Perspectives From Four Continents: Solving the Global Public Pensions Crisis

On December 8-9 the Cato Institute and The Economist cosponsored a conference on the global public pensions crisis at the Queen Elizabeth II Conference Centre in London. Among the speakers were Michael Tanner, director of the Cato Project on Social Security Privatization; Clive Crook, deputy editor of The Economist; Carlos Boloña, former finance minister of Peru; Mukul Asher of the University of Singapore; and Peter Ferrara, chief economist at Americans for Tax Reform and an associate policy analyst at the Cato Institute. Excerpts from their remarks follow.

Michael Tanner: Around the world, pension systems are in crisis—not because of downward trends in the economy or individual circumstances of any individual nation but because pay-as-you-go systems are fundamentally flawed in their structure.

Pay-as-you-go systems do not produce or create any real investment, any real wealth. They are simply transfer systems—they transfer wealth from today’s workers to today’s retirees. And when today’s workers retire, they have to hope that there will be another generation of workers behind them that will, in turn, transfer their wealth. That system, that chain letter, if you will, is supposed to continue indefinitely.

Unfortunately, there are two major problems with that chain letter. The first is demographic. Quite simply, we have an aging world. The proportion of the population of the world over the age of 65 will double by the year 2030, from about 8 percent to more than 16 percent. And that phenomenon is even more acute in countries that are members of the Organization for Economic Cooperation and Development—essentially the United States, Western Europe, and Japan. In those countries, the percentage of the population over the age of 65 will go from approximately 18 percent to an astounding 32 percent.

At the same time that we are living longer—which, in my opinion, is a wonderful thing—we are also experiencing a decline in fertility rates around the world. In 1970 the fertility rate was approximately 3.3. Today it is down to 2.96, and by 2020 we can expect it to be as low as 2.5. In fact, in every country of Western Europe—with the exception of Ireland—the birth rate is now below the replacement rate. So West European populations will actually shrink.

The result of such changing demographics is that the worker/retiree ratio is shrinking rapidly. The number of workers paying into the system and transferring their wealth to retirees is getting smaller and smaller. In many nations—for example, Austria and Belgium—that ratio is already below two to one. And by 2030 it will likely be below one to one. Clearly, you cannot have a system under which each worker has to support a retiree.

The second problem is perhaps more fundamental. Pay-as-you-go systems break the link between contributions and benefits—or, as Josˇ Piñera likes to say, the link between effort and reward. And whenever you break that link—that is, whenever the benefits you receive are not directly tied to the contributions you make—the door is open to political mischief. Politicians are likely to succumb to the elderly lobby and attempt to increase payments when such a move is not economically feasible.

In November 1997 a participant at a conference in Yugoslavia told me how that phenomenon is wreaking havoc with Yugoslavia’s pension system. Retirees in Yugoslavia now receive more in retirement benefits than they did in wages when they were working. And the reason given for that anomaly was simple: "We have a lot of elections and every time there’s an election, the elderly lobby, which is about 33 percent of the electorate, demands higher pensions. And naturally, politicians who wish to win office, give them higher pensions—even though such policies are unstable in the long run."

Pay-as-you-go systems around the world are collapsing under their own weight. Payroll taxes are already over 25 percent in many countries of Western Europe, and in many countries in Eastern Europe payroll taxes are approximately 50 percent. Such burdens are simply crushing those countries’ economies. The only solution for them, and for the United States, is to fundamentally change the structure of their systems—that is, to privatize their systems.

Clive Crook: In this company of speakers, I am very much an amateur, so I’m going to confine myself to a brief plea: that we keep in mind the importance of individual liberty as we discuss potential reforms. It seems to me that should be our guiding principle.

When you discuss pension reform, you repeatedly come across two arguments: that privatization is inevitable because of the changing demographics of countries and that privatization would increase national savings and economic growth. There is merit to both of those arguments. Indeed, on the latter score, Martin Feldstein of Harvard has estimated that if the United States privatized its pension system, the nation’s capital stock would rise by about 12 percent after 25 years and by about 34 percent over an extended period. But while changing demographics and increased economic activity bolster the case for privatization, they are ultimately not reliable counterarguments to those who favor the existing system.

It is true that the current systems are not sustainable as they are now structured. But they can always be altered slightly—by either decreasing benefits or increasing taxes—and made sustainable for an indefinite period of time. And that is all proponents of the status quo need to do to meet their goals.

Well, you might think, that might be true, but how can one reject the arguments that Feldstein makes? The answer, I think, lies in his assumptions. He assumes that capital accumulation and economic growth are worthwhile goals—assumptions that I think most people would agree with. But if such things are undeniably good—and if it is the proper role of government to promote them through compulsory savings programs—why not say that everyone has to save 30 or 40 percent of his income instead of just 12.4 percent? That would increase capital accumulation even more. Feldstein dodges that question.

