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Social Security Reform in Other Countries Part III

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

As we consider converting our present Social Security System from an unfunded defined benefit plan to a partially funded defined contribution plan, we might do well to consider the experience of other countries that have traveled that path.

Chile was an early example of a country that switched from a pay as you go (PAYGO) system to a privatized one, and a number of other countries made that move as well. However, not all of them opted for a totally privatized system: Many incorporated a tiered approach where the state runs one plan, and private accounts supplement or compliment the state system. Because no forced savings/retirement investment plan can ever replace a social safety net in every case, minimum death, disability and welfare benefits were provided. Nevertheless, the way these ancillary benefits are funded varies widely, greatly complicating any comparisons between programs.

The different funding mechanisms used by other countries range from nonprofit cooperatives, state run investment pools, private investment companies, notational accounts, and/or national bonds. Some systems operate as state sponsored monopolies, while others offer wide competition between providers for accounts.

Inevitably, any system converted from PAYGO to “funded” will experience additional transition expenses. Each generation finds itself paying for their parents’ retirement benefits while simultaneously accumulating for their own and for the benefit of succeeding generations which inherit a properly funded system. In other countries, additional costs have been funded by additional taxes, issuing bonds, reducing benefits, cutting other government spending, delaying retirement, selling state assets or some combination of the above. Short term transition costs are inescapable and will not be trivial. Over time these transition costs will decrease and disappear. Presuming a successful program, long term costs will be reduced.

Successful programs do not magically appear. We can certainly find great examples of what not to do. For example, the British turned loose an army of salesmen armed with substantial tax incentives to convince their citizens to switch from a state system to a private one. Unfortunately, the advice that they gave was so tainted by their own compensation that it fostered a national scandal, referred to as the “mis-selling scheme”. More than 350,000 unsuspecting participants switched to private systems providing substantially inferior projected benefits. To date, these sponsoring companies have had to disgorge more than 20 billion pounds as partial compensation. Evidence suggests that mis-selling continues today.

In the case of Poland, the country now has more than 1% of its population licensed to sell retirement benefits. The only qualification to provide this investment advice appears to be the absence of a felony conviction. While the financial advice may not be first rate, the impact on administrative and marketing costs is dramatic.

Competition between commercial providers for assets, coupled with generous commissions and incentives to switch providers, run up administrative costs to unacceptable levels. For instance, some estimates of the Chilean system indicate that more than 25% of the potential benefits have been consumed by these costs. Not all systems are transparent, and many hidden costs exist to drag down performance.

In an effort to provide participants with more choices, some countries like Mexico are allowing investment companies to offer sub accounts with unlimited switching. While it sounds good in theory, there is no evidence that investors will benefit from this freedom. And, frequent switching introduces a moral risk. If participants deplete their accounts through poorly conceived market timing adventures, the government may have to bail them out later with minimum benefit payments.

Meanwhile in other countries, government regulations covering asset allocation are so restrictive that market rates of return are highly unlikely. At the extreme, some countries fund only with their own bonds, eliminating any potential benefit to economic growth and capital formation. A combination of reduced total return coupled with high administrative costs and commissions could easily void any of the claimed potential benefits of funding or privatized accounts.

Accordingly, my worst nightmare for the Social Security System would be to turn it into a super IRA account complete with an army of commission crazed variable annuity salesmen. While funding seems appropriate and separate accounts may provide some additional benefits, the system is simply too important to be turned over to Wall Street’s robber barons. I would far prefer the government to invest the funding in a globally diversified passive portfolio designed to capture global market returns at minimum risk and cost. Even then, a conversion to a defined contribution system must not sacrifice the safety net which we provide to our citizens. Rugged individualism is just fine, but some members cannot compete for reasons that may be legitimately beyond their control. At the end of the process, not only should the system be more efficient, but it also should lead to a kinder, gentler society. How this might be accomplished in the Administration’s proposals has not been made abundantly clear.

Available evidence in several countries points toward reduced benefits for the lower paid participants, those that enter and leave the workforce frequently, and women who have career interruptions for childrearing. Careful plan design will be necessary to insure that these vulnerable segments will not lose the benefits. Defined contribution plans are not as easily adopted to transfer payments as the existing system, but with some thought they could be made to work.

At this time it appears that the Bush proposals are dead in the water. But the debate is far from over. Reform of Social Security is necessary and inevitable. No one should want to see one of our greatest accomplishments dismantled or weakened. A careful balanced review of other countries’ efforts will help us to get it right.