Reforming Social Security: Lessons from Thirty Countries

Policy Reports | Social Security

No. 277
Thursday, June 09, 2005
by Estelle James

Executive Summary

Social Security reform in the United States has become a nationally debated topic, but privately managed, funded plans are already a component of the social security systems of more than 30 nations around the world. Chile, Switzerland, the Netherlands and the United Kingdom were the first countries to reform, in the 1980s. Most countries in Latin America, Eastern and Central Europe, as well as some in the Asian-Pacific region, created similar systems during the past 10 years. The Latin American and Eastern European countries funded their worker-based personal account systems by diverting money from a pre-existing payroll tax. By contrast, the industrial countries in Western Europe, along with Australia and Hong Kong, made employer-based retirement plans mandatory, in addition to their tax-financed systems.

Examining these reformed systems may offer useful insights for the United States as we consider our own social security reforms. The experience of other countries suggests problems to be avoided and solutions to be emulated. In particular, we can learn how to keep administrative costs low, how to reduce risk, how to handle payouts and how to ensure that the elderly are kept out of poverty.

Structural Differences and Similarities. Although most pension reforms have similar goals, we find dramatic structural differences and also some striking similarities among them. For example:

  • Contributions to personal accounts range from a low of 2.5 percent of wages in Sweden to a high of 12.5 percent (including fees) in Chile.
  • In most cases, contributions are made with funds that otherwise would have been paid as payroll taxes (called a “carve out”); however, in the mandatory employer-based plans the contributions are typically in addition to payroll taxes (an “add on”).
  • Most countries that use a carve-out approach gave individuals already working a choice between the old and new systems; but practically every country (except Argentina, Colombia and the United Kingdom) requires new labor market entrants to enroll in the new systems.
  • Most of the reformed systems use worker-based accounts and workers choose their own fund managers and investment portfolios, subject to regulations. In a smaller number of countries, mostly industrialized ones, employers, sometimes together with unions, choose investment strategies for the private pension plans.
  • Administrative costs are generally much lower after several years experience, as the asset base grows. Currently they range from a low of 0.7 percent of assets or less in Sweden and larger, mature employer-based plans in Australia, Switzerland and the Netherlands — as well as Chile — to a high of 20 percent or more during the first year of operations in countries like El Salvador and Poland.
  • The private benefit is projected to provide workers with more than 70 percent of their total mandatory retirement income in most of the Latin American countries and around half of the total in Western Europe and Australia. Eastern and Central Europe and the former Soviet Union have adopted a variety of systems — ranging from Kazakhstan, which adopted the Chilean model, to Bulgaria and Latvia, where the private benefit provides less than 30 percent of the total.
  • Typically countries require workers to receive their retirement benefits in the form of an annuity or gradual withdrawal from their personal retirement accounts. However, most Latin American systems allow lump-sum withdrawals once retirees have passed a stringent threshold, such as purchasing a pension that is 70 percent of their preretirement wages or 200 percent of the poverty line.
  • Every country with individual accounts provides a minimum income, in the form of a minimum pension guarantee or a flat (uniform) benefit to retirees, most commonly between 20 percent and 30 percent of the average wage.

Keeping Administrative Costs Low. A 1 percent annual expense ratio reduces the final accumulation and pension by 20 percent for the full career worker. Administrative costs vary widely across countries and time, allowing us to learn which techniques keep costs low. In all systems, startup costs mean that expenses will be high initially and economies of scale mean that they will fall over time as a percent of assets, as average account size grows. Administrative costs have been lower in the wholesale, or institutional, market used by employer-based systems and higher in the worker-based systems that invest small individual accounts through the retail market, incurring high marketing expenses. Passive investment also reduces costs.

All Eastern and Central European countries (with the exception of Hungary) and about half the Latin American countries use centralized collection systems, piggybacking on the tax or social security system (or, in the case of Croatia, a private clearinghouse) to keep marginal collection costs low.

What could a well-run U.S. system expect? Assuming that the system (1) keeps record-keeping and communication costs per account to about $20 per year (the estimated cost in the Thrift Saving Plan for U.S. federal workers and low-cost mutual funds), (2) invests in low-cost index funds and (3) chooses a limited number of asset managers in a competitive bidding process (thereby harnessing the institutional market), after eight to 12 years the annual expense ratio in the new personal account system will be 3/10ths of 1 percent of assets (30 basis points) or lower. This is less than what people with small accounts would pay in the mutual fund market today.

Reducing Investment Risk. In most countries with worker-based plans, financial markets were undeveloped and investment choices were tightly circumscribed at first, limited to government bonds and bank deposits. In some cases, most notably Chile, financial markets have matured considerably in part due to their pension reforms. As a result, investments are now diversified across corporate bonds, equities, mortgage-backed securities and international funds — diversification is the best way to reduce risk. Although a variety of investment portfolios are now offered in Chile, the proportion that can be invested in stocks remains limited for those nearing or past retirement age. This is an example of “life cycle investing” (a gradual shift out of stocks and into bonds or annuities over a period of years for older workers), designed to reduce their exposure to a sudden drop in the stock market or the interest rate.

In addition, some countries require fund managers to offer absolute or relative rate of return guarantees for the private accounts. For example, pension funds in Kazakhstan must guarantee that no one will lose money (or earn a negative rate of return). Switzerland’s pension funds must pay at least a 4 percent nominal return (recently reduced to 2.5 percent) over the worker’s tenure with his employer. Chile and many other Latin American countries penalize funds whose rate of return deviates from the industry average by more than 2 percentage points. The object is to reduce volatility across time and disparities across individuals. A better way to accomplish this, in countries with well-developed financial markets, is to require that portfolios closely track broad stock market benchmarks such as the S&P 500 or Wilshire 4500 or to use options to protect workers from a sharp downturn in the stock market. Large employer-based plans have used these techniques for many years. New financial instruments are being developed for sharing risk between individuals, asset managers and insurance companies, during the accumulation and payout stage.

Protecting Against Poverty. All countries with individual retirement accounts guarantee a minimum benefit to workers who participate in the system. This is usually financed by the government, out of general revenues. Most Latin American countries guarantee a minimum income from private accounts, while most Eastern and Central European countries maintain a floor on the traditional pay-as-you-go benefit. Most countries with employer-based plans accompany these with a flat benefit that is paid to all older residents regardless of earnings and contributions, although in some cases these benefits have been partially replaced with means-tested benefits. Most commonly, the minimum pension varies between 20 percent and 30 percent of the average wage.

Protections for Women. Minimum benefit guarantees are especially important for women, who are at a greater risk of old-age poverty than men due to their longer life expectancies and time spent out of the labor market. In Latin American countries, wives are also protected by a group survivors insurance policy that covers all workers and by a requirement that, upon retirement, husbands purchase a joint pension from their individual accounts. Widows of retirees get a survivor’s benefit — but it is financed by their husbands rather than by taxpayers. Widows get to keep their own pension in addition to the joint pension. In Chile, Argentina and Mexico, the minimum pension combined with the joint pension mean that the relative position of women is projected to improve after the pension reform. The lifetime benefits of married women with full work careers are projected to equal or exceed the lifetime benefits of men.

Read Article as PDF