longevity. 
Another way of looking at it is to index the retirement age to 
longevity. If longevity increases, it is not unreasonable to 
expect that people would spend some of those years working 
more, and you can put a built-in mechanism in there, which 
would make it politically easier for you Congressmen and women, 
down the road.
    Mr. LEWIS. We are talking about similar demographic areas 
or concerns, too. We are coming up on two people working for 
one person on retirement, so----
    Ms. CORONADO. The Swedish system was in a much more dire 
demographic situation than the United States, and they did 
follow the route of building in some of these macroeconomic 
stabilizers, although it will remain to be seen when those 
actually have to kick in, whether that will itself induce a 
revisitation of the system. That is how they chose to set the 
system on a fiscally sustainable course, and then it could be 
revisited.
    Mr. LEWIS. Thank you.
    Chairman MCCRERY. Mr. Levin.
    Mr. LEVIN. Briefly, thanks again. Last--almost the last 
thing that was said, I think struck a chord, at least with me, 
that in order to tackle these issues, there has to be 
consensus. This issue started off on the wrong foot in that 
regard. Instead of there being an effort to sit down across 
party lines across the Rotunda and with the White House, it was 
started very differently. I do think consensus is an absolute 
essential. You can't tackle any of these long-term issues 
otherwise, including the tax issue, and that was done with the 
opposite of consensus. So, I think that is one bit of your 
experience, some of you, that I think should be taken 
seriously. Second, Mr. Chairman, is how often we have to do 
this. I do think there are other issues that may be more 
pressing in terms of fiscal impact. I think that is true. We 
acknowledge that. I would assume every 20, 30 years we will sit 
down.
    For example, the assumptions as to growth may turn out to 
be very wrong at 1.7 or 1.8. I realize that if that turns out 
to be wrong, it will have an impact not only on dollars that 
are coming in, but also on wage indexing. That is true, and I 
am not an economist, and I don't know exactly what the 
relationship would be. Immigration issues, as we look at them 
today--and they are a very difficult issue here--we may find 
out 10 or15 years from now that work force estimates were 
wrong, and the ratio of workers to recipients may have turned 
out to be incorrect. Even a two-or three-tenths of a percent 
change is a major change, I take it, in our calculation. That 
is why, for all those reasons, there has been a major 
resistance to upsetting the Social Security apple cart, a 
system that in this country has worked so well.
    Let me finish with one other point about administrative 
costs. I do think one of you said that this country is really 
different. I think the person--I think it was the person who 
ran the TSP who warned us that in terms of administrative 
costs, it was going to be very different with huge numbers of 
people paying in, employers paying into a system, than it is in 
other countries; you can't equate them. I think it was he, or 
somebody else, who thought that the private account proposal 
was therefore unworkable. I just think we need to look at the 
entire administrative picture.
    Last, I just wanted to emphasize what has been said. I 
think you have tried to create an atmosphere of fairness here, 
of objectivity, even though we have some basic disagreements. I 
don't always know what the staff says to each other. These 
staffs are talented people who work very, very hard, but they 
don't always say to us what they say to each other. So, for 
example, as to the hearing next Tuesday, I think it was said 
that we were allocated one witness, and I hope you might talk 
with the staff and see if we could be allocated more than one 
witness for next Tuesday.
    I didn't mean to lump all of you together--and if I did 
that, I should not have, even though I think there is a 
disequilibrium here. I think it would be useful if these 
hearings proceed to do what you really intend to do, and that 
is to make sure that we have a full airing because, while I 
think we started on the wrong foot--I am sure of that, the way 
this has turned out--at some point we are going to have to get 
on the right foot. I don't mean left or right. I mean the 
effective foot.
    Chairman MCCRERY. Thank you, Mr. Levin, and I agree with 
you that this panel has been excellent in their expertise 
certainly. I think it is something that we all took advantage 
of today and all appreciate. I appreciate your comments. I have 
one final question to take advantage of this expertise. One 
concern that has been expressed about personal accounts in the 
context of Social Security--and I think it is a legitimate 
concern that needs to be addressed--that low-wage workers and 
workers without continuous attachment to the workforce--women 
who have had to stay at home to raise children or those who 
have gone through times of unemployment--may have small 
personal account balances. In your studies of other countries' 
systems, has this problem been addressed in their personal 
account systems? If so, how?
