Transcript How to Set Up an IA System in the US

Key Decisions in Constructing a
Social Security System that
Includes Individual Accounts
by
Estelle James
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Social security has become a
contentious issue. I will discuss:
• Many points of agreement on all sides
• One key point of disagreement
• Issues concerning best way to reform DB
scheme and best way to set up IA
• Questions, not answers; I would appreciate
your answers
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Points of agreement:
• 1. Need for change to make system
financially solvent for the long run:
– Baby boomers will begin retiring 2010. By
2016 social security’s expenditures >payroll
taxes; ss will begin cashing in govt iou’s
– By 2038 iou’s will be exhausted. At that point,
expected revenues will cover only 72% of
promised benefits
– Therefore some changes in benefits and/or
revenues are needed to keep system sustainable 3
Points of agreement (Cont’d)
• 2. Important to improve output and
productivity in economy--real source of
security for workers and pensioners
(savings, work incentives)
• 3. Improved protection for low earners
beneficial
• 4. Gradual change better than sudden
• 5. Pre-funding is desirable--gradual, builds
saving, obligations and assets transparent
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Many people on all sides believe that
pre-funding is part of solution
• 1) Gradual-avoids need for sharply rising
contribution rates as populations age.
• 2) Increases national saving and investment
– if doesn’t crowd out other personal saving
– if doesn’t increase government deficits
– enhances capital formation, productive capacity
• 3) Enhances transparency of long term
obligations that are being incurred and
builds up assets to cover these obligations
• 4) Gradual change options imply funding
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Disagreement: Who should
control investment strategy-public or private sector?
• Once we have funds, someone has to
manage them
• Should funds be managed publicly or
privately? Which is best for social security
system and broader economy? Need for
public debate on this issue.
• Argument for IA’s stems from belief that
private competitive is better than public
management.
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Why private management? (Why
not public investment of trust fund?)
• Historically, surpluses used to increase current
benefits so no saving--funds not there later
• When funds accumulate many countries have
had serious problems with public management
of pension reserves--funds not there later
– Low, even negative rates of return, inefficient
allocation of capital
– Mainly invested in government bonds--may
increase national deficits that are hidden and
wastefully spent--no net increase in saving.
– Also invested in failing SOE’s and other politically 7
motivated projects--bad for system and economy.
-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%
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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%
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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?
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– Public investors & corporate governance
IA’s are not a totally new
experiment. More than 20
countries have adopted IA’s.
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
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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
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Key facts about these plans
• 6-12% contribution rate to funded pillar.
– Larger % of wages than under considered in US
• All plans have included PAYG or taxfinanced social safety net
• OECD countries used add-on, Latin America
and Eastern Europe carve-out--transition
costs
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2 key issues for 2-tier system
with IA’s
• In system with IA’s, social security consists
of two parts: Part I is modified PAYG DB,
Part II is IA.
• IA’s can be designed in better or worse way-what is best way?
• Modified PAYG DB will remain as part of
final system--how should it be restructured
for sustainability, equity, and efficiency?
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How to restructure remaining
PAYG system
• With or without IA’s, DB benefits will have
to fall or taxes rise for solvency
• 1) Should benefits be cut? How? When?
• 2) Should taxes be raised?
– payroll tax rate?
– payroll tax ceiling?
– general revenues (by raising taxes or cutting
other public goods?)
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3) Should retirement age be
changed as longevity increases?
• This would improve work incentives,
economy’s productive capacity, finances of
DB plan, but with disutility from more work
• Would workers prefer benefit cut, tax hike,
or retirement age increase?
– raise normal retirement age? early RA?
– index NRA to longevity?
– increase # of years that enter into lifetime wage
(currently no added benefit for years > 35)?
– How much to leave to collective choice v.
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individual choice with incentives?
Key decisions for IA Design
• Voluntary or mandatory participation in IA?
• Should add-on or carve-out be used?
• How to structure the benefit offset?
• How to finance the transition?
• How to moderate risk?
• How to keep administrative costs low?
• How to handle the payout stage (annuities)?
• Impact depends on details of answers
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How to cover transition costs?
• In long run funded system should cost less
because of positive rate of return that stems
from productive capital, but in short run
added money is needed to build capital in
IA’s while still paying pensioners
• In well-designed system financing gap lasts
about 30 years. How to cover this
temporary transition financing gap?
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Sources of transition finance
• Keep some workers and their contributions
in PAYG system (older workers, voluntary
opt-out, only partial shift to funded IA’s)
• Use other assets or general revenues to cover
temporary gap (budget surplus, smaller govt
expenditures, SOE sales)
• Borrow in short run, repay in long run
– flexible, spreads burden over generations
– can borrow part of assets in IA’s
– repayment necessary for positive savings effect
• Transition costs are simply an explicit
recognition of past debt. Temporary.
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What to do about risk?
• Risk and uncertainty inevitable in all old
age security plans, given long time horizon
• Political risk--governments change,
benefits cut, accumulated funds dissipated
• Financial market risk--price volatility
• Other countries restrict portfolios, have
relative or absolute guaranteed, safety net
• Key to limiting risk: require broad
diversification across stocks and bonds,
avoid market timing (historically, no loss with20
20-years of diversified investment); pub + pvt
How to keep administrative costs low-controversial but soluble
• Key issue in system with small accounts,
because record-keeping & communication
costs are fixed per account--can use up returns
• Keep service modest to contain R&C costs
• Constrain choice to low cost products
(index funds), especially at start-up
• Aggregate funds and use competitive
bidding--scale economies, low marketing cost
• Hold investments for long term
• Annual costs .15-.20% of assets, much
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lower than in Latin Am. or US mutual funds
Conclusion
• Basic problem is that many people would like to
keep benefits we have without increased cost-but that is not a viable option. All viable options
cost small amount more initially (funding &
transition costs) or much higher taxes, lower
benefits later.
• “Do-nothing” option means large benefit cuts or
tax increases later. Funding can improve benefits
and economy in long run. Private mgt of funds
avoids political manipulation. Impact of private
mgt depends on details of how system is set up.
• Public ed. about difficult choices and trade-offs.
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Sooner means more gradual, less painful.