Social Insecurity

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

Brink Lindsey from the March 2002 issue

(Page 4 of 4)

Other risks lurk in designing a new system. While some measure of prudential regulation may be necessary, especially in countries with underdeveloped financial markets, excessive government meddling in how private accounts are to be invested can reduce returns for savers -- possibly catastrophically. Chile, for example, still requires AFPs to guarantee a minimum return relative to other AFPs. Consequently there is little difference in the portfolios of the various AFPs, therefore denying savers the opportunity to choose different mixes of risk and return. Also, Chile has rigid restrictions on the commissions charged by AFPs that prevent discounts based on maintaining a specific balance or keeping an account for some specified amount of time. Thus prevented from competing effectively on product or price, the AFPs attempt to lure customers through marketing ploys -- just as American banks in the days of interest rate controls offered toasters for new accounts. Such empty competition drives up administrative costs.

In Mexico, meanwhile, fund managers are required to invest a minimum of 65 percent of assets in government securities -- a grievously wrongheaded mandate that risks turning the system into a dumping ground for government debt. A fiscal crisis, not a remote contingency in Mexico by any means, could wipe out the retirement savings of a generation. The Mexican system also prohibits investments in equities or any foreign assets. Such restrictions stifle the new sophistication in financial markets that is an enormous side benefit of privatization, as well as preventing prudent portfolio diversification. In poorer countries with underdeveloped financial markets, it is especially important that savers be allowed to invest in high-quality foreign assets.

Whether in the form of regulation or market participation, overweening government control over investments in a "privatized" system merely substitutes one form of hyper-centralization for another. Indeed, for decades many developing countries have pursued this variation on top-down control in a pure and explicit form. Rather than adopting pay-as-you-go systems, these countries, including India, Malaysia, Singapore, and a number of African nations, created retirement plans in which there is a single retirement fund or "provident fund" and the government manages all the investment assets.

These provident fund systems do avoid the perverse Ponzi-scheme dynamics of conventionally collectivized social insurance -- but only to fall prey to other dysfunctions. Specifically, the government as investment-fund monopolist is immune from competitive pressure to earn a decent return; consequently, it is not constrained from investing in ways that are politically advantageous but economically dubious. Unsurprisingly, the performance of provident fund systems has ranged from lackluster to disastrous. In the latter category, Kenya's system averaged a negative 3.8 percent rate of return during the 1980s, while returns in Zambia averaged negative 23.4 percent.

Social insurance is not menaced by excessive reliance on markets. On the contrary, it is the systematic suppression of market principles that has put the retirement security of millions in jeopardy. Undoing past mistakes will require formidable resolve, as will resisting the continuing temptation to attempt control from above. But if the resolve can be found, the proper direction is clear: For the sake of retirement security, for the sake of true social cohesion, the growing movement for market-based reform in social insurance is the one best hope there is.