    Ms. CORONADO. I could start with the Swedish system. They 
actually give credits to one of the parents of small children 
up until they are school age, so, there is a fixed credit that 
get applied to your individual account and your notional 
account for child rearing. Likewise, your unemployment benefits 
count as income in the determination of your benefits. They 
have tried to address those issues through the individual 
account mechanism.
    Mr. LEVIN. Has it affected the birth rate?
    Ms. CORONADO. No. The birth rate is very low in Sweden.
    Dr. JAMES. This problem is a problem in every contributory 
scheme. It is not specific to individual accounts. Any time you 
base your payout on contributions, on amounts or years of 
contribution, you have to deal with this issue. Some countries 
simply have a flat benefit for every old person out of general 
revenues. Then they don't have to deal with the issue. As long 
as it is contributory, you do have this problem.
    Chile has this issue certainly, because developing 
countries have it more so than Sweden. They deal with it partly 
through the minimum pension guaranty, which everyone gets who 
has contributed for at least 20 years; and that is a kind of 
insurance for low work participation, low contribution 
densities, as they call it. In fact, those are the main people 
who would end up getting the minimum pension guarantee, people 
who have not contributed for their entire working life. Once 
you have contributed for your entire working life, your own 
pension would far exceed the minimum pension guaranty. Chile 
also has a social assistance program which is means tested for 
people who have not contributed for 20 years. It pays 
approximately half to two-thirds of the minimum pension, and on 
a means tested basis, people can apply for that.
    Mr. WHITEHOUSE. Could I add something? I do have a section 
in my written testimony on treatment of low earners, and one 
further example is the case of Mexico where the government pays 
a fixed amount. I think it is--when it was introduced, it was a 
peso a day into all the workers' accounts regardless of their 
incomes. So, that is one way you can--by putting a flat rate 
amount into everyone's account as well as, say, 4 percent of 
earnings, a way you can help the low earners out. That is 
another international example.
    Chairman MCCRERY. Anyone else?
    Mr. HARRIS. Congressman, in Australia, for low-income 
earners there is a rebate system where the government will 
assist them on a dollar-for-dollar basis up to a certain level 
in terms of making co-contributions, if you like, into their 
individual accounts. With regard to smaller accounts, they are 
rolled up into what is called eligible rollover funds. They are 
high-volume, low-margin individual managed funds where a number 
of accounts are pooled together and literally put out into the 
market; and the charges on those are very low, and there is 
also some regulatory capping of pricing or charges that can be 
applied to those small accounts.
    Chairman MCCRERY. Thank you. Mr. John.
    Mr. JOHN. In the UK they have a series of credits for 
things like unemployment, inability to work due to illness, or 
family situation. Also, under the new State second pension, if 
an individual earns--which is the individual related component, 
if an individual earns under 12,001 pounds a year, they are 
credited as though they had actually earned that much, so, 
there actually is a subsidy for low-income workers in that 
case.
    Chairman MCCRERY. Thank you very much, once again, for your 
excellent testimony and your patience in answering our 
questions. We hope to report back to you in the not-to-distant 
future that we have changed our system to meet the fiscal 
obligations that we face and also meet the obligations of a 
society to its elderly. Thank you.
    [Whereupon, at 1:00 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]
              Statement of Margaret Daniels, Hurst, Texas
    I am a retired elementary school secretary for the Hurst-Euless-
Bedford School district in Bedford, Texas. I became a secretary for the 
school district while my children were in secondary school to have my 
working hours more in accord with theirs. I previously worked in banks 
under Social Security. I began drawing my own Social Security when I 
was 62 years old. I have been affected by the WEP offset for my own 
pension. However, that does not affect me as much as the GOP offset 
will should my husband pass away before I do. I would like to be able 
to draw the portion of his Social Security benefits that I would even 
if I had never worked during our marriage. I know this is a hard 
decision for you to make at this time. I believe Texas is one of the 
last sixteen states to not have repealed this. My daughter-in-law is a 
teacher in Louisiana and I believe will also be affected. Your 
consideration of this matter in your committee will be greatly 
appreciated.

