Advocates of privatizing Social Security point to the success
of Chile. In 1981, Chile replaced its inefficient state-run pension
program with a private system where workers fund their own retirements
through compulsory private savings. The Chilean solution has captured
the imagination of free-market believers the world over. But a
closer look suggests that Chile is no model for the United States.
One problem is huge management fees. Up to 20 percent of worker
contributions go to middlemen. A second failing is that only a
little over half of Chilean workers make regular social security
contributions. And even for those who do contribute, Chile's new
private system provides little progressive redistribution of income.
Chile has also benefited from fortuitous timing. Unsustainable
high rates of return in both stocks and bonds have exaggerated
its long-term success.
Even more fundamentally, the two systems are not comparable. Chile's
old system was an administrative mess. Like many other Latin state-run
pension systems, it was underfunded and failed to provide adequate
coverage to most workers. Our system, by contrast, is well managed,
clean, and nearly universal. In the U.S., privatization is far
too radical a cure for what is essentially a modest actuarial
THE PRIVATE GRAIL
In the Latin American context, privatization seemed a plausible
remedy to the corruption and inefficiency of state-run systems,
in nations not noted for clean and reliable government. In the
Southern Cone of South America, aging populations and massive
evasion by both employers and workers created a system disastrously
out of balance. Surpluses had been wasted on bad investments;
benefits were often inegalitarian and financed regressively; deficits
were mounting; and management was inefficient. By the 1980s, ever
fewer contributions were supporting more pensioners, and payroll
taxes were among the highest in the world. Latin America's large
informal sector left millions more with no coverage at all.
By the end of the 1980s (that "lost decade" of Latin
American economic development), an era of crushing interest rates,
negative growth, and fiscal calamity, there was broad support
for pension reform, coupled with intense political conflict over
the particulars. Reforms ranged from partial privatizations in
Argentina and Uruguay, to an aborted privatization drive in Brazil,
where reform is still underway. In recent years, Mexico, Peru,
Bolivia, and Colombia have attempted variations on the theme.
Chile's plan, enacted during the Pinochet dictatorship,
is the only case of total privatization. The Chilean approach
reversed a 100-year global trend toward increased state sponsorship
of social insurance. Most countries, including the United States,
use a tripartite "pay-as-you-go" model, in which payroll
taxes on workers and employers, supplemented by government contributions,
fund current benefits. By contrast, in Chile's private plan workers
are required to contribute 10 percent of their salaries to private
investment accounts, whose funds are invested by private pension
fund companies in closely regulated portfolios. Upon retirement,
the accumulated capital can be used to purchase an annuity.
A MIDDLEMAN'S PARADISE
Seemingly, Chile's private system has achieved impressive average
returns on investment. However, once commissions are factored
in, the real return for individual workers is considerably lower.
Nominally, the real annual return on investment between 1982 and
1995 averaged 12.7 percent. But a recent paper by World Bank economist
Hemant Shah demonstrated that an individual's average rate of
return over this period after paying commissions would have been
The real return after commissions over other periods of time is
even lower. For example, although the average rate of return on
funds from 1982 through 1986 was 15.9 percent, the real return
after commissions was a mere 0.3 percent! Between 1991 and 1995,
the pre-commission return was 12.9 percent, but with commissions
it fell to 2.1 percent. Chilean regulators have sought to lower
commissions, which have come down from their peak of 8.69 percent
of taxable salary in 1984 to around 3.1 percent today (this includes
a disability insurance premium of around 1 percent of income),
but these middleman fees still represent between 16.7 percent
and 20 percent of a worker's overall social security contributions
(administrative costs under the old public system in Chile represented
5 percent of total contributions). By contrast, the U.S. system
pays no commissions, and administrative costs are less than 2
percent of workers' contributions. Upon a Chilean worker's retirement,
financial advisors charge fees as high as 3 percent to 5 percent
of the worker's total accumulated funds to help the worker choose
among various financial options.
Although market competition was supposed to lower commissions
in Chile, the private pension fund market is dominated by a handful
of companies. These, according to economists Peter Diamond and
Salvador Valdes-Prieto, form a "monopolistic competitive
market" rather than a truly competitive one. A similar process
seems to be taking place in Argentina, where commissions have
remained around 3.5 percent of taxable salary.
Private pension funds engage in costly sales campaigns to capture
members from each other. An estimated 25 percent of affiliates
in Chile switch pension fund companies each year. These marketing
wars of attrition keep administrative costs high. Moreover, evasion,
which was rampant in the old public system, has continued in the
private one. While many believed that a private system would reduce
evasion because workers have a greater incentive to contribute
to their own personal retirement accounts, 43.4 percent of those
affiliated with the new system in June of 1995 did not contribute
regularly. Furthermore, while it is difficult to quantify, there
is evidence that there is substantial evasion among workers who
do contribute. Chilean economist Jaime Ruiz-Tagle reports that
while income for contributing workers in February 1995 averaged
$1,000 per month, the average declared taxable income was only
$460 per month.
Even if commission costs were lowered, the impressive returns
on capital likely cannot be sustained. The 12.7 percent average
return between 1982 and 1995 coincided with boom years in Chile
complemented by government's high borrowing costs. Because of
the debt crisis of the 1980s, Latin governments were paying double-digit
real interest rates on their bondsthe main investment vehicle
of social security funds. In effect, government was subsidizing
the "private" system by paying astronomical rates on
government bonds. Today's rates on government securities are much
lower. Predictions for future annual returns, which will determine
pension benefits, range between 3 percent and 5 percent.
