All over the world, public pension funds – like Social Security- are heading for bankruptcy under the impact of three trends: ageing population, slowing productivity growth and increases in longevity. Unless these systems are reformed immediately, governments face an unsavoury choice of raising taxes and/or cutting benefits to maintain the current systems. Because most public pension plans are, at present, not funded, they are feeling the negative impact of these trends. They are financed instead, thanks to an ingenious piece of financial engineering called Pay-As-You-Go (PAYGO), by the current contri-butions of the younger working generations.
It is readily understandable that the three developments mentioned will have the effect of reducing the income and contributions of the young relative to the pension claims of those retired, pushing a PAYGO system toward insolvency. But the remarkable thing is that these same trends would tend to not impact a funded system, because the pensions of the retired are paid by their own accumulation. The problems of PAYGO are not imme-diate but the longer we wait, the harsh-er the costs borne by future generations.
Faced with the problem, many well-meaning reformers have come out in favour of moving towards a type of radical restructuring of the current PAYGO system, which goes under the name of ‘privatisation of social security’. This is a (highly misleading) name, ably picked by its inventor and propagandist, namely Chile, at a time when ‘privatisation’ was a holy word. The aim of its 1981 pension reform was that of eventually eliminating social security, by redirecting the individual contributions to individual accounts, whose accumulation would serve to fund the pension, replacing the social security PAYGO pensions.
The Chilean example has had a remarkable appeal. It was promptly imitated by many large and small countries in South America and eastern Europe, partly at the urging/coercion of agencies such as the World Bank. It has also been proposed for other developed countries including the US, where President Bush’s commission to strengthen social security has recommended offering an option to shift contributions to private accounts. There are a number of reasons why this approach seems appealing.
In the first place the name ‘privatisation’ and the elimination of a public pension agency (social security) appealed to the many (especially the fans of the market) that were easily persuaded that the malady affecting all PAYGO systems was due to the well known shortcomings of publicly managed agencies (stupidity, wastefulness, dishonesty, personal interests, etc). Hence returning to the private investor the right to decide how to invest his retirement reserves was bound to be a great improvement.
Actually this view of the cause of social security’s problems is largely fallacious. The current difficulties arise from the interaction of the structure of PAYGO and exogenous events. These difficulties were compounded when the system was poorly designed, for example, failing to provide an adequate inflation protection, or investing surpluses poorly, as was variously the case in Chile and other Latin American countries. On the other hand, social security in the US and numerous other countries with PAYGO, are running into difficulties without any evidence or record of any of the above public failures.
Conclusion: the troubles are not due to public mismanagement, but to poor design, which can be eliminated without recourse to individual accounts.
The second source of appeal is the replacement of PAYGO with funding, a system less accident prone, and possibly more cost effective. But the proponents forget that a funded system is superior because it is already funded!
A funded system has accumulated the capital necessary to pay pensions. But with PAYGO there is no accumulated capital, hence in order to move to funding, that capital has to be accumulated. It cannot be accumulated by simply redirecting contributions from social security to individual accounts, because social security needs those contributions to pay the current pensions – something the Bush commission does not address clearly. To accumulate the capital requires appropriate forced saving, for example, by requiring current participants to pay double contributions: one to finance the old pensions and one to fund the new system. This poses a very difficult problem, known as the ‘transition problem’ involving some highly delicate intergenerational equity issues. These issues have been poorly handled in the South American reforms, generally worse than in Chile. Fundamentally, the transition has been financed through government deficits, which impoverish the country through less capital and more taxes.
Those who have pushed for the imitation of the Chilean privatisation have failed to realise some very fundamental flaws. The crucial one is that it eliminates the government guaranteed progressive pensions under the current DB structure to replace it with ‘defined contributions’, a structure under which the contributions remain government mandated, but benefits become highly erratic. One must conclude that privatisation leaves to the government all major decisions: the only thing it truly ‘privatises’ is risk! This results in an arbitrary and capricious redistribution of pension income. Some will end up above average, but they will be offset by those who will do worse. The inequalities generated by privatisation are especially repellent because they are artificial and serve no useful functions. Individual portfolios will tend to increase the gap between the rich and the poor.
Result: the poor will receive smaller pensions while the pensions of the rich will be enhanced. The management costs, combined with additional costs of administration and regulation are prohibitive, often causing a reduction in pensions of as much as 15%-20%.
Franco Modigliani is Professor Emeritus Massechussets Institute of Technology, and winner of Alfred Nobel Prize in Economics (1985), and Arun Muralidhar is managing director at FX Concepts Inc in New York