Reforming Social Security: Lessons from Thirty Countries

Policy Reports | Social Security

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

Preventing Poverty and Controlling Risk

Table III - Minimum Pension and Guarantees

“Every country with personal accounts offers a minimum pension that reduces the risk of old-age poverty.”

Personal account systems are not inherently redistributive and they entail financial market risk. So how do we prevent poverty and control risks? One way to reduce market risk, discussed previously, is to limit investment choices to less risky portfolios that track broad market indexes. Another way, discussed in a following section, is to encourage or require annuitization. There is also a risk that workers with low wages or workers who spend a number of years out of the labor market will have insufficient balances in their personal accounts to provide adequate retirement incomes. This is especially important to women, who are likely to work fewer years and at lower rates of pay then men. [See the sidebar: “Protections for Women.”] It is also important to all workers who fear the possibility of a prolonged downturn in investment or labor earnings. To reduce the risk of old-age poverty, every country with a personal account system includes a minimum pension, usually financed out of general government revenues.

The minimum pension takes one of several alternative forms: a minimum pension guarantee (MPG) on the personal accounts, a floor on the traditional defined benefit only, or a flat (uniform) benefit that every eligible person receives, regardless of other benefits [see Table III]. Women have been disproportionate gainers from the minimum benefit, whatever form it takes.11

Minimum Pension Guarantees on the Personal Accounts. Most common is the minimum pension guarantee, which guarantees a minimum retirement income from the social security system, including the personal accounts, for all eligible workers (those with 20 to 25 years of contributions). Most Latin American countries and Kazakhstan incorporate this feature into their plans.

Floors on the Traditional Benefit. A second type of minimum pension sets a floor on the traditional defined benefit only, regardless of the size of the personal accounts. This is common in the Eastern and Central European countries, which retained large earnings-related defined benefit plans. In these countries the public benefit increases with work and contributions, but it also has a floor. This has the disadvantage that the government’s liability is not reduced if benefits from the personal accounts are larger than expected — nor does it protect retirees from unexpected negative outcomes in the accounts. Often, this feature is a remnant of the old systems and, as such, the years of work required for eligibility are quite low (five to 15 years). Not surprisingly, the minimum is smaller in the “floor” countries — 10 percent to 20 percent of average wage in most “floor” countries versus 20 percent to 40 percent in most minimum pension guarantee countries [see Table III].

“Joint annuities raise the retirement income of married women.”

Tradeoffs with Minimum Pension Guarantees and Floors. In both minimum pension guarantee and floor countries, the government incurs an unfunded contingent liability that is often not calculated in advance. Mexico reduces the unfunded liability in its minimum pension guarantee by putting a peso-per-day-worked into the account of every worker, thereby making it less likely that they will fall below the minimum and encouraging work at the same time.

The eligibility requirement for the minimum pension guarantee or floor poses another problem, as workers who miss it by one year receive no protection while workers who have many extra years get no additional reward. Some countries (for example, Switzerland and Croatia) counter this problem by offering a higher minimum for workers with more years of contributions. All three examples (Mexico, Switzerland and Croatia) illustrate ways to reduce the trade-off between work incentives and the safety net.

“Flat public benefits to all workers are expensive but avoid moral hazard problems.”

Flat Benefits. The remaining countries have established a minimum by giving a flat (uniform) pension to all people who have passed a specified age, such as 65, even if they haven’t worked and contributed. This is characteristic of the industrialized countries that recently added mandatory employer-sponsored plans to the flat public benefit that they had had for many years. Since money goes to every person, the flat benefit is considerably more expensive than the minimum pension guarantee or the floor. While the minimum pension guarantee and floor countries concentrate their subsidies on the bottom 20 percent of pensioners, the flat benefit redistributes as well to the second and third quintiles, whose members are likely to receive, on average, more than they put in the tax pool. Thus, the choice between these methods depends in part on the degree and nature of redistribution desired and feasible.

To control the fiscal costs, some countries have tried to downsize their flat benefits and replace them with means-tested benefits. Britain, for example, shifted from wage to price indexation of the flat benefit to accomplish this. As wages grew over the last two decades, the basic benefit fell from 24 percent to 15 percent of the average wage. Fiscal costs are very low as a result. But expenditures have increased on means-tested benefits, where the income threshold is wage-indexed and now exceeds the basic benefit. If the current system continues, more than half of all Britain pensioners will qualify for means-tested benefits as they age. Reliance on means-testing may discourage voluntary saving. The recent report of the British Pensions Commission pointed out that either the basic benefit or the personal accounts would have to increase (or the span of retirement would have to decrease), in order to keep pensioners above the poverty line without excessive use of means-testing.

