What We Can Learn From Other Countries About the Why’s and

How’s of an IA System in the US?

by

Estelle James

Main Questions

• Why have many countries adopted funded individual accounts (IA’s) as part of their mandatory social security systems?

• Why have they chosen private management of the funds?

• How have they covered transition costs?

• How is financial market risk handled?

• How can we keep administrative costs low?

• Relevance to the US now--next steps?

What is an IA system?

• By IA we mean individual accounts--funded account, usually defined contribution

• Worker’s annuity depends on contributions + investment earnings (not on wages and years of work, as in defined benefit plan)

• Pensions closely linked to contributions, subject to financial market volatility, usually with regulations and constraints

• Accompanied by defined benefit safety net

More than 20 countries have adopted IA systemsDiffusion of structural reform around the world, 1980-2000

0

5

10

15

20

25

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Cum

ulat

ive

num

ber

of r

efor

min

g co

untr

ies

0

10

20

30

40

50

60

70

80

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

In m

illio

ns

Chile

SwitzerlandNetherlands

United Kingdom

ArgentinaAustraliaColombiaDenmark

Peru

Uruguay

HungaryKazakhstan

Bolivia Mexico

El SalvadorPoland

Hong Kong

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

Typical size plan

• 6-12% contribution rate to funded pillar

• This usually includes some disability and survivors’ insurance, administrative costs

• Therefore, larger than under consideration in US--but wage base is often lower

• Sweden has new 2.5% IA, complex system to keep administrative costs low

1. Why? Growing realization that part of social security system should be funded

(not completely PAYG)--sustainability

• In funded system part of revenue is saved & invested (in PAYG system contributions today are used to pay pensioners today)

• Funding keeps assets & liabilities in balance so helps maintain system sustainability (in PAYG large unfunded implicit pension debt develops)

Percentage of GDP

0 50 100 150 200 250 300

France

Germany

Italy

Canada

United States

Japan

Explicit debt

Implicit public pension debt

Implicit Public Pension Debt, 1990

Why funding?--impact on taxes

• Makes ss tax less sensitive to demography, avoids payroll tax hike as worker/retiree ratio rises (may raise take-home pay, employment)

• For aging populations, allows higher pension to be generated by same contribution rate, so helps keep ss tax low ($1 tax=$2-3 benefit if PAYG, $5 if funded)

• Reduces intergenerational redistribution (in PAYG future generations lose, as system matures)

Why funding?--impact on national saving and income

• Also increases national saving & investment– if doesn’t crowd out other personal saving– if doesn’t increase government deficits – depends largely on how transition is financed

• Increases national income if raises saving, investment, employment (so higher pension doesn’t mean less income elsewhere)

• Therefore helps system and economy, adds security--makes restructuring worthwhile

2. Funds must be managed--public or private management? Key issue

• Many countries have had serious problems with public management of pension reserves

• Low, even negative rates of return, inefficient allocation of capital

• Mainly invested in government bonds--may increase national deficits

• Politically motivated investments--bad for system and for economy

-1.8%

-12% -10% -8% -6% -4% -2% 0% 2% 4%

Japan

Korea

Philippines

Sweden

US

Malaysia

India

Costa Rica

Morocco

Singapore

Canada

Jamaica

Kenya

Guatemala

Sri Lanka

Ecuador

Egypt

Venezuela

Zambia

Uganda

Average

gross returns minus bank deposit rateRETURNS TO PUBLICLY MANAGED FUNDS

-8.4%

-50% -40% -30% -20% -10% 0% 10%

Philippines

Morocco

US

Sweden

Malaysia

Canada

India

Japan

Korea

Jamaica

Sri Lanka

Singapore

Kenya

Guatemala

Costa Rica

Ecuador

Tanzania

Egypt

Venezuela

Zambia

Uganda

Peru

Average

gross returns minus income per capita growthRETURNS TO PUBLICLY MANAGED FUNDS

-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

United Kingdom (84-96)