In fact, the only way to deal effectively with that question is to argue that it is simply none of the government’s business how much we save. There should be no government target for growth and no government target for capital accumulation. Such decisions should be left to individuals.

And that brings me back to my central point: the principal reason we should privatize our government pension systems is that doing so would increase individual liberty. Indeed, privatizing those systems is the biggest opportunity we have to advance the cause of self-determination in today’s advanced economies.

In America, one of the richest countries in the world, half of all workers retire with savings equivalent to less than six months of earnings. That, in my view, is largely because Social Security leads them to believe that they don’t need to save. If we privatized Social Security—or, better yet, if we made all retirement savings voluntary—people would not feel that they could rely on the state in their old age and would begin to take responsibility for their retirement early in life. Such a change would produce marked increases in both individual liberty and self-determination and a marked decrease in dependence on the state.

When we discuss pension reform, we must not forget that big government is a bad thing in its own right. It would be a bad thing even if it didn’t keep screwing up public finances. And it would be a bad thing even if it promoted rapid growth and capital accumulation. Big government makes people think that it is the government’s responsibility to take care of them—or, at the very least, to mandate how they should take care of themselves. We should oppose such paternalism and replace it with self-determination.

Carlos Boloña: In 1991, when I was minister of finance, Peru was the second country in the world to privatize its pension system. The reason we did so was simple: the system was bankrupt and becoming an unsustainable burden. In short, when you’re in hell, you need to make changes. And it helps to make changes as rapidly as possible.

Since Josˇ Piñera is on the panel here today, please allow me one digression before I make a few observations about how best to implement a privatized system. At the time of the reform, the president of Peru was very concerned. He wasn’t convinced that we should privatize the pension system. So we brought Josˇ to talk to him, to discuss what privatization had done for Chile. And, of course, Josˇ was able to convince him that privatization was in Peru’s best interest. The reform might not have been signed into law without Josˇ’s assistance.

Now, I would like to reflect briefly on our experience in Peru:

• Proponents of privatization must present a very clear message to the workers of their countries. You shouldn’t get bogged down in the macroeconomic aspects of privatization. From my experience, people don’t find those arguments compelling. What they do find compelling—or at least what the workers of Peru found compelling—was the following message: "We want to return your savings to you. The savings are yours and the government has taken them from you and misused them for too long."
• You need to have a persuasive national figure—someone who is not seen as beholden to the government, to unions, or to big business—who will really push the reform and inform people that privatization is in their best interest.
• Do not tax retirement savings. If you’re going to tax anything, tax consumption. One of the problems we encountered when we privatized our system was that we initially taxed savings and, as a result, decreased the number of pension firms that was willing to get involved in the system.
• Do not close the doors to new entrants. Allow new pension firms to enter the system, and give workers wide discretion over how they invest their money—and with whom.
• Do not simply assume that you must have a minimum pension guarantee.
• We do not have such a guarantee in Peru, and I don’t think that we should. I believe that minimum pensions present a moral hazard problem. If you guarantee someone a minimum pension, you give that person an incentive to invest haphazardly—to place his money in highly risky investments in hopes of huge returns.

Any country that follows such broad guidelines will, I believe, have success. In Peru, retirees are now averaging a 9 percent annual return on their savings. That’s not as high as we would like it to be, but it is certainly higher than it was. Indeed, under the old government-run system, retirees could expect a negative rate of return on their retirement savings.

But, despite such success, we still face another challenge—the final challenge. The final challenge is to allow individuals to move from a forced savings system into a voluntary savings system. I would like to see the people of Peru demonstrate that, as individuals, we can manage our destiny, our future, our pensions, in a much better way than the government can—either directly or indirectly. If we wish to live in a free society—where people are free to live their lives as they wish—that must be our ultimate goal.

Mukul Asher: I would like to take this opportunity to briefly discuss how Singapore is performing and to address what I think is the central issue in the worldwide debate on pension reform: how to structure a system that will produce sufficient benefits for retirees while simultaneously minimizing adverse effects on economic incentives and international competitiveness.

I think Singapore’s case is quite interesting, because Singapore is one of the few countries that never had a pay-as-you-go system. Instead, its retirement system consists of state-mandated and state-managed individual retirement accounts.

Before I go into a detailed analysis of the system, let me tell you that Singapore is not doing well at providing an adequate replacement rate. And that suggests that just because a system is supposedly centered around "individual retirement accounts," it isn’t necessarily desirable and sustainable. If the system is still regulated heavily by the state—or, indeed, managed almost wholly by the state—it could encounter many of the same problems that a pay-as-you-go system encounters. In this case, the devil really is in the details.

The retirement system in Singapore is administered by the Central Provident Fund, which is a government statutory body. In addition to retirement benefits, the CPF also administers housing and health care schemes, educational loans, various investment schemes, and a number of other programs. So the system is really not a pure retirement system. The multiple-objectives character of the CPF reduces transparency and makes it difficult for participants and policymakers to assess its full impact.

