Social Insecurity

Why an increasing number of countries are turning to market-based pension plans

Brink Lindsey from the March 2002 issue

(Page 3 of 4)

Broken Promises, Spectacular Reform

The breach of faith has been especially severe in developing and transitional countries. Failure to adjust benefits for inflation was a favorite strategy in Latin America. The average real pension dropped 80 percent in Venezuela between 1974 and 1992 because of inflation; benefits fell 30 percent in Argentina between 1985 and 1992 for the same reason. In the transitional economies, a combination of inflation, explicit benefit cuts, and accumulation of arrears kept pension expenditures as a percentage of GDP more or less constant despite rapid growth in the number of pensioners. Consequently, in Romania, retirees' real per-capita income fell 23 percent between 1987 and 1994; in Hungary, the fall was 26 percent; in Latvia, 42 percent. In 1999, some four million elderly Russians were expected to survive on the minimum pension of 234 rubles (less than $10 dollars) a month. Millions more received nothing as the government simply failed to honor its obligations to its most vulnerable citizens.

On a less dramatic scale, chiseling has been occurring in rich countries as well. In the United States, a 1983 patch-job for Social Security included making benefits taxable for high-income recipients, skipping inflation indexation for one year, and gradually raising the retirement age from 65 to 67. Germany has scheduled an increase in the retirement age and reduced benefit levels by basing them on post-tax rather than pre-tax wages. Japan cut benefits back in 1986. Iceland shifted to a means-tested benefit in 1992, thereby eliminating payments altogether for thousands of retirees. While such moves and others like them may have been necessary under the circumstances, the fact remains that promises have been broken, repeatedly, and more infidelity is in store.

As the gap between promise and reality grows ever wider, countries around the world have begun to experiment with alternatives to the collectivized status quo. Leading the way was Chile, which in 1981 moved to phase out its pay-as-you-go system and replace it with privately owned individual retirement accounts. Instead of the old 26 percent payroll tax, workers are now required to deposit 10 percent of their wages into special savings accounts. Private companies, known as "administradoras de fondos de pensiones" (AFPs), manage the accounts. Workers are free to choose their AFP and switch their savings from one to another. Upon retirement, workers can either use their accumulated savings to purchase a lifetime annuity from an insurance company, or else leave the money in the account and make programmed withdrawals. Any money remaining in the account when the retiree dies can be passed on to heirs.

Workers who entered the labor force after the new system was in place were required to participate in the new system, while those who had already retired had their benefits under the old system guaranteed. Transitional workers were given the choice between sticking with the old system or switching to the new; if they switched, they were given a "recognition bond" to credit them for their prior contributions. The bond was placed in the worker's account and its amount was set so that, at retirement, it would be equal to the worker's accrued benefits under the old system.

Finally, the Chilean pension reform maintains a safety net in the form of a minimum pension guarantee. If for any reason a retiree's private benefits do not meet a minimum threshold, the government will supplement those benefits to bring them up to that threshold. Such supplemental payments are funded from general tax revenues, not a payroll tax.

Chile's pension reforms have been a spectacular success. Some 5.9 million workers owned private savings accounts by the end of 1998 -- up from 1.4 million at the end of 1981. More than 95 percent of the transitional workers who were given a choice have decided to join the new system. Assets in that system have grown to over 40 percent of GDP and are projected to reach 134 percent of GDP by 2020. The real rate of return on those assets averaged a gaudy 11.3 percent a year through 1999. A 1995 study found that pension benefits averaged 78 percent of a retiree's average salary over the last 10 years of his working life.

Meanwhile, the reforms have generated an impressive array of ancillary benefits. In conjunction with other market-oriented reforms, pension privatization has helped to raise Chile's national savings rate from around 10 percent in the late 1970s to over 25 percent at the beginning of the 21st century. Capital markets have deepened dramatically thanks to the accumulation of large private pension funds. Financial markets have grown in sophistication as well as size: Stock market liquidity has increased; new financial instruments like indexed annuities and mortgage-backed bonds have been developed; and transparency has improved with better disclosure and the emergence of credit-rating institutions. One econometric analysis credits the development of financial markets promoted by pension reform and related factors with increasing total factor productivity in Chile by 1 percentage point per year, or half the overall rate of increase.

Perhaps most important, pension reform has helped to end the class conflict that so convulsed Chile during the 1970s. "We recognized that when workers do not have property, they are vulnerable to demagogues," recalls José Piñera, who as minister of labor was the architect of Chile's pension privatization. (Full disclosure: Piñera and I are colleagues at the Cato Institute.) "The key insight of our pension reform was that, by allowing workers to acquire property in the form of financial capital, we could strengthen their commitment to the free market by aligning their interests with the health of the economy."

Piñera and his fellow reformers turned the tables on Marx: Workers became owners of the means of production, but through the expansion of the market system rather than its overthrow. In the process, Marxist-style collectivism lost much of its appeal. "Since our reforms we have had three center-left governments," observes Piñera, "and none of them has touched the core of our major free-market policies. And one reason for this is that nobody dares to threaten the value of the workers' retirement accounts."

Recovering from Dysfunction

A host of other countries have followed Chile's example in recent years. Argentina, Australia, Bolivia, Colombia, El Salvador, Hungary, Kazakhstan, Mexico, Peru, Poland, Sweden, Switzerland, the United Kingdom, and Uruguay have all instituted mandatory private savings plans that, to a greater or lesser extent, supplant the old pay-as-you-go approach. In most of these countries the new private system only partially replaces the pay-as-you-go system. In Hungary, for example, workers contribute 6 percent to private accounts while a 24 percent payroll tax continues to support the old system. In Sweden, a 16 percent payroll tax goes to maintain the old system, while 2.5 percent of a worker's salary now goes into a private account. The Bush administration is now considering a similar partial privatization for the United States.

Partial reforms are still only a partial solution. Private accounts will help to generate higher returns for future generations of retirees, but those generations will still be saddled with a dysfunctional, if somewhat shrunken, pay-as-you-go Ponzi scheme. The longer that thorough reform is delayed, the more unfavorable the demographic situation becomes and the more onerous the burdens of maintaining the old system are.

It must be acknowledged, though, that the path toward full-scale privatization -- with government-provided benefits limited to ensuring some guaranteed minimum -- is arduous and lined with hazards. The most obvious hurdle to overcome is financing the transition from the old to the new system. Phasing out the traditional system does not create any new costs; on the contrary, by preventing future unfunded liabilities from accruing, reform contains and ultimately cuts off the flow of red ink. But there is a temporary cash-flow problem: Benefits under the old system must be paid out to current retirees, but the contributions that formerly funded those benefits are now being directed into private accounts. Other sources of funds must be tapped to pay off the remaining liabilities -- which can be staggeringly large.

The Chilean experience shows that this obstacle, though daunting, is not insuperable. The implicit debt of its pay-as-you-go system had grown in excess of 100 percent of GDP. But shifting most current workers out of the old system quickly slashed that figure. To deal with what remained, Chile used a variety of methods. It continued a portion of the payroll tax for a number of years, sold off state-owned enterprises to raise revenue, cut other government expenditures, issued new government bonds, and painlessly reaped the benefits of the additional tax revenues that came from a faster-growing economy. Together, these measures have sufficed to cover the transition's financing requirements, which have ranged from 1.4 to 4.4 percent of GDP per year.