Reforming Social Security in the US.: An International Perspective

Business Economics, Jan, 2001 by Estelle James

However, pre-funding retirement accounts will increase national saving only if they do not crowd out other private savings or increase public dissaving. Regarding the first point: if workers believe that a pre-funded system is more credible than a PAYG system, they may save less on a voluntary basis for their own old age (or borrow more for current consumption), thereby offsetting some of the increased mandatory saving. In the U.S., since few people save voluntarily, this offset is likely to be small, except among high earners. The fact that the saving constraint will be more binding for low earners is a reason for targeting the public pillar more closely toward this group.

Regarding the second point: if the build-up of pension reserves relaxes fiscal discipline, or if the government finances the transition through issuing additional bonds, this will simply mean that increased public deficits have absorbed the increased personal saving. The choice of debt finance versus other means of financing the transition will be discussed further below. In Chile, where this issue has been actively researched, the current consensus is that total national saving increased significantly as a result of the pension reform (Schmidt-Hebbel (1998), (1999a), and (1999b) and James (1998a) and (1999b)). In the U.S., the largest contribution to saving for financing the transition is likely to come from use of the budget surplus, which would reduce its availability for increased government spending or tax cuts.

Why privately managed? This maximizes the likelihood that economic rather than political objectives will determine the investment strategy, thereby producing the best allocation of capital and the highest return on savings. Empirical data show that publicly managed pension reserves around the world typically earn low returns, far below the bank deposit rate or the growth of per capita income (Figures 8 and 9)--largely because public managers have been required to invest in government securities or other politically motivated loans that pay low rates of return (Iglesias and Palacios 1999). Politicians are also subject to pressures to raise benefits if publicly managed funds are available (for example, this happened in the early years of the U.S. social security system). Moreover, the hidden and exclusive access to these funds makes it easier for governments to run large deficits or to spend more wastefully than they could if they had to rely on a more accountable source of funds--a negative impact on the econ omy as well as the finances of the pension system. (Some economists believe this happened in the 1980s in the U.S., as the social security trust fund was used to finance the public deficit in a non-transparent way).

Competitively managed funded pension plans, in contrast, are more likely to be invested in a mixture of public and corporate bonds, equities, and real estate, thereby earning a higher rate of return (Figure 10). They enjoy the benefits of investment diversification, including international diversification, which enables them to increase their yield and reduce their risk. They build constituencies that help them resist political manipulation. They spur financial market development by creating a demand for new financial instruments and institutions, especially important in middle-income countries. In Chile, financial markets became more liquid as the number of traded shares on the stock market and their turnover increased; demand was created for the equities of newly privatized state enterprises; information disclosure and credit-rating institutions developed; the variety of financial instruments including indexed annuities, mortgage and corporate bonds grew; and asset pricing improved. These developments have played a particularly important role in explaining Chile's rapid growth rate during the twenty years that have elapsed since it started its multi-pillar system. (Valdes-Prieto (1998) and Schmidt-Hebbel (1999a); also see Musalem and Catalan (1999) on OECD countries.)