As you would expect, to cover those numerous schemes, you have to have very high contribution rates. Currently, the contribution rate is 40 percent—20 percent is paid by the employee and 20 percent by the employer.

Because the CPF administers so many different programs, there are substantial preretirement withdrawals. Indeed, such withdrawals averaged 71 percent of total contributions annually during the period from 1992 to 1996. Obviously, that reduces the amount available for retirement and substantially dilutes any net impact of high contribution rates on aggregate domestic savings. Indeed, an econometric study done in 1995 by the International Monetary Fund found that the CPF had virtually no impact on aggregate savings in Singapore.

Now let me focus a little bit on the system’s return on investment. There are three separate pools of investible funds under the CPF system. The net value of the largest is equivalent to about 55 percent of gross domestic product. At the end of 1996, 99 percent of the assets in that pool were in nonmarketable government bonds, issued specifically to the CPF Board to meet their interest obligations. The interest on these bonds is identical to what the CPF Board pays its members. This in turn is the average of short-term deposit rates of four local banks. The bonds do not have quoted market values.

For the last decade, the effective real rate of return on the bonds has been close to zero. And that is the primary reason why the Singapore system is failing, because no accumulation fund that provides such a rate of return can provide a proper replacement rate at the end.

And that isn’t the end of the story. Although the government of Singapore has been running a budget surplus since 1968, it has, of course, also been issuing the retirement bonds. And as a result, there is, in fact, a very large internal public debt. Currently, it is equivalent to about 80 percent of GDP. The money raised from issuing bonds to the CPF Board is invested by the Singapore Government Investment Corporation. Its portfolio and investment performance are not made publicly available. Thus, CPF members do not know the ultimate deployment of their funds.

So what you have in Singapore is a retirement system with little transparency in the investment function and a bad replacement rate. The system consists of retirement accounts that are individual in name only. Countries that are contemplating pension reform based on individual accounts may find it necessary to undertake the investment functions differently. The CPF system, however, is quite efficient in its housekeeping functions.

Peter Ferrara: I would like to briefly discuss what I think should be the eight major elements of a privatized pension system. First, you should effectively decrease the tax burden. Americans currently pay 12.4 percent of wages into the Social Security system. But in a private system, you wouldn’t need to put as much in because the returns would be significantly higher. What I would suggest is that instead of the worker and the employer each paying 6.2 percent into the system, they should each put only 5 percent in. The remaining 2.4 percent would be used to finance the transition from a public to a private system; it would then be eliminated.

Second, we should privatize the survivors’ and disability benefits that Social Security currently provides. Part of the funds that go into the private system would be devoted to life insurance to cover the survivors’ benefits, some would buy private disability insurance to cover the disability benefits, and the rest would be saved and invested in individual accounts.

Third, the government should license a number of investment companies to handle retirement accounts, and individuals should be free to choose their company at will. In Chile there are 21 companies that are licensed. In the United States I would expect that number to be a hundred times as large, given the size of the country and the sophistication of its financial markets.

Fourth, funds contributed to the private retirement accounts should be taxed once, either up front or at retirement. That is, if the contributions to the private accounts are tax-deductible, then the retirement income they pay should be included in taxable income. If the contributions to the private accounts are not deductible, then the retirement income they pay should not be taxed. The returns to the private account investments should be tax-exempt, as IRA returns are today.

Fifth, the government should issue recognition bonds, as they did in Chile. People who were already in the workforce at the time of privatization would get a bond that would pay them a portion of future Social Security benefits equal to the proportion of lifetime Social Security taxes that they had already paid. I would also guarantee a minimum benefit level. But since returns under the private system will be so much higher than they are currently, I think only a tiny fraction of all retirees would actually qualify for the minimum benefit.

Sixth, workers can choose to remain in the current system if they desire. I think that proposal is a winner both in theory and in practice. In theory, we should not change the rules of the game in the middle of a contest. If people want to stick with the system they have, they should have that right. In practice, it enables us to demonstrate that opponents of privatization really are paternalists. In a debate, for example, we could say, "Let’s allow the people to choose what they think is best. If they agree with my opponents that the status quo is wonderful, they can stay in that system. And if they agree with me that a private system is a better deal, then they can chose the private system. But let’s not impose our choice on them." That, I think, is an unanswerable argument, at least in the American political context.

Seventh, participation in one of the systems—either private or public—should be mandatory, at least for now. Although I would like to see retirement savings be completely voluntary, I do not believe that option is politically viable at the moment. I hope it will be in the future. In fact, I think privatization may help get us to that point.

Eighth, for those who stay in the current system, the rate of growth in benefits would have to be reduced, because they are growing at an untenable pace.