                                 

     Statement of Marilyn Sprang Fransen, Rapid City, South Dakota
    I was a music teacher in Colorado from 1963 to 1975. When I quit 
teaching I went into business and took out in cash what had been put 
into the retirement association. I was married with two children and 
felt ``burned out'' by the demands of teaching.
    In 1981 I returned to the school district but in the capacity of an 
elementary office manager or secretary. I felt that my work was every 
bit as important to the education of the children of this school as my 
teaching had been, perhaps more so, because I knew the demands upon 
teachers and I aided them in every way I could. I also became nurse: 
surrogate Mommy; liaison between teachers, administrators, parents, and 
other community; and believed that I accomplished much toward making 
the school run smoothly and efficiently. I stayed happily in that 
position for sixteen years and bought back some of the teaching years' 
retirement benefits so that I could retire in 1998.
    Because I retired as a classified employee and not a certified 
employee my retirement is only adequate and just above poverty level. I 
was never informed about the GPO/WEP laws that came into effect in 
1983. I had realized that no Social Security had been taken from my 
salary those years but I also knew that as a married spouse and later 
as a divorced spouse I would be eventually eligible for half of my ex-
husband's benefits as a supplement. I realize now that my divorce 
lawyer was not aware of the laws either. Also, because of the animosity 
of my ex-husband I was driven into bankruptcy, and I truthfully believe 
my lawyer for that process was not aware, also, of the laws. I finally 
learned about my predicament when I applied for my benefits after 
turning 62 in July 2002!
    It came as a complete shock. I contacted friends and co-workers in 
the school district where I was employed and learned that they, also, 
were in ignorance about the effects these laws would have on their 
lives. They didn't and still don't believe me. The laws are so 
complicated to understand. I've had three years to try to verbalize 
what I believe has happened to me and it is still hard to make sense of 
it. I am weary of this problem and worried about how I will be able to 
live out my senior years on such a limited budget.
    Because of the loss of much needed Social Security supplemental 
benefits I am forced to work again despite health issues. I try to make 
enough each year to put money into an IRA. How unfortunate for me that 
I wasn't aware of this problem when I was working those years 1983 
to1998 in the schools. I could have been investing money in other ways 
then for this time in my life.
    I have been actively trying to contact Senators, Congressmen, the 
White House, AARP, NEA, and anyone who will listen to my plight and, 
always it seems, it falls on deaf ears. I have given up hope that the 
GPO will ever be repealed but, to me, the most unfair law is the WEP. 
Now that I have been forced back to work I am contributing to Social 
Security with the knowledge that I will never get back the benefits in 
total that people in the other 35 states of the U.S. not affected by 
WEP will get. My retirement from the school district which I served is 
so little how could anyone believe it is ``a protection against double 
dipping by highly paid State Employees'' to deny me my full benefit?
    I am convinced that the WEP arm of the SS Pension Offset Law is 
unconstitutional. I am being denied, after the fact, the right to 
pursue happiness in being able to provide ably for myself in my 
declining years! 
    It is too late for me to make up the loss of several hundreds of 
dollars a month for the rest of my life. What difference should it make 
upon my eligibility for complete benefits that I worked at very low pay 
for 20+ years as a school secretary? It is absurd that this badly 
written law should have not had a floor on it so that people in my 
salary range wouldn't be victimized in this way. I am also convinced 
that this law discriminates against women who are in lower wage slots 
in the states that are affected. Most of my co-workers in classified 
positions--cooks, kitchen managers, office clerks, bus drivers, 
custodians, nurses, teacher instructional aides, and etc.--were women 
by a large percentage as they are in most every school. We all know 
very well that statistics bear out the fact that these women live 
longer than their spouses and will suffer either widow-hood or divorce 
in their later years when supplementary benefits will be critical to 
them!
    Classified personnel have no one to lobby for them, no national 
associations that I have been able to find; and, frankly, do not 
comprehend what is being done to them. As I stated before I am having 
great difficulty convincing them that this law even exists. It is not 
particularly humorous to me that one senator in one of the affected 
states admitted to an acquaintance that he didn't even understand the 
law when he signed for it's legislation in 1983!
    I am praying that the wrong will be made right. I am praying that 
my country's governmental representatives will see the injustice I am 
seeing. And I am praying that when I reach my own 40 credits in a year 
or so I will be able to receive my full benefits and not something 
lowered by a complicated formula thought out erroneously in 1983!
