Design features of an IA System: What Can We Learn from Other

Countries?By

Estelle James

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Reasons for including an IA in social security system

• Pre-funding puts system on firmer financial basis, less sensitive to demographic change

• Pre-funding can help to increase national saving, therefore productivity and growth

• Central control of funds can lead to deficits, political manipulation, misallocated capital

• Decentralized control (IA’s) avoid these dangers, increases benefits, diversifies retirement income – especially important as increase in world’s L/K ratio

will depress wages, raise returns to capital

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Crucial design features determine whether IA system is good or bad • How to keep administrative costs low• How to handle payout stage• How to protect low earners and women

Over 30 countries now have IA systems. We can learn from international experience

what works and doesn’t work. I focus on Chile (has had IA system since 1982)

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How to keep administrative costs low• In Chile, administrative costs are .76% of assets

annually, less than mutual funds in US. Higher fees in other countries.

• But Thrift Saving Plan in US costs only .1% of assets, .3% in other large pension funds. Costs as % of assets fall as account size rises due to fixed costs per account.

• Important to keep costs low: If expenses fall .5% of assets, pension rises 10%.

• Difficult to keep costs low when accounts are small, at start-up. How can we solve this problem?

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Cost of U.S. Thrift Savings Plan, 1988-1998

Relation Between Cost as % of Assets andAverage Account Size

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Assets per Account (in thousands U.S. $'s)

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We can do better than Chile, using institutional rather than retail market

(but this involves trade-offs)• Use competitive bidding process to choose small number

of asset managers instead of many managers marketing directly to individuals. Aggregating small accounts increases bargaining power, reduces marketing costs – (this cuts fees but limits choice)

• Use passive investing (indexing to benchmark like S&P500 or Russell’s 3000)—(didn’t exist in Chile)

• Collect contributions through tax system, centralize record-keeping (less money, more time)

• With these measures, Commission estimated costs at .3% of assets--benefits 10% greater than Chile

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How to handle payout stage• How can we be sure that worker won’t spend

down all his IA money before he dies? Annuities guarantee workers life-long income. Can private sector handle this? Will annuities be offered on good terms? Will workers buy them?

• Chile has had IA system since 1982, many workers have retired, 2/3 annuitized.

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Percentage of policies that are annuitized, 1988-2002

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years since 1988

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normal old age

early retirement

total retirement

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2/3 retirees annuitized. Why?

• Payouts limited to annuities or gradual withdrawals – (lump sums permitted only after 70% replacement rate)

• Regs give insurance companies competitive edge• Life insurance industry grew rapidly after 1982 to

meet demand (stringent solvency requirements)• Insurance companies market annuities aggressively • Competition brings money’s worth ratio on annuities

to 100% (annuitants expect to get back entire premium)

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Other payout rules in Chile

• Annuities must be price-indexed, joint for married men--inflation insurance, protection for widows

• Workers can stop contributing, start withdrawing when annuity gives 50% replacement rate. Labor force participation rate of pensioners has risen because they don’t pay pension payroll tax

• Private sector can handle payout stage, but only if government sets careful rules of the game

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How low earners are protected• IA isn’t redistributive, entails financial market risk, so how

is poverty prevented?• Minimum pension guarantee in Chile--25% of av.

wage guaranteed for retirees with 20 years service + relative rate of return guarantee

• Mexico--flat matching contribution by govt into IA of every worker per day (flat=same amt for all) + MPG after 25 years of service

• IA supplemented by flat or means-testeded benefits in Netherlands, Australia, UK

• Switzerland—progressive public DB + private benefit with floor on long term rate of return

• Each method implies different fiscal liabilities, work (dis)incentives and distributional effects.

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How to protect women• Why do women need special protection? They work less, earn

less, live longer, and if married their husband are older, so they become widows with low incomes. Very old women are pockets of poverty in most countries.

• Women are the biggest gainers in lifetime income from the pension reform in Latin America. Why? – Minimum pension guarantee or flat benefit helps low

earners– Husbands required to purchase joint pension--

survivors benefits financed by husbands (in US by taxpayers)

– Widows keep their own pension plus joint pension (in US widows must choose between the two; many women who work & contribute get no additional benefit)

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Conclusion

• The devil is in the details. Instead of asking whether IA system is good or bad, we should focus first on “what is best design of IA system?”

• We can learn from other countries what works and doesn’t work

• Many objections to IA’s disappear when best design is chosen.