Social Security Reform: Other Countries Are Leading the Way

From the inception of Social Security, politicians encouraged us to think of it as similar to private pensions. Yet as Baby Boomers near retirement, the cruel reality is becoming more and more evident.

Under the program, no money is being stashed away in bank vaults. No investment is being made in real assets. What about the Social Security Trust Funds? These are trust funds in name only, consisting only of IOUs the government has written to itself.

Social Security in fact is a pay-as-you-go system under which taxes collected from current workers are used to pay current retirees. Every dollar collected in payroll taxes is spent – the very day, hour and minute it comes in the door. In the future, we will need to impose more and higher taxes in order to pay promised benefits. And that's the problem.

Everyone who will be 65 years of age or older in the year 2060 is already alive today. Yet Social Security actuaries forecast that in that year Social Security and both parts of Medicare will consume anywhere from 35 percent (intermediate assumption) to 61 percent (pessimistic assumption) of the total taxable U. S. payroll. When other spending on elderly medical bills (Medicaid, VA system, mandates on private employers, etc.) is thrown in, the National Center for Policy Analysis estimates that the figure reaches 43 to 77 percent.

Fortunately, there is growing bipartisan support for reform through a partial or complete privatization of the Social Security system. For example, Senators Bob Kerrey (D-NE) and Alan Simpson (R-WY) have proposed letting individuals put 2 percentage points of the current payroll tax into personal retirement savings accounts. Rep. Nick Smith (R-MI) has also proposed to phase in private accounts.

Congress need not search for solutions unguided, however. Several countries already have private social security systems, and they have a great deal to teach us.

Chile was the first nation in the Western Hemisphere to adopt a social security system (1929) and the first nation in the world to completely privatize one (1981). Currently, employees must pay 10 percent of their wages to the Chilean equivalent of Individual Retirement Accounts. Individuals cannot direct their own investments. However, they can choose among competing private investment companies, which are similar to U.S. mutual funds. These funds are required to invest conservatively in a diversified portfolio of stocks and bonds. People dissatisfied with their funds can easily switch to another.

Workers must also contribute to buy private life and disability insurance, bringing the total required contribution to about 13 percent. The benefits of this approach are compelling. Retirement benefits, which depend on the rate of return earned by private accounts, have generally been anywhere from 50 to 70 percent higher under the new system. Disability benefits are at least twice as high and survivors' benefits at least 50 percent higher.

Like Chile, Singapore also has a private retirement system; but unlike Chile, Singapore's system was private from the beginning. Residents are required to save for all manners of reasons: retirement, medical expenses, education, even the purchase of a home. The rate of contribution for both employers and employees is 20 percent. In effect, residents of Singapore are forced to save 40 percent of their incomes.

The country's pragmatic commitment to economic growth has ensured a steady source of capital for investment and undoubtedly is responsible for the country's high economic growth rate. As a result of these high rates of contribution, Singapore has the highest savings rate in the world. It also has the highest home ownership rate, with about 85 percent of the population living in homes they own.

European countries are also searching for private alternatives, and Britain is leading the way. Britain's two-tiered system consists of a bottom tier (a minimum income paid to all retirees) and an earnings-based tier which is comparable to a private pension.

In 1978 the British government began to permit employers to contract their employers out of the second tier by providing them with a private pension, at least as generous as the pension they would have received from the government. Since 1988, all British workers have been allowed to individually opt out of the second tier by setting up personal pension accounts, similar to American IRA accounts. Through these private options, more than 70 percent of British workers have opted out of the second tier.

Individuals who contract out give up the right to draw a second-tier pension from the state. In return, they receive a tax reduction of 4.8 percentage points. In general, the tax reduction is calculated so that employees will, on the average, gain financially from being contracted out. As Congress considers Social Security reform, it has the opportunity to learn from a number of other countries. We may not want to copy the system of any one of them, but they can provide some valuable lessons and help us avoid a number of mistakes.