    Please consider my situation and do the right thing.

                                 

     Statement of Dr. Ronald J. Gathro, Springfield, Massachusetts
Teacher Recruitment & Retention Issues
    On the Springfield Public Schools website www.sps.springfield.ma.us 
under (Teacher Resources/Teachers Helping Teachers) the following quote 
can be read: ``It's alarming but true: studies have shown that 35% of 
teachers leave the profession during the first year. By the end of the 
fifth year, 50% of teachers have left he field!'' WOW!
    Before going further, what is the profile of new teachers in 
Springfield? This statement is based on observation of participants in 
Springfield's Teacher Licensure Program over the past three years. This 
program assists new teachers in getting their Preliminary License 
(generally pass the Communication & Literacy Test and a subject matter 
test) and their Initial License. The rules on obtaining an Initial 
License vary according to what you bring to the table but for many it 
involves taking the equivalent of 18 credits (6 courses) of appropriate 
Educational Professional Development.
    What is the profile of a new teacher? Most people would say a new 
teacher just graduated from college with an appropriate education 
degree (major or minor) and is in their early 20's and raring to go! My 
observations at the Professional Development Center where teachers take 
courses for Licensure or attend New Teacher Orientation, is that this 
profile fits probably less than 25% of the new teachers in Springfield. 
I think it would be worthwhile to research new teacher profiles for the 
past 3 to 5 years. Most of the new teachers are career changers, most 
over 30, many pushing 50 or more. These people like me have had their 
careers terminated for some reason and are faced with major career and 
life choices. One acceptable choice appears to go into teaching.
    Many of the new teachers I have met in the system have one or more 
master's degrees and need only the educational component to become 
fully certified under the No Child Left Behind Act.
    Allow me to give my profile. I am 48 years old and entered the 
Springfield Public School system at the age of 46. I am a degreed 
engineer (Ph.D.). I worked in local industries for 23 years of my 
professional career. I taught part time at Western New England College 
in the School of Engineering part time for twenty of the past twenty-
three years. When my last job terminated, given the state of 
manufacturing in western Massachusetts and northern Connecticut where 
good jobs are hard to come by, I decided to give teaching a try at the 
high school level. With strong family ties, a spouse with a good job 
(25+ years) and good benefits, it is extremely hard to leave the area. 
Therefore, teaching (math in my case) became an obvious option. Not 
being certified / licensed means that only Springfield would consider 
hiring me. I was hired in 2002 on a waiver from the state. I took the 
Mathematics test and the Literacy and Communications test to obtain my 
Preliminary License. I am currently enrolled in Springfield's Licensure 
Program. This program takes between 3 and 5 years (5 being the state 
limit) to obtain your initial license.
    In 2003, at the Professional Development Center, I took the first 
class in the program. Over 20 new teachers were participating in the 
class. This past August, I took the second class in the program. There 
were 14 teachers enrolled; 13 from last year and 1 new one. After 
discussing what happened to the other 7+ teachers, the group accounted 
for over half leaving the system because they didn't like teaching or 
they got better job offers from other local cities and towns. More than 
\1/2\ left teaching altogether! I think that if the economy turned 
around maybe another 4 to 5 would leave teaching because of the 
bureaucracy and return to industry or business. For many it is 
frustrating to deal with what is going on.
    In my case as many others, I took a pay cut from $72,000 per year 
to $42,000 per year and with a Ph.D. I am at the top pay scale, new-
teachers without masters degrees get closer to $30,000. For most of the 
people at my class, their pay cuts were in the range of 25% to 50%. The 
problem is they couldn't find work in their chosen profession and are 
faced with the challenge of changing professions. In many cases, this 
career change involves obtaining another masters degree after 
completing these 18 credits of education. Most of us have never taught 
at the high school, middle school or elementary level before. Based 
upon my college teaching experience, I was not prepared for the issues 
confronting me at my high school! Additional education is generally 
mandated by law (No Child Left Behind), however it is the teacher that 
has to pay for it, out of their own pocket. In any industry that I 
worked in prior to this, if the employer mandated additional education, 
it was the employer who paid for it not the employee. If the employee 
wanted additional (not mandatory) education, the company typically paid 
a substantial portion of the cost ranging from 70% to 100%. The level 
of reimbursement may be dependent upon the grades attained.
