Transcript How to Set Up an IA System in the US

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 systems
Diffusion of structural reform around the world, 1980-2000
Cumulative number of reforming countries
25
20
15
10
5
0
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Number Contributors to Mandatory Multi-pillar Systems, 1982-2000
80
Ho n g Ko n g
70
Hu n g a ry
E l S a lv a d o r
Ka z a kh s ta n
P o la n d
B o liv ia
Arg e n tin a Me x ic o
60
In millions
50
Un ite d Kin g d o m
40
30
Au s tra lia
Co lo m b ia
De n m a rk
P e ru
Uru g u a y
S witz e rla n d
Ne th e rla n d s
20
Ch ile
10
0
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 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)
Implicit Public Pension Debt, 1990
Explicit debt
Canada
Implicit public pension debt
France
Germany
Italy
Japan
United States
0
50
100
150
200
250
300
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%
Average
Uganda
Zambia
Venezuela
Egypt
Ecuador
Sri Lanka
Guatemala
Kenya
Jamaica
Canada
Singapore
Morocco
Costa Rica
India
Malaysia
US
Sweden
Philippines
Korea
Japan
-12%
-10%
-8%
-6%
-4%
-2%
0%
gross returns minus bank deposit rate
RETURNS TO PUBLICLY MANAGED FUNDS
2%
4%
-8.4%
Average
Peru
Uganda
Zambia
Venezuela
Egypt
Tanzania
Ecuador
Costa Rica
Guatemala
Kenya
Singapore
Sri Lanka
Jamaica
Korea
Japan
India
Canada
Malaysia
Sweden
US
Morocco
Philippines
-50%
-40%
-30%
-20%
-10%
gross returns minus income per capita growth
RETURNS TO PUBLICLY MANAGED FUNDS
0%
10%
Average private schemes
Average public schemes
Switzerland (70-90)
Japan (70-87)
United States (70-90)
Canada (75-89)
Denmark (70-88)
Hong Kong (83-96)
Netherlands (70-90)
Japan (84-93)
Switzerland (84-96)
Denmark (84-96)
Australia (87-94)
United Kingdom (70-90)
Spain (84-93)
Netherlands (84-96)
Ireland (84-96)
Chile (81-96)
Belgium (84-96)
United States (84-96)
Sweden (84-93)
United Kingdom (84-96)
-10% -8% -6% -4% -2%
0%
2%
4%
6%
Gross returns minus income per capita growth
RETURNS TO PRIVATELY MANAGED FUNDS
8% 10%
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 1530% 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 optout? 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.