Social Security Reform: Preliminary Lessons from Other Countries'
Experiences (16-JUN-05, GAO-05-810T).				 
                                                                 
Many countries, including the United States, are grappling with  
demographic change and its effect on their national pension	 
systems. The number of workers for each retiree is falling in	 
most developed countries, straining the finances of national	 
pension programs, particularly where contributions from current  
workers fund payments to current beneficiaries--known as a	 
"pay-as-you-go" (PAYG) system. Although demographic and economic 
challenges are less severe in the U.S. than in many other	 
developed countries, 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. The Chairman of
the Subcommittee on Social Security of the House Committee on	 
Ways and Means asked GAO to testify on preliminary results of	 
ongoing work on lessons learned from other countries' experiences
reforming national pension systems. GAO focuses on (1)		 
adjustments to existing PAYG national pension programs, (2) the  
creation or reform of national pension reserve funds to partially
pre-fund PAYG pension programs, and (3) reforms involving the	 
creation of individual accounts.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-810T					        
    ACCNO:   A26778						        
  TITLE:     Social Security Reform: Preliminary Lessons from Other   
Countries' Experiences						 
     DATE:   06/16/2005 
  SUBJECT:   Federal funds					 
	     Federal social security programs			 
	     Funds management					 
	     Pensions						 
	     Retirees						 
	     Retirement 					 
	     Strategic planning 				 
	     Lessons learned					 
	     Foreign governments				 
	     Retirement benefits				 
	     Social Security Program				 

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GAO-05-810T

United States Government Accountability Office

GAO	Testimony Before the Subcommittee on Social Security, Committee on
Ways and Means, House of Representatives

For Release on Delivery

Expected at 10:00 a.m. EDT SOCIAL SECURITY

Thursday, June 16, 2005

REFORM

             Preliminary Lessons from Other Countries' Experiences

Statement of Barbara D. Bovbjerg, Director, Education, Workforce, and Income
Security

GAO-05-810T

[IMG]

June 16, 2005

SOCIAL SECURITY REFORM

Preliminary Lessons from Other Countries' Experiences

  What GAO Found

Based on preliminary work, all countries in the Organisation for Economic
Co-operation and Development (OECD), as well as Chile, have, to some
extent, reformed their national pension systems, consistent with their
different economic and political conditions. While reforms in one country
may not be easily replicated in another, their experiences may nonetheless
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 included provisions to ensure adequate benefits
for lower-income groups, though these can lessen incentives to work and
save for retirement. Also, how well new provisions are implemented,
administered, and explained to the public may affect the outcome of the
reform.

Countries with national pension reserve funds designed to partially
pre-fund PAYG pension programs provide lessons about the importance of
early action and sound governance. Funds that have been in place for a
long time provide significant reserves to strengthen the finances of
national pension programs. Countries that insulate national reserve funds
from being directed to meet other social and political objectives are
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, cut back
or eliminated the PAYG programs, or some combination of these. Because no
individual account program can entirely protect against investment risk,
some countries have adopted individual accounts as a relatively small
portion of their national pension system. Others set minimum rates of
return or provide a minimum benefit, which may, however, limit investment
diversification and individuals' returns. To mitigate high fees, which can
erode small account balances, countries have capped fees, centralized the
processing of transactions, or encouraged price competition. Although
countries have attempted to educate individuals about reforms and how
their choices may affect them, some studies indicate that many workers
have limited knowledge about their retirement prospects.

                 United States Government Accountability Office

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.

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,

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.

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.

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

  Background

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:

o  	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.

o  	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

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.

rates to pay scheduled benefits. Funds can be invested in a combination of
government securities and domestic as well as foreign equities.3

o  	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:

o  	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.

o  	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.

o  	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

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.

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

a

      Groups of countries undertaking different types of reform Luxembourg

                            Adjustments to   Adjustments to   
                            PAYG and         PAYG and         
Only adjustments to PAYG National Pension Individual       All Three Types 
                            Fund             Accounts         
Austria                  Belgium          Australia        Denmark         
bCzech Republic          Canada           Chiled           Sweden          
Italy                    Finland          Hungary           Switzerlandg   
cGermany                 France           Icelande         
Turkey                   Greece           Mexico           
                            Ireland          Poland           
                            Japan            Slovak Republic  
                            Korea            UKf              

                                  Netherlands

                              New Zealand Portugal

                                     Norway

Spain

U.S.

Source: OECD, International Social Security Association, and the Social
Security Administration.

aMember nations of the OECD and Chile.

bThe 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.

cGermany'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.

dChile is not an OECD country, but was included in our study because it
pioneered individual account reforms.

eIceland'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.

fThe UK requires either participation in a state earnings-related pension
program or an approved alternative including individual accounts.

gSwitzerland'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.

o  	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.

o  	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.

o  	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.

o  	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.

o  	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 meanstested
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

  Early Action and Effective Management Help Make National Pension Reserve Funds
  Successful

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.

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
prefunding. 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.

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

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.

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.

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

6 The countries we reviewed require a range of annuity options, including,
for example, inflation indexed, joint and survivor, or gender-neutral.

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
widelypublicized "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.

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.

  Concluding Observations

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

(130503)

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.

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