HOW DOES THIS RELATE TO SOCIAL SECURITY?
    On top of all of this, after becoming a teacher most of us find out 
that when we retire we will be faced with the Windfall Provisions/
Government Pension Offset act. This law reduces the amount of social 
security we can collect simply because we work as teachers in the state 
of Massachusetts for a period of time at the end of our careers. Once 
you work as a teacher for 10 years, this law will impact you and 
possibly your spouse depending on the retirement options you chose. 
Since I worked in Industry for 23 years and I will work as a teacher 
for between 17 and 20 years (retiring between 62 and 65) the WEP/GPO 
will cost me personally between $2,900 and $3,800 per year. This 
represents about a 12% reduction of my retirement income. When I retire 
after 17 years at age 62, I will only receive about 69% of my highest 3 
years average salary at retirement. This is less than the career 
teacher who gets 80% and typically leaves earlier.
    After all this, you might ask why did I enter into the teaching 
profession? Simply put, I discovered that I loved teaching when I 
taught at the college level and given the loss of my career, teaching 
was a natural progression. My mortgage holder prefers to be paid 
monthly and teaching pays substantially more than unemployment or 
welfare. I teach at Putnam Vocational Technical High School. It is an 
under-performing school as designated by the state of Massachusetts. 
Teaching at Putnam is a challenge but it is fun as I can relate real 
uses of what we are learning in math class to what the students are 
doing in shop and what they will do for a living after graduation. I 
can answer the proverbial student question: ``When will I ever use this 
stuff, Mister?'' Putnam is a good fit for me and I enjoy it there.
    The congress has been educated with respect to the national 
shortage of certain teaching specialties such as Mathematics, Science, 
etc. There are a vast number of professionals who when facing economic 
downturns (layoffs vs. relocation), would gladly change professions, as 
I have done, if the change was made to be less painful!
What is needed to solve the Teacher Recruitment & Retention Issue?
      Eliminate the WEP/GPO (Windfall Elimination Provision/
Government Pension Offset) from Social Security. This costs individuals 
vast sums of retirement income when they have already taken an earnings 
reduction during their working career.
      Money for training new teachers/career changers. Money to 
hire more teachers and reduce class sizes.
      Money to hire or develop Special Education Teachers who 
are qualified in the appropriate subject matter i.e. math, science, 
history, etc. Currently, many special education teachers are in 
classrooms helping in subject areas where they have no academic clue 
regarding what is being taught. These are great people being wasted.
      Money to be used for new classroom books and equipment.
      Money to be used for curriculum development and 
improvement.
      Money to provide more in service training time for new 
teachers (less than 5 years of service).
      Money to provide a reasonable number of course electives 
and offerings that make sense of each school. Many schools cut back on 
electives when resources are tight.
      Money to pay for mandatory advanced degrees for teacher 
certification.

SOCIAL SECURITY NEEDS TO DO ITS PART IN SOLVING THE TEACHER SHORTAGE 
ISSUE BY REPEALING THE WEP/GPO!

                                 

    Statement of Bruce Hahn, American Homeowners Grassroots Alliance
    The American Homeowners Grassroots Alliance (AHGA) appreciates the 
opportunity to submit this testimony to the Ways and Means Subcommittee 
on Social Security on the subject of Protecting and Strengthening 
Social Security. Social Security is a critically important and widely 
supported tool that supports our nation's retirees. For most it is not 
the only source of retirement income, and it was never intended to be 
the sole source of retirement income. As members of the Ways and Means 
Committee look at ways to strengthen Social Security we urge that you 
simultaneously consider other programs and incentives to expand 
retirement savings. To the extent that other programs may be created or 
enhanced to increase broad based U.S. retirement savings, the pressure 
to assure higher future social security program payout rates will be 
mitigated. For that reason we recommend that the focus of the 
Subcommittee be broadened to include all elements of retirement savings 
reform.
    Retirement savings reform and other tax reform efforts are 
inextricably linked from both a policy and political standpoint. No 
matter what plans to strengthen Social Security and enhance other 
retirement savings are eventually adopted, there will be costs 
associated with them. Other pending tax reform proposals, including a 
variety of tax provisions that will expire in coming years unless 
extended will also be subject to the same budget pressures, so it makes 
sense to try to address these issues simultaneously.
