Testing times for private accounts
If people are free to choose, they will choose freedom. This political philosophy, which was strongly embraced by Thatcher and Reagan in the 1980s, is now at the core of the Bush administration in every field, including economy.
It is the very same principle that would justify a pension reform centered on individual private accounts, where workers will be free to invest a portion of their own salary that now goes to the public retirement system. The idea has been tested already in other countries, such as the UK, as well as in some American states, thanks to their relative independence from central government. The problem, according to Bush’s critics, is that experience does not encourage great expectations: only 125,000 American public employees have opted for individual pension accounts, or 8% of the 1.5m workers who were given the opportunity to do so during the last decade; and most of them made the choice during the stock market boom of the late 1990s. Where private accounts are not voluntary but compulsory, the results are controversial.
In 1964 Nebraska introduced individual retirement accounts for state and county workers, while it left teachers, judges and others public employees in traditional defined benefit (DB) pension plans, managed by professionals. In 2000, during a revision of its pension system, the state discovered that employees invested their accounts too conservatively and achieved returns nearly 5% less than the DB plans’ professional managers. Hence it decided to abandon the private accounts for all employees hired after January 2003, in favour of a centrally run ‘cash balance’ plan that guarantees a minimum of 5% annually and can deliver higher returns depending on its performance.
Since the early 1980s a sort of cash balance plan – which is a DB plan that creates a hypothetical account for each employee – has been in place in three Texas counties, Galveston, Brazoria and Matagorda, where 5,000 government workers decided to forgo social security in favour of the ‘Alternate Plan’.
The latter does not allow members to invest directly in the stock market, but solely in annuities, earning a guaranteed 4% annual interest rate; since its inception the average annual return has been 6.5%. Workers’ contribution is 6.1% of their salaries, their employers’ is 7.7%. In the three Texas counties there are several hundred retirees now collecting benefits (a lump sum or an annuity) based on contributions plus any earnings on that money; but there are still no statistics about how happy they are. Ironically, if cash balance plans look like a viable solution in the public sector, in the private one they are becoming less popular because of their uncertain legal status.
A state that is discussing whether to follow Nebraska’s example is West Virginia: it switched teachers’ retirement to accounts in 1991 to cope with a funding problem, but the move did not solve the problem and it proved that the teachers were unable to make sensible choices. According to a report, they put 40% of their money into investments that were so conservative their projected benefits would be lower than in the old system. The state is now debating whether to switch back.
Michigan quit offering its traditional pension programme to new employees in 1997 and replaced it with defined contribution (DC) accounts, giving existing workers the right to choose the new plan. But only 3,000 eligible workers out of 57,000 opted for the private accounts, which allow investing in 23 different funds.
Washington, Ohio, Florida and Montana are states with voluntary private accounts for public employees – hybrids with a combination of a pared-down pension and a private account. In Washington 75% of the teachers who have chosen the new plan did it on 1996-97 when the stock market was climbing; only 14% chose it in 2003-2004 after the crash. Since 2001, in Ohio, only 5%of eligible workers have opted for the new plan.
The story is the same in Montana, where 30,000 public employees were offered the two options in 2002. Only 900, or 3%, chose individual accounts. Even those who opted for the new system, allowed the majority of their money to flow into a default investment set by the state, a balanced fund of half stocks and half bonds. In other words they chose not to actively manage their money. In 2002 in Florida about 7% – 43,000 of the 600,000 – public employees chose a similar hybrid plan, which was strongly backed by governor Jeb Bush, and was supposed to be a big test of pension privatisation.
This lack of enthusiasm for private accounts can be explained by the very generous pension benefits usually granted to state employees or simply by the fact that most people are risk averse. The latter reason spells trouble for Bush’s pension reform.