EQUITIES AND EQUITY
Given the vast informal sectors in the region, the neediest members
of the population remain outside of the social security system.
Argentine economist Ruben Lo Vuolo estimates that given unemployment,
underemployment, and the working poor, only 50 percent of the
economically active population in Argentina are able to contribute
regularly to the social security system. In Brazil, 57 percent
of the workforce is in the informal sector.
Privatization also abandons the redistributive aspects of the
public systems. As José Piñera, the founder of the
Chilean system, noted, "the idea is not to redistribute income
after a person retires." In a private system, benefits depend
exclusively on the level of individual contributions and investment
performance, so social security ceases to be an antipoverty program.
Public systems tended to compensate for the intermittent work
history characteristic of women. But the private social security
systems in South America favor men by placing men and women in
separate actuarial categories. Because they tend to earn less,
spend more years of their lives in unpaid labor, and have greater
longevity, women purchasing annuities upon retirement will systematically
receive lower benefits than men. Furthermore, certain predominantly
male occupations continue to receive special treatment. Military
and police pensions, which have traditionally been generous, have
been exempted from privatization.
The extraordinary transition costs of privatization, and their
distribution, is the most overlooked issue in the privatization
debate. In a privatized system, workers stop paying social security
contributions to the government, but the government must still
pay benefits to those already retired. This shortfall in revenue
can only be financed through cutting other government spending,
raising taxes, or incurring debt. To pay for the social security
debt in Chile, which is expected to be between 4 percent and 6
percent of their gross domestic product over the next seven years,
the former military government ran a budget surplus while cutting
spending on redistributive programs like health and education.
Argentina, which passed a partial privatization law in 1993, dealt
with the revenue shortfall by cutting social security benefits.
Such cuts would have been too controversial to include during
the 1993 debate over the privatization law, which barely passed.
However, once workers began affiliating with the new private system
and the transition costs of privatization began to come due, the
public social security system became vulnerable to further cuts.
The lesson here is that privatization is very expensive, and that
the true costs of such a reform must be transparent. In one plan
being discussed by the U.S. Social Security Advisory Council,
5 percent of workers' income would go into private accounts, diverting
$1.2 trillion from the public system over 35 or 40 years. How
the United States would eventually pay for this transition is
anybody's guess, but if the South American cases are any guide,
the public redistributive component of Social Security and other
public programs would become vulnerable to cutbacks.
POLITICAL RISK VERSUS MARKET RISK
In Latin America, politicians have often used social security
as a political tool, doling out benefits and administrative jobs
to loyal political supporters. Leaders like Juan Peón
in Argentina and Getulio Vargas in Brazil used social security
to attract support for their urban-based populist political coalitions.
For the politically connected, benefits were generous and easy
to obtain, but average workers usually had to go through political
intermediaries or endure long waits before getting benefits. Since
industry and labor were protected from international competition,
the costs were simply passed on to consumers.
Privatization, arguably, replaces political risk to pensions with
market risk. In Latin America, social security benefits were always
subject to political risk, because unlike in the United States,
governments often failed to index benefits against inflation,
or did not pay what they legally owed. By 1994, underpayment of
benefits led to the filing of 335,000 lawsuits against the Argentine
government for failing to fulfill its obligations.
Although Social Security has also been used by U.S. politicians
to score points among voters, it has always paid its benefits
on time, is fiscally solvent, and has never been subject to the
episodes of fraud and mismanagement that have occurred in South
America. Unlike their Latin American counterparts, would-be privatizers
in the United States cannot substantiate rhetoric about government
inefficiency ruining Social Security. Furthermore, although one
of the virtues of privatization is that it removes Social Security
from the hands of politicians, the vast sums invested in private
pension funds will require adequate regulation, and hence will
be subject to both political and market risks. The form of "political
risk" can be modified, but in a government-mandated system
that uses the power to tax, it cannot be eliminated.
As this brief description indicates, the Latin American
social security systems suffered from financial and administrative
problems that we in the United States can scarcely imagine, and
their debates over privatization were informed by fundamentally
different political and economic realities. Yet the private alternative
displays serious flaws, and the rush to emulate it has slowed,
even in Latin America. Ultimately, Argentina and Uruguay's governments
divided political and market risks by passing privatization laws
that preserved a strong public pillar.
Given that our own Social Security system does not suffer the
maladies that plagued those in South America, privatization is
a risky strategy for resolving a tractable actuarial shortfall.
A key unresolved issue is how the transition costs of privatization
would be distributed. Would they be paid for by new taxes, government
borrowing, or cuts in other areas of public spending? Would cuts
come in health or education, as in Chile? Would Social Security
retain a progressive redistributional component? How much of the
market risks of privatization would be shouldered by individuals,
and how much by the government? Would membership in a private
system be optional or mandatory? How closely would pension fund
investments be regulated? Would men and women be placed into separate
actuarial categories, with women receiving lower benefits? And
finally, given the Chilean experience, how would administrative
costs be kept down?
These policy questionsnot fleeting, bull-market-inspired visions
of high investment returnsshould be at the center of any debate
over privatization in the United States. So far, the South American
experiments in privatization do not provide evidence that should
compel us to exchange one of our government's most successful
programs for the expense, risk, and inequity of privatization.
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