Key Decisions in Constructing a Social Security System that Includes Individual Accounts

1. Key Decisions in Constructing a Social Security System that Includes Individual Accounts by Estelle James

2. Social security has become a contentious issue. I will discuss: • Many points of agreement on all sides • One key point of disagreement • Issues concerning best way to reform DB scheme and best way to set up IA • Questions, not answers; I would appreciate your answers

3. Points of agreement: • 1. Need for change to make system financially solvent for the long run: • Baby boomers will begin retiring 2010. By 2016 social security’s expenditures >payroll taxes; ss will begin cashing in govt iou’s • By 2038 iou’s will be exhausted. At that point, expected revenues will cover only 72% of promised benefits • Therefore some changes in benefits and/or revenues are needed to keep system sustainable

4. Points of agreement (Cont’d) • 2. Important to improve output and productivity in economy--real source of security for workers and pensioners (savings, work incentives) • 3. Improved protection for low earners beneficial • 4. Gradual change better than sudden • 5. Pre-funding is desirable--gradual, builds saving, obligations and assets transparent

5. Many people on all sides believe that pre-funding is part of solution • 1) Gradual-avoids need for sharply rising contribution rates as populations age. • 2) Increases national saving and investment • if doesn’t crowd out other personal saving • if doesn’t increase government deficits • enhances capital formation, productive capacity • 3) Enhances transparency of long term obligations that are being incurred and builds up assets to cover these obligations • 4) Gradual change options imply funding

6. Disagreement: Who should control investment strategy--public or private sector? • Once we have funds, someone has to manage them • Should funds be managed publicly or privately? Which is best for social security system and broader economy? Need for public debate on this issue. • Argument for IA’s stems from belief that private competitive is better than public management.

7. Why private management? (Why not public investment of trust fund?) • Historically, surpluses used to increase current benefits so no saving--funds not there later • When funds accumulate many countries have had serious problems with public management of pension reserves--funds not there later • Low, even negative rates of return, inefficient allocation of capital • Mainly invested in government bonds--may increase national deficits that are hidden and wastefully spent--no net increase in saving. • Also invested in failing SOE’s and other politically motivated projects--bad for system and economy.

8. -8.4% Average Peru Uganda Zambia Venezuela Egypt Tanzania Ecuador Costa Rica Guatemala Kenya Singapore Sri Lanka Jamaica Korea Japan India Canada Malaysia Sweden US Morocco Philippines -50% -40% -30% -20% -10% 0% 10% gross returns minus income per capita growth RETURNS TO PUBLICLY MANAGED FUNDS

9. Average private schemes Average public schemes Switzerland (70-90) Japan (70-87) United States (70-90) Canada (75-89) Denmark (70-88) Hong Kong (83-96) Netherlands (70-90) Japan (84-93) Switzerland (84-96) Denmark (84-96) Australia (87-94) United Kingdom (70-90) Spain (84-93) Netherlands (84-96) Ireland (84-96) Chile (81-96) Belgium (84-96) United States (84-96) Sweden (84-93) United Kingdom (84-96) -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% Gross returns minus income per capita growth RETURNS TO PRIVATELY MANAGED FUNDS

10. Is this relevant to US?Should funds accumulate in private IA’s or public trust fund? • We have good governance, trustee laws • But we also have pressure groups, lobbying, campaign contributions • Which companies, industries, indexes? • Which products to prohibit? • Market timing--prop up market? • Conflicts between anti-trust cases & regulations v. maximizing returns. • Will deficit spending be encouraged? • Will investment power be too concentrated? • Public investors & corporate governance

11. IA’s are not a totally new experiment. More than 20 countries have adopted IA’s. Diffusion of structural reform around the world, 1980-2000 25 20 15 Cumulative number of reforming countries 10 5 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

12. Number Contributors to Mandatory Multi-pillar Systems, 1982-2000

13. Key facts about these plans • 6-12% contribution rate to funded pillar. • Larger % of wages than under considered in US • All plans have included PAYG or tax-financed social safety net • OECD countries used add-on, Latin America and Eastern Europe carve-out--transition costs

14. 2 key issues for 2-tier system with IA’s • In system with IA’s, social security consists of two parts: Part I is modified PAYG DB, Part II is IA. • IA’s can be designed in better or worse way--what is best way? • Modified PAYG DB will remain as part of final system--how should it be restructured for sustainability, equity, and efficiency?

15. How to restructure remaining PAYG system • With or without IA’s, DB benefits will have to fall or taxes rise for solvency • 1) Should benefits be cut? How? When? • 2) Should taxes be raised? • payroll tax rate? • payroll tax ceiling? • general revenues (by raising taxes or cutting other public goods?)

16. 3) Should retirement age be changed as longevity increases? • This would improve work incentives, economy’s productive capacity, finances of DB plan, but with disutility from more work • Would workers prefer benefit cut, tax hike, or retirement age increase? • raise normal retirement age? early RA? • index NRA to longevity? • increase # of years that enter into lifetime wage (currently no added benefit for years > 35)? • How much to leave to collective choice v. individual choice with incentives?

17. Key decisions for IA Design • Voluntary or mandatory participation in IA? • Should add-on or carve-out be used? • How to structure the benefit offset? • How to finance the transition? • How to moderate risk? • How to keep administrative costs low? • How to handle the payout stage (annuities)? • Impact depends on details of answers

18. How to cover transition costs? • In long run funded system should cost less because of positive rate of return that stems from productive capital, but in short run added money is needed to build capital in IA’s while still paying pensioners • In well-designed system financing gap lasts about 30 years. How to cover this temporary transition financing gap?

19. Sources of transition finance • Keep some workers and their contributions in PAYG system (older workers, voluntary opt-out, only partial shift to funded IA’s) • Use other assets or general revenues to cover temporary gap (budget surplus, smaller govt expenditures, SOE sales) • Borrow in short run, repay in long run • flexible, spreads burden over generations • can borrow part of assets in IA’s • repayment necessary for positive savings effect • Transition costs are simply an explicit recognition of past debt. Temporary.

20. What to do about risk? • Risk and uncertainty inevitable in all old age security plans, given long time horizon • Political risk--governments change, benefits cut, accumulated funds dissipated • Financial market risk--price volatility • Other countries restrict portfolios, have relative or absolute guaranteed, safety net • Key to limiting risk: require broad diversification across stocks and bonds, avoid market timing (historically, no loss with 20-years of diversified investment); pub + pvt

21. How to keep administrative costs low--controversial but soluble • Key issue in system with small accounts, because record-keeping & communication costs are fixed per account--can use up returns • Keep service modest to contain R&C costs • Constrain choice to low cost products (index funds), especially at start-up • Aggregate funds and use competitive bidding--scale economies, low marketing cost • Hold investments for long term • Annual costs .15-.20% of assets, much lower than in Latin Am. or US mutual funds

22. Conclusion • Basic problem is that many people would like to keep benefits we have without increased cost--but that is not a viable option. All viable options cost small amount more initially (funding & transition costs) or much higher taxes, lower benefits later. • “Do-nothing” option means large benefit cuts or tax increases later. Funding can improve benefits and economy in long run. Private mgt of funds avoids political manipulation. Impact of private mgt depends on details of how system is set up. • Public ed. about difficult choices and trade-offs. Sooner means more gradual, less painful.