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Special Report

ESG: The metrics jigsaw

Sections

And the 'Blue Ribbon' answer...

We propose a more pragmatic direction that leverages the best practices adopted by corporate pension funds. If anything, the mistake made by many reformers was to confuse ‘corporatisation’ with sprivatisations. In our forthcoming book ‘Rethinking Pension Reform’ (Cambridge University Press), we propose a ‘permanent’ solution to the problem of maintaining current benefits levels and stable contribution rates. Our approach, which we label ‘Risk diversification through a common portfolio’, achieves lasting reform by gradually shifting from PAYGO toward one more like a traditionally funded system under which pensions are funded by the capital accumulated, through lifetime contributions, while maintaining the defined benefit (DB) structure.
To cover the growing funding gap in social security, reserves must be gradually increased above the level projected with the current system. We agree with President Bush’s Social Security Commission that one way to secure these additional resources is to invest reserves in the securities market, rather than in low-yielding loans to the government. But we hold that the cost and risk effective way to do so is not through individual accounts managed by some manager from a government approved list, but by continuing to direct all contributions to the existing trust funds that will invest all reserves in a common portfolio. We require the portfolio to be invested in market securities in the form of a highly diversified portfolio, under the supervision of a Blue Ribbon Board. Ireland and Canada have successfully created such boards. The common portfolio, together with some imaginative financial arrangements (eg, a swap between the Treasury and the Social Security Administration), insures that all participants enjoy the same safe return, thereby providing the foundations for the continuation of defined benefits. Pooling also dramatically lowers management and administrative costs. In addition, our book demonstrates how innovative arrangements such as variable contributions – practices that are commonplace to the corporate fund world – can lower asset-liability risk. It also demonstrates that retaining a defined benefit as the first pillar, combined with voluntary savings, is critical to the achievement of diverse retirement objectives.
However, any proposal to invest reserves in the market, even in the more efficient form of the common portfolio, is no longer sufficient to solve the social security funding problem in many countries including the US. Such a step alone might have been sufficient if supplemented by the kind of government contribution that had been promised by former President Clinton out of the huge surplus that he bequeathed to President Bush. Unfortunately, the Bush tax cuts, plus declining revenues and rising spending have eaten up the entire surplus.
Given that the budget deficits are projected to grow dramatically into the future, the only feasible alternative is to increase, once and for all, individual contributions. By how much depends upon how promptly such an increase is implemented: the longer the wait, the greater the cost. We calculate that if done immediately, the contribution increase necessary to cure the problem for the indefinite future can be very modest (1 percentage point or raising contributions from 12.5% to 13.5%) assuming very prudently that the portfolio in the Trust Fund would have a long run real return of approximately 5.25%. And that increase could be reduced, or even eliminated, with a higher return and /or by introducing some reasonable modifications, such as indexing the standard retirement age to life expectancy. The contingency of an appreciably different long-term return can be readily handled by allowing some flexibility in the rate of contribution.
If we procrastinate until the Trust Funds are exhausted, individual contributions needed to maintain benefits would have to rise by approximately 50% to a tax of 20% of wages. But if we act now, social security can be saved for the indefinite future, in substantially its present form with a few simple, affordable reforms, namely: (i) continue to direct all contributions to social security with instructions to invest any surplus in an indexed market portfolio under the supervision of a Blue Ribbon Board; (ii) authorise Social Security and the Treasury to implement a swap to guarantee a real rate of return and thereby insuring the continuation of DB; (iii) decree a small, permanent increase in the contribution rate; and (iv) allow for some long run flexibility in contributions.
These are personal views of the authors.

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