Reforming Social Security in the US.: An International Perspective

Business Economics, Jan, 2001 by Estelle James

The Private Funded Pillar: Commonalities

The second pillar differs dramatically from traditional systems. Its most important characteristics are: it is mandatory; it links benefits actuarially to contributions, often through a DC plan; it is fully funded; and it is privately, competitively managed. These are the personal retirement accounts that were discussed during the presidential campaign. Contribution rates to the second pillar vary widely, but range between seven and twelve percent of payroll in most countries. Since this is the newest and most controversial of the three pillars, it is worth examining the rationale for these common characteristics.

Why mandatory? The rationale here is myopia and moral hazard--a significant number of people may be shortsighted, may not save enough for their old age on a voluntary basis, and may become a burden on society at large when they grow old. In countries that have adopted structural reforms, retirement savings pillars have been adopted as part of the mandatory scheme in order to keep the PAYG tax and transfer system small. In countries where retirement saving plans are voluntary, coverage is invariably less than half of the population. The bottom half of the income distribution is unlikely to save for retirement in illiquid accounts on a voluntary basis. The PAYG part of the system--with all its problems--therefore continues to carry a large burden.

Why defined contribution? DC is actually another term for personal saving accounts with a fixed contribution schedule. The worker simply accumulates his or her defined contributions plus the investment returns earned and eventually turns this into retirement income. In a DC plan, benefits depend linearly on the contribution rate; there is no intervening DB formula that cuts this link. This close link between contributions and benefits is designed to discourage evasion and labor disincentives. Evasion and escape to the informal sector are big problems in many countries, especially developing countries. In DC plans, those who evade bear the cost in the form of lower accumulations and benefits rather than passing the costs on to others and undermining the financial viability of the scheme. Very importantly, the pension that is eventually acquired through the market is likely to be actuarially fair, meaning that workers have some choice over their own retirement age, but those who choose to retire early bear the cost themselves by getting a lower benefit. For this reason, DC plans are likely to deter early retirement and to raise the normal retirement age automatically as longevity increases--without a collective decision that is often difficult for politicians to make. [4]

Why fully funded? First, for countries with relatively young systems, pre-funding makes costs clear up front so policymakers won't be tempted to make promises today that they will be unable to keep tomorrow. Second, it avoids steep payroll tax increases that are needed in a PAYG system as populations age, for the reasons just described. Third, it prevents large, inadvertent, intergenerational transfers from young people to older workers. Fourth, funding may be used to help build and mobilize national saving, particularly saving that is committed for the long term. [5] If savings are sub-optimal to begin with, due to public or private myopia or a tax wedge between social and private returns, the increase in savings increases efficiency as well as growth. That is, the increase in saving can make everyone better off under these circumstances. These savings can be invested productively at home and abroad, they can enhance worker productivity and output, and they can later be redeemed by individuals to finance co nsumer goods. Thus, saving can be an important ingredient of a long run strategy for increasing productivity and providing additional domestic consumption when the ratio of retirees to workers increases.