Privatizing social security: lessons from Mexico.

• Author: Hastings, Justine

Social security privatization is a top political and economic issue for countries world-wide faced with aging populations and underfunded pensions. Often seen as a third-rail of American politics, aging populations may soon force the country to make tough decisions about our pay-as-you-go system, and current public pension crises have revived the private-accounts vs. public pension debate, as state governments faced with pension fund shortfalls consider moving workers toward 401(k)-style plans.

A handful of countries have already opted for partially- or fully-privatized social security systems. What can we learn from their experiences? Can a privatized social security system deliver greater retirement wealth by allowing individuals greater control over their investment decisions? Does the free market deliver price competition and efficiency? My recent research uses administrative data from OECD countries in Latin America with privatized schemes to illuminate the potential benefits and pitfalls of social security privatization. In this article, I highlight findings from two such projects.

Does Competition Work?

Mexico launched a fully-privatized defined contribution plan in 1997, with 17 participating fund managers which could compete to manage investors' privatized social security accounts. Given the tight regulations on investment vehicles, fund managers each offered one, essentially homogenous investment product. Investors could choose which firm they wanted to have manage and invest--for a fee--their personal social security account.

Despite the large number of competitors selling an essentially homogeneous product, management fees and fund manager profits were high. Fund managers charged an average load (a fee taken as a share of account contributions at the time of contribution) of 23 percent and an annual fee on assets under management of 0.63 percent, implying that a 100peso deposit earning a 5 percent annual real return would only be worth 95.4 pesos after five years. Indeed, five years after the launch of the privatized system, fund managers' annual return on expenditure averaged 39 percent. How could competition among many firms result in fees at this level?

The new system was characterized not only by high fees but by high expenditures on sales force and advertising. The government, trusting competitive pressures to work to inform customers and incentivize low prices, invested little in financial education, but spent advertising funds on simply informing workers that they needed to choose among the approved social security fund managers.

Based on archived television advertisements and sales force training manuals, fund managers spent substantial resources appealing to investor emotion by communicating themes of experience, winning, and wisdom in investment. When fees were mentioned at all, it was in vague terms or focused only on the fee dimension on which the firm was relatively less expensive. Many advertising claims were technically truthful but misleading. For example, one advertisement, featuring apples, claimed that the fund manager did not take a bite out of your investment apple like other firms did. This is technically true if "bite" referred only to load fees; this firm charged no loads. However it...