“Public benefits will fall relative to the average standard of living if indexed to prices rather than wages.”

Australia cuts the cost of its flat benefit in a different way: by income- and asset-testing eligibility to exclude the top income group. About 70 percent of retirees are below the threshold receive the benefit.

Wage or Price Indexation of the Minimum? In all these minimum pensions, indexation is a key issue. Wages usually rise faster than prices, due to productivity growth. If the minimum pension is indexed to wages, its cost may grow more rapidly than expected and it may become a large unfunded liability. But if indexed to prices, it will fall in value relative to the average standard of living in society, which is set by wages. Which is better? Temporary price indexation is a possible method to reduce the fiscal burden in cases where the minimum is very high to begin with. In Sweden, for example, the minimum was 40 percent of the average wage and is now being reduced through price indexation. The Netherlands, which pays a flat benefit of 38 percent of the average wage to single individuals (28 percent per person to couples), is also considering temporary price indexation or no indexation at all when finances are strained. But if wage indexation does not resume eventually, the minimum will become irrelevant (as discussed above for the United Kingdom).

In Chile, the minimum pension guarantee is currently 25 percent of the average wage — almost double the poverty line — for workers with at least 20 years of contributions. It rises to 27 percent once workers pass age 70, but is lower for workers who retire early. The minimum is formally indexed to prices; however, due to a series of political decisions, it has increased with wage growth over the past 20 years, and the increase applies to all retirees, not simply to new ones. As a result, it may lead to higher costs than were initially projected.

If Chile wants to slow down the growth in expenditures on the minimum pension guarantee, one option is to wage-index the minimum for new groups of retirees but to price-index after retirement (as we do for our defined benefit in the United States). Another option is Swiss indexation — which is a combination of wage and price indexation. Benefits would then grow as wages grow, but at a slower rate. Still a third option is to modify payout rules so that fewer retirees fall below the rising minimum.

“A disincentive to work can be avoided if the minimum guaranteed pension rises with years worked.”

Moral Hazard Problems. The minimum pension guarantee has the advantage of being less expensive than a flat benefit and easier to administer than a means-tested benefit, since it doesn’t require a careful check of all income sources. Its main disadvantage is that it may involve moral hazard problems; that is, risky behavior may increase, which raises total costs, when a minimum is guaranteed. Evidence from Chile suggests three types of moral hazard:

  • First, low-income earners may stop working, or try to evade contributions, once they pass the 20-year point required for eligibility, since any small addition to their pension would simply displace the government subsidy.
  • Second, when given a choice of investment options, workers near the minimum may choose the riskiest option, since they will benefit from the upside potential while the government bails them out of the downside risk. (This has only become relevant in Chile since investment choice was expanded in 2002.)
  • Third, retirees with small accumulations — who are not necessarily required to annuitize their accounts — may use up their retirement savings as fast as possible because they know that the government will pay their pension when their own money is gone.

These moral hazard issues could be mitigated by making the minimum pension guarantee a positive function of years worked, ruling out very volatile investment strategies, and setting stringent payout rules that prevent lump sums and front-loading.

Rate of Return Guarantees. Besides the minimum pension, many countries have established rate of return guarantees designed to smooth returns in the personal accounts over time and reduce variations among individuals. Asset managers, not the government, bear these costs, but ultimately pass them on to worker-investors.

Absolute rate of return guarantees are rare. Kazakhstan requires a zero real rate of return guarantee. This is likely to be called upon very rarely if it applies as an average over the workers’ lifetime, but it can obviously be costly and distortionary if it applies on a year-to-year basis.

“Many countries limit the disparities in rates of return on personal accounts.”

Switzerland has a more binding floor on returns to accounting contributions in plans for which investment strategy is determined by the employer. Until 2002, a worker’s account was required, over his tenure with a particular employer, to earn an average nominal return of at least 4 percent per year. During the 1980s and early 1990s this was not a demanding rate to achieve, as even conservative government bonds yielded more than 4 percent. However, as interest rates plummeted over the last few years, asset managers found it difficult to earn 4 percent without taking on considerable stock market risk, and this risk meant that at times the floor would not be reached. Pressure grew for a change in regulations. Finally, in 2002, the Swiss government began a downward readjustment of the guarantee, and by 2005 it had fallen to 2.5 percent. Moreover, a process to re-evaluate the rate automatically every two years was put in place. This illustrates the dangers of absolute rate of return requirements: they become political footballs when rates in the broader economy unexpectedly change.

