Reforming Social Security in the US.: An International Perspective

Business Economics, Jan, 2001 by Estelle James

LESSONS FROM ABROAD CAN HELP THE U.S. GET IT RIGHT.

Social security reform (or its absence) will have important impacts throughout the U.S. economy, including business. This paper describes the multi-pillar social security reform strategy that many countries have adopted in recent years. This strategy includes a public pillar that provides a social safety net; a privately managed, funded pillar that handles peoples' mandatory retirement savings; and a voluntary pillar for people who want more consumption in old age. The basic rationale is that relying to some extent on pre-funding and defined contribution plans enhances system sustainability and has a positive impact on the broader economy by increasing long term national saving and labor market incentives.

The paper contrasts three variations on the multi-pillar model-the Latin American model pioneered by Chile, in which individual workers choose the investment manager for their retirement funds; the OECD model, in which employers are required to provide a retirement plan and (sometimes together with union trustees) choose the investment manager; and the institutional model in which small individual accounts are aggregated into large blocs in order to keep administrative costs low and negotiate better fees.

The paper explores the relevance of these experiments in other countries for the social security debate in the U.S. If a small proportion of the current contribution rate to social security were "carved out" and placed in individual accounts that earn a market return, this would help to keep over-all benefits at their present level without a tax increase. It would increase the sustainability of the system and, under conditions specified in the paper, would also enhance economic growth. This transition could be financed in many different ways, but use of the budgetary surplus might have the most beneficial impact on growth, while partial reliance on borrowing, with scheduled repayment, would provide the greatest intergenerational equity.

The U.S. presidential election of 2000 put social security reform on the political agenda. Rather than treating social security as the third rail, to be avoided at any cost, both major candidates took strong and contrasting positions as major parts of their campaigns. It is likely that the debate will accelerate over the coming year, possibly resulting in significant changes in our current system. The outcome will have widespread ramifications for business as well as for the rest of society. Changes in social security will affect aggregate economic growth, the health and composition of financial markets, and incentives to work and save.

The U.S. is not unique in its willingness to pay attention to this issue. Over the past decade, many countries around the world have confronted serious problems with their current systems and have instituted major structural reforms. This article aims to place the U.S. debate in international perspective. It explains the problems with old systems that have led countries to reform, outlines the commonalities and differences in reforms around the world, and considers the applicability to the U.S. The most important commonality is the shift toward greater pre-funding, in accounts that are privately managed, as an important part of the mandatory social security system. This shift is designed to make the system more sustainable, more equitable, and more favorable toward economic growth--objectives that are widely shared in the U.S. These shared objectives suggest that such a shift may be appropriate in the United States, also.

It may come as a surprise to many to note that, compared with many other countries that have not yet reformed, the U.S. social security system is relatively healthy. Yet, it is clearly not sustainable with its current contribution and benefit rates, since cash outflows will exceed inflows in just a few years. How can we cover this gap in a way that minimizes the cost, is fiscally balanced, contains mechanisms that will keep it that way in the long run, and increases national income that will be available both for old and young? The experience of other countries may help us find an answer.

Over the next thirty years, the proportion of the world's population that is over age sixty will nearly double, from nine percent to sixteen percent. Population aging is due to a sharp drop in the birth rate, hence relatively fewer young people, together with an increase in life expectancy, particularly at the older end in recent years. In industrialized OECD countries almost thirty percent of the population will be over age sixty by 2030. (Figure 1). The population of the U.S. is still young compared with most European countries and Japan, but the proportion of people over sixty will increase from seventeen percent to twenty-eight percent in this period.

Cross-sectional analysis shows that public spending on formal pension plans increases exponentially as populations age. In developing countries today, only two to three percent of GDP is spent on old age security, but in many industrialized countries this figure now exceeds ten percent, and it will grow still higher in the years ahead (Figure 2). Because of its young demography, U.S. expenditures on old age security are now only six percent of GDP but this number will escalate when the baby boomers start to retire; and public spending on pensions and health (primarily Medicare) combined is already almost twice as high (Figure 3). Programs for the old are by far our largest civilian public programs and they are destined to grow further.