    It also makes political sense to address these issues as part of a 
larger effort. The Social Security debate has become quite polarized, 
but other alternatives to increase retirement savings and other 
elements of the tax reform debate are at this point less partisan. A 
broader approach will no doubt be more complex but under the best 
circumstances may avoid gridlock and lead to a tax reform package that 
can be supported by a majority of the populace as well as Republicans 
and Democrats in Congress.
    We commend President Bush for his courage in addressing the issue 
of Social Security. You can debate the timetable, but the projections 
make it clear that this issue must be addressed. It is much better to 
begin work on social security reform today, while there are more 
options, than in the future, when Congress will have fewer options. We 
believe that the President's proposal has much to recommend but that 
thoughtful supporters of a strong Social Security program have pointed 
out some real challenges as well. We urge the Committee to take the 
best of the Administration's package and modify it so as to address the 
legitimate concerns of many thoughtful Social Security supporters who 
have made alternative suggestions. It is also important to keep in mind 
that Social Security is only one part of the puzzle in retirement 
savings, and that other unrelated retirement savings incentives may be 
key to expanding retirement saving in the U.S. To the extent that other 
programs are successful in increasing retirement savings the pressure 
for higher future social security payouts will be lessened.
    For most homeowners the single largest form of savings they can tap 
for retirement is their home equity. In many cases homeowners retiring 
today can use the equity in their pre-retirement homes to purchase for 
cash a very nice retirement home without having to draw upon any other 
retirement savings. Based on our informal discussions with many recent 
retirees this is extremely common, and may even be the dominant source 
of retirement home funding. For retirees, who often have more modest 
ongoing financial needs than their children or grandchildren, the 
economics of a reasonable retirement lifestyle that doesn't involve a 
monthly mortgage payment is not nearly so daunting as it would be for a 
couple or individual with only social security and income from 
relatively modest savings and/or pension.
    In the last decade U.S. home ownership has expanded 10 million to 
nearly 75 million, thanks to economic circumstances, and home ownership 
programs enacted by Congress and promoted by the Bush and Clinton 
Administrations. To the degree that these programs have contributed to 
the expansion of home ownership, they are almost certainly very cost-
effective contributors to retirement savings. Home financing has always 
been highly leveraged. A home that costs $100,000 and appreciates a 
modest 3% per year provides a substantially higher return relative to 
it's fractional down payment, and a huge return on that down payment if 
the equity is allowed to accumulate over the life of its ownership (or 
is rolled into successor primary residences).
    As appreciating and marketable assets (in most cases) the downside 
risk to the government's programs that stimulate home ownership is 
reduced by a home's underlying utility and likely long term 
appreciation. For this reason we believe that expanded home ownership 
incentives, especially for those at the margin of home affordability 
and with good indicators of fiscal responsibility, should be a 
significant component of a comprehensive tax reform package that has, 
as one of its primary objectives, the growth of U.S. retirement 
savings. Such a package has to take into account existing negative 
incentives, such as the fact that some low income home buyers would be 
giving up subsidized rent if they became homeowners
    Home equity as a savings vehicle has several additional advantages. 
Serious observers of human behavior of savings patterns have noted that 
inertia plays a significant role. If someone participates in a company 
401K program they are likely to stay in, and if they don't now they are 
unlikely to participate in the future. To an even greater degree a 
mortgage is a forced savings plan relative to the growing home equity 
because your mortgage lender probably won't let you opt out of future 
payments. In addition because the amount of the equity can't easily be 
precisely measured at any given time, and accessing that equity through 
refinancing requires time and effort, there is a good chance that home 
equity will be left in place and will continue to grow.
    There are many ways to increase home ownership and the attendant 
long term savings through home equity growth. They include the 
expansion of many existing programs and worthy new policy proposals 
such as home ownership tax credits and other tax incentives to 
encourage the use of existing equity for the purpose of home financing. 
They all deserve consideration. The criteria against which all 
proposals should be measured are cost effectiveness and the degree to 
which they create home ownership opportunities for those who otherwise 
would be unable to afford it.
