Rethinking Pension Reform: Ten Myths about Social Security Systems

1. Rethinking Pension Reform:Ten Myths about Social Security Systems Peter R. Orszag (Sebago Associates, Inc.) Joseph E. Stiglitz (The World Bank)

2. The “World Bank model” • Averting the Old Age Crisis put forward a three-pillar approach to pension reform • In principle: Three pillars expansive enough to reflect span of possible policy measures • In practice: The "World Bank model" interpreted as involving one specific constellation of the pillars. Second pillar is privately managed and defined contribution.

3. Framework To analyze myths, must distinguish: • Privatization • Prefunding • Diversification • Defined benefit versus defined contribution • Any combination of these elements possible • Spectrum of choices along each dimension

4. Analytical foundations Four key analytical foundations: • Inherent features vs. imperfect implementation -- apples vs. apples • Tabula rasa versus transformation choices -- can’t assume away PAYG systems • Inter-generational analysis • Ultimate focus on welfare, not growth or saving

5. Myth #1: Individual accounts raise national saving Myth #2: Rates of return are higher under individual accounts Myth #3: Declining rates of return on pay-as-you-go systems reflect fundamental problems Myth #4: Investment of public trust funds in equities has no macroeconomic effects Myth #5: Labor market incentives are better under individual accounts Myth #6: DB plans necessarily provide more of an incentive to retire early Myth #7: Competition ensures low administrative costs under individual accounts Myth #8: Inefficient governments provide a rationale for individual accounts Myth #9: Bailout politics worse under public DB plans Myth #10: Investment of public trust funds is always squandered and mismanaged The ten myths

6. Myth #1: Individual accounts raise national saving • Assertion: Individual accounts raise saving • Narrow vs. broad prefunding • Narrow: Pension system accumulating assets against future projected payments • Broad: National saving increased to ease future pension burden (inter-generational issue) • Privatization and broad prefunding distinct • Privatization neither necessary nor sufficient for broad prefunding

7. Myth #1: Individual accounts raise national saving Privatization without broad prefunding: • Pay-as-you-go to individual account system • Government prefunds accounts (narrow) • Government issues debt to finance • Debt-financed privatization does not engender broad prefunding. • Conclusion: Privatization need not produce prefunding in broad sense.

8. Myth #1: Individual accounts raise national saving Broad prefunding without privatization: • Government can contribute to national saving in anticipation of future pension payments • Bateman and Piggott (1997): Malaysia's Employees Provident Fund accounts for 20-25% of national saving in 1980s • Conclusion: Privatization not necessary for broad prefunding

9. Myth #1: Individual accounts raise national saving Conclusion: • Heller (1998) and Modigliani, Ceprini, and Muralidhar (1999): Prefunded public DB system may be preferable to prefunded private DC system • Automatically linking broad prefunding with privatization -- rather than examining each choice separately -- fails to reflect the full range of policy options

10. Myth #5: Labor market incentives are better under private defined contribution plans • Common claim: Individual accounts provide better labor market incentives than defined benefit systems • Differential labor market incentives result from differences in both risk and redistribution

11. Myth #5: Labor market incentives are better under private defined contribution plans • Distortion not measured by payroll tax itself. Instead: NPV(benefits)-tax • Ultimately interested in welfare, not labor supply • Key tradeoff: redistribution and incentives • Diamond (1998): "Any redistribution will create some labor market distortion, whether the redistribution is located in the benefit formula or in another portion of the retirement income system."

12. Myth #5: Labor market incentives are better under private defined contribution plans • Counterfactual: Isolate privatization • Consider program of privatization without broad prefunding. Additional taxes necessary to finance debt will distort labor market • Corsetti and Schmidt-Hebbel (1997): Debt-financed transition to individual accounts reduces output by 1-4 percent in long run because of distortions from higher income taxes necessary to finance the debt

13. Myth #5: Labor market incentives are better under private defined contribution plans • Imperfections in labor markets • Stiglitz (1998): Efficiency wage model. Urban job -- participation in public social insurance. Social insurance increases rents of those in urban sector, but also shifts no-shirking constraint (e.g., in Shapiro-Stiglitz model) down, so equilibrium wages are reduced and equilibrium employment increased. • Conclusion: No simple dominance of one system over another in terms of labor market incentives

14. Myth #7: Competition ensures low administrative costs under private defined contribution plans • The Economist: "let many kinds of firms (banks, insurance companies, mutual funds) compete for the business. Fierce competition in sophisticated markets has driven down costs in these businesses. There is no reason why the same should not be true for pensions..."

15. Myth #7: Competition ensures low administrative costs under private defined contribution plans • Competition, however, only precludes excess rents; it does not ensure low costs • Instead, the structure of the accounts determines how high the costs are • Centralized versus decentralized. Decentralized -- not constrained -- surprisingly expensive

16. Myth #7: Competition ensures low administrative costs under private defined contribution plans • Murthi, Orszag, and Orszag (1999) present accounting structure for administrative costs • The accumulation ratio captures costs for a worker contributing funds to a single financial provider • The alteration ratiomeasures additional costs of failing to contribute consistently to single financial provider over an entire career • The annuitization ratioreflects costs of converting account to annuity

17. Myth #7: Competition ensures low administrative costs under private defined contribution plans • UK has decentralized approach • Murthi, Orszag, and Orszag (1999) estimate that, on average over lifetime, 40 to 45 percent of the value of individual accounts is consumed by various fees and costs. • As-implemented point: Centralized approach could offer much reduced administrative costs -- but political economy concerns?

18. Conclusions • Need for pension reform in many developing countries • Policy reform suggestions viewed too narrowly -- private DC second pillar • Most of the arguments in favor of this particular approach are based on a set of myths that are often not substantiated in either theory or practice. Do not compare idealized version with as-implemented.

19. Conclusions • A more expansive perspective would allow policy-makers to weigh appropriately all the tradeoffs they face, including: • private vs. public systems • prefunding vs. pay-as-you-go • diversifying vs. not diversifying; and • defined contribution vs. defined benefit