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Chile's Model Social Security System.

The United States is certainly not the first nation to try personal accounts in Social Security, and it probably will not be the last.

The National Center for Policy Analysis notes:

"Currently, some 80 million workers in 20 countries have access to personal retirement accounts. These countries include Chile, the United Kingdom, Switzerland, Denmark, the Netherlands, Argentina, Colombia, Peru, Bolivia, Mexico, Uruguay, Australia, Hungary, Kazakhstan, Poland, Latvia, Sweden, Hong Kong, El Salvador and Croatia (roughly in the order in which they adopted the plans).

Macedonia, the Dominican Republic, Kosovo and even China have passed reform laws, which they are now in the process of implementing. Other countries are moving in that direction."

Social Security systems designed like Ponzi schemes are destined to fail (more on this from a previous WILLisms.com post); a high priority in reforming Social Security in any country must be the creation of a self-sustaining system, based on market forces, not beholden to demographics.

For American workers and American companies to continue to compete (and typically win) against emerging economic powers in China and India, Social Security must offer Americans advantages, or, at least, must NOT place the U.S. at a disadvantage, as it does now.

The first country to "privatize" its Social Security system was Chile. José Piñera, who was a member of the Chilean government that transformed its Social Security system almost 25 years ago, answers whether it has been successful:

"Since the system started on May 1, 1981, the average real return on the personal accounts has been 10 percent a year. The pension funds have now accumulated resources equivalent to 70 percent of gross domestic product, a pool of savings that has helped finance economic growth and spurred the development of liquid long-term domestic capital market. By increasing savings and improving the functioning of both the capital and labor markets, the reform contributed to the doubling of the growth rate of the economy from 1985 to 1997 (from the historic 3 percent to 7.2 percent a year) until the slowdown caused by the government's erroneous response to the Asian crisis."

Estelle James, offering a fair examination of the pros and cons of Chile's system in the Washington Post, describes "How It's Done in Chile:
Personal Accounts -- With Strings Attached."

"The virtues of Chile's system have been trumpeted by those seeking to replicate it here. Unlike traditional social security payments, benefits in Chile are based on personal investment accounts owned by workers. Chileans don't worry about whether the government will run out of money as baby boomers retire, because benefits are financed by their own assets, which have been accumulating in their own accounts, not by taxes paid by current workers. The funds are privately managed and therefore insulated from political interference."

James argues that the principles of Chile's system are great, but the United States can do better in a few key areas:

1.

"Workers in Chile had practically no investment choice for 20 years. Each asset manager could offer only one portfolio and portfolios were all similar.

....

If we create personal accounts in the United States, we should also make portfolio choices simple, limited and diversified -- including international securities -- to protect inexperienced investors from themselves."

Meaningful choices, but not unlimited choices.

2.

"Chile's system initially had very high administrative costs, in part because fund managers had to invest in new information technologies and marketing tools. As assets grew, costs fell dramatically and are now about 1 percent of assets, lower than in the average U.S. mutual fund.

....

In the United States, we can do better. We can enjoy economies of scale and the bargaining power obtained from aggregating many small accounts into enormous sums. For example, we could auction off the rights to run the funds to a limited number of asset managers, which would push down their fees. We could require the use of index funds and collect contributions through the existing tax collection system. The experience of the retirement plan for federal civil servants suggests that these techniques would cut our costs to about one-third of those in Chile."

When critics talk about "costs" of "privatization" adding up to trillions of dollars, they are consciously distorting the fact that reforming the system would mean moving future liabilities to the nearer term to make them more manageable (are those really "costs" at all?). Rather, those with anti-reform agendas are purposely trying to elicit notions of Wall Street guys in pinstriped suits collecting fees galore. This is simply not the case. 30 basis points is nothing.

3.

"Chile's minimum pension is good, but could be even better. On the plus side: It keeps low-income pensioners from falling way below the average standard of living. On the negative side: It offers no extra safety net for more than 20 years of work. Some low earners avoid contributing beyond 20 years because their additional contributions would simply replace subsidies they would get otherwise. In the United States, we could avoid creating such perverse incentives."

Other nations, including the U.K., Australia, Sweden, and even Russia have moved to one form or another of privatization, mostly with positive results, although anti-reform forces like to point out the problems in those systems, problems the U.S. will certainly avoid.

Reforming Social Security will require a careful examination of the potential consequences, in order to create a system without unnecessary drawbacks. The United States can learn much from the successes and failures of other countries on the issue, repeating the successes and avoiding the failures.

Posted by Will Franklin · 14 February 2005 11:01 AM

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