    Of course home ownership is not the only way to increase retirement 
savings (albeit very likely one the most cost-effective under the right 
circumstances). President Bush's personal account proposal is based on 
the correct historical observation that the stock market outperforms 
the formula that drives social security payments. Some substantial 
concerns have been raised about other aspects of the proposal, but many 
critics of the President's proposal would not object to the personal 
account concept if it were funded as a separate program not tied to the 
existing Social Security program. Budget realities largely drive the 
need to integrate personal accounts into the existing Social Security 
system. If revenue could be found to fund incentives for personal 
accounts through other parts of the tax reform process, personal 
accounts could make significant contribution to peoples retirement 
savings, even if it were reduced from its current scope.
    President Bush has expressed his willingness to be flexible on his 
personal account proposal, and given that flexibility there is a basis 
for a bipartisan approach that could include other concepts to 
stimulate retirement savings as part of a broad tax reform package. 
Some other worthy proposals include:

      Make permanent the 401k improvements enacted in 2001 and 
which sunset in 2010. We suggest that the concepts in the 
Administration's personal savings account proposal be blended with an 
enhanced, means tested version of proposal to expand 401k/IRA or other 
retirement saving incentives.
      Make 401K participation automatic rather than opt in. 
Savings patterns suggest that once people participate in retirement 
savings programs they will stay in. The lowest participation rates 
(which are declining overall) are among low and moderate income 
workers. Consider additional incentives for employees (such as faster 
vesting) and employers (such as incentives to make it easier and cost 
effective for small businesses to use outside plan administrators).
      Make the tax credit for IRAs and workplace retirement 
plans permanent (many of the benefits expire in 2006). Increase the 
contribution limits and make the incentives permanent.
      Expand allowed contributions into health savings account 
IRAs, and allow annual surpluses to be rolled into retirement years 
when healthcare costs will typically rise.
      Allow for tax deduction of private mortgage insurance 
(PMI) premiums and condominium fees as these are both also costs of 
home ownership.
      Repeal the ``new homes tax'', a protectionist tariff 
which adds approximately $1,000 to the cost of a new home through the 
taxation of Canadian softwood lumber.
      Create a first time home buyers tax credit of 10% of the 
home's price, capped at $6,000 and a new home ownership tax credit to 
encourage development and rehabilitation of resident-owned housing for 
those of affordable to low and moderate income.
      Provide tax credits to homeowners and builders to 
encourage higher standards of energy efficiency in new home 
construction and remodeling.
      Tax the proceeds of annuities at the rate of dividends 
rather than ordinary income.

    The cumulative cost of all of these proposals would be substantial. 
Given federal budget realities some of these suggestions will have to 
be dropped and many of those that survive will have to be means-tested 
to focus their benefits on segments of the population that are 
currently unable to increase their savings and segments of the 
population that could be saving more but do not feel the incentive for 
savings that was instilled in our nation's generations who experienced 
the Great Depression.
    Restrictions on existing tax incentives, including some that 
benefit homeowners, will have to be enacted to generate additional 
revenues to pay for new incentives.
    What benefits will have to be trimmed? To generate additional 
revenue the current $250,000/500,000 capital gains exemption on home 
sales might be limited to the application of the proceeds to worthy 
purposes (there are currently no restrictions on the use of the 
proceeds). There are some indications that there is an unfortunate and 
growing trend towards tapping real estate equity for the purposes that 
do not either contribute to savings or other worthy uses. While there 
are many productive ways to reinvest real estate equity, we consider 
the use of tax-favored real estate equity withdrawals for such purposes 
as fancy vacations a questionable use of this favorable tax treatment. 
Worthy purposes might include income producing investments upon 
retirement, home remodeling (since it contributes to equity), the 
purchase of a second home or a more expensive primary residence (same 
rationale), education (a worthy investment in the minds of most), and 
other similarly meritorious investments.
    This same philosophy should be applied to all other tax incentives. 
To the extent that they contribute to individual wealth building, 
competitiveness, and productivity, they should be retained. Absent 
evidence that they are making a contribution to those goals, or that 
their contribution is limited, they should be more precisely targeted 
to achieve their intended objectives, cut back, or eliminated.
    The American Homeowners Grassroots Alliance is a national consumer 
advocacy organization serving the nation's 75 million homeowners. AHGA 
engages in policy issues that significantly impact homeowners and home 
ownership.