More common than absolute rate of return guarantees are relative rate of return guarantees, in which limits are set on the degree to which an asset manager can deviate from the industry average [see Table III]. For example, if an asset manager in Chile beats the industry average return by more than 50 percent or 2 percentage points (whichever comes first), it must put the excess into a special reserve fund. When the manager earns less than the industry average by more than 50 percent or 2 percentage points, it must make up the difference in the accounts by drawing down the reserve fund and then by dipping into owners’ equity, if necessary. Understandably, asset managers were reluctant to deviate from the typical industry portfolio — thereby creating “herding,” where all the investment portfolios are very similar. To overcome this problem, Chile has recently allowed pension funds to offer multiple portfolios, with different bands and penalties allowed for each portfolio (see earlier sidebar on Chile).

While herding may have reduced investment choices, the purpose of this guarantee — to reduce volatility across time and disparities across individuals — remains worthwhile in a mandatory system. A better and more transparent way to achieve this goal is to require that all portfolios be indexed to broad market benchmarks such the S&P 500 or Wilshire 4500, rather than allowing concentration in particular companies or sectors. The Latin American and Eastern European countries did not have this option, given their undeveloped financial markets, but we do. Additionally, some financial analysts have recommended “life cycle investing” (a gradual shift out of stocks and into bonds or annuities over a period of years as individuals approach retirement) or the use of options, to protect older workers from a sudden downturn in the stock market. These arrangements would automatically reduce disparities among individuals and across different age cohorts.

Lessons for the United States. As we revise our system to include personal accounts, the United States needs to rethink how high the safety net should be, how it should be financed, and what linkages and trade-offs we want to make between work incentives and poverty prevention. In this context, we should seriously consider establishing a minimum pension as a way to redistribute income to low earners and protect retirees from investment risk.

One simple way to accomplish this could be to modify our current defined benefit to become a flat benefit that pays a poverty-level pension (currently about $750 monthly for an individual living alone12) to everyone, as in several Western European countries. Our current average defined benefit from Social Security is $1,000 per month and it is slated to go up around 1 percent per year. Flattening out the public benefit to the poverty level would make the system solvent and, in fact, would generate a surplus that could be used to help fund the individual accounts.

“Personal accounts should be accompanied by a more progressive public benefit to protect low-wage workers.”

Alternatively, and more consistent with good work incentives, the benefit could be a flat sum per year worked. For example, retirees could be promised a public benefit that is 1 percent of the average wage per year for the first 20 years of contributions, and 0.5 percent per year thereafter. A 20-year worker would then get $600 per month while a 40-year worker would get $900 per month. If defined in terms of the average wage, it would grow over time together with the average standard of living — it would thus be wage-indexed for successive cohorts but could be price-indexed after retirement, as our current benefits are. This would be a highly progressive public benefit, with work incentives built in, that would cost less than our current scheduled benefits. Yet, together with an annuity purchased with a 4 percent account, the total benefit would exceed that received by the average worker today.

In general, countries with large accounts complement them with very progressive public benefits to get desired distributional outcomes over-all. Our public benefit is not as progressive as we sometimes claim, given the longer life spans of high-income earners. We should consider making it more progressive — yet still positively related to years worked — as part of the package of changes that establishes personal accounts. This would protect low-income earners both from labor market instabilities and financial market volatility.

As an alternative to government-financed minimum pensions, financial analysts are now developing alternative market mechanisms (sometimes called “collars”), in which worker-investors agree to give up some of their upside gain in order to qualify for a downside floor. The worker must also relinquish control over the portfolio to private market guarantors. A contract would peg returns to a particular index, but the guarantor rather than the worker would control specific investments, in order to avoid moral hazard (excessive risk-taking) problems. While this may turn out to be a promising way to guarantee a minimum pension without incurring a contingent liability for the government, it introduces two new risks: 1) workers may not be able to evaluate these guarantees, to figure out whether they are getting a good or bad deal, and 2) the private market guarantor may not be able to honor its commitment when it comes due. This is particularly a potential problem given that many workers will be trying to collect at the same time if the market drops precipitously. Such private market guarantees are promising, but they place an extremely heavy burden on regulators — and introduce a third new risk — 3) that regulators may fail and government (or workers) will end up bearing the burden after all.

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