Sweden (84-93)

United States (84-96)

Belgium (84-96)

Chile (81-96)

Ireland (84-96)

Netherlands (84-96)

Spain (84-93)

United Kingdom (70-90)

Australia (87-94)

Denmark (84-96)

Switzerland (84-96)

Japan (84-93)

Netherlands (70-90)

Hong Kong (83-96)

Denmark (70-88)

Canada (75-89)

United States (70-90)

Japan (70-87)

Switzerland (70-90)

Average public schemes

Average private schemes

Gross returns minus income per capita growthRETURNS TO PRIVATELY MANAGED FUNDS

Public v private management

• Danger that centralized, public investment will distort political process, allocation of capital– Some countries prohibit investment in govt bonds,

domestic securities, to avoid these problems

• Movement toward IAs, decentralized control of funds--– choice by workers (Latin America, Eastern Europe)

– by unions and employers (OECD)

– by competitive bidding for large blocs (Bolivia)

– more diversification, higher return, lower risk

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

3. How have other countries covered transition costs?

• Some countries (OECD) have put additional contribution into funded accounts--add-on, no transition costs

• Most countries (Latin America, Eastern Europe) have diverted part of contribution to IA’s--carve-out, transition costs, because money is needed to pay current pensioners

• Eventually existing obligation declines, but temporary financing gap under carve-out

Sources of transition finance• Cut benefits in existing system, substitute annuity

from IA’s; raise retirement age – long run, gradual– protect benefits of existing pensioners

• Use other assets, general revenues to cover temporary gap (budget surplus, smaller govt expenditures, tax hike, SOE sales)

• Borrow in short run, repay in long run– flexible, spreads burden over generations– repayment necessary for positive savings effect

Transition costs and budget surplus

• National saving increases if transition is financed by benefit cut, smaller govt expenditures, higher taxes (add-on)

• Some debt-finance is desirable, inevitable-- but no savings gain if transition is fully debt-financed without repayment plan--

• Budget surplus could be used to finance transition or to partially fund IA’s, thereby reducing carve-out (more saving instead of tax cut or government spending)

4. What to do about financial market risk?

• Latin American and Eastern European countries restrict portfolios, have guarantees; in OECD countries employers back plans

• Guarantees serve social & personal purpose but difficult to reconcile guarantees with choice--moral hazard problem

• Simple rules for limiting risk: limited choice, wide diversification, avoid market timing, floor in unfunded first pillar

• Too little risk is also bad--low returns, pension

5. How to keep administrative costs low

• Important at start-up and in system with small accounts, because record-keeping and communications costs are fixed per account– $20-30 is 3-5% of $600 account, consumes returns

• IA systems in Latin America, UK cost 15-30% of contributions, .75%-1.5% of assets per year; marketing costs half total

• US mutual funds also cost 1.4% per year

• Can we do better in a mandatory system?

Ways to keep costs low

• Constrain choice to low cost products – index funds cut investment & marketing costs

• Use competitive bidding process to limit number of fund managers, cut fees, reduce marketing expenditures (Bolivia, US TSP)

• Keep service modest to contain R&C costs

• This can keep costs $30-$40 per account, .14-.18% of assets per year in long run

• Trade-off: less flexibility, choice for workers

Other nuts and bolts issues• Should IA be mandatory or voluntary opt-

out? Voluntary choice for existing workers common, but high earners might opt out to avoid progressive benefit schedule

• What reforms should be made in remaining PAYG system--raise retirement age, make more progressive to offset neutral IA?

• How to handle payout stage (annuities?)?--mandatory? public or private? unisex tables? single or multiple risk categories?

Conclusion

• Many details to be decided• But experience of many countries indicates that

it is do-able--IA’s can be incorporated into mandatory social security system

• Economic logic suggests it is good for sustainability of system and can be used to keep social security tax low, increase national saving, enhance economic growth. That makes all the trouble worthwhile.