Prospects for Social Security reform in the United States.

• Author: Smetters, Kent

One of the most far-reaching shifts in fiscal policy around the world during the past two decades has been the fundamental restructuring of public pension systems. Over two dozen countries across five continents have converted at least part of their pay-as-you-go, defined-benefit, public pension systems into systems based on funded, defined-contribution accounts. Several additional countries are currently in the process of conversion, and even more countries, including the United States, are debating it.

The shift toward defined-contribution plans in the private sector has increased the mobility of workers, because traditional defined-benefit plans have a "lock-in effect" that discourages employees from switching employers. Therefore, the conversion of public pension plans to the defined-contribution model sometimes has been lumped together as part of this same "modernization" movement. However, that explanation is problematic, because public pension plans are typically already fairly portable across employers. With a few exceptions, the public pension benefit formula in most countries is dependent on the wages of the worker regardless of the actual employer.

In fact, the public plan conversions seem fairly puzzling at first. To be sure, many common arguments have been put forth in favor of "personal accounts" including the potential to earn higher rates of return in equities, increased national savings, as well as greater bequeath-ability. However, even if we believed that a portion of the equity premium were a "freebie" and not just a compensation for risk, higher returns could be earned by a public pension system by investing in equities, which has the added benefit of potentially improving risk sharing across generations. (1) National saving also could be increased by pre-funding the traditional pension system. The traditional pension scheme also could be complemented with a life insurance payment upon death that replicated the bequeath-ability aspect of personal accounts.

Indeed, in a deterministic setting, the traditional public defined benefit pension systems in theory could achieve the same economic objectives as personal accounts. In the presence of idiosyncratic risks, traditional defined-benefit systems more easily allow for sharing wage and longevity uncertainty. (2) Relatively larger transaction costs in defined contribution plans, as well as problems associated with financial literacy, moral hazard, and adverse selection, only seem to buttress the case for the traditional design. So why are more and more countries abandoning the traditional design for the funded, defined contribution model that, in theory, is no better than the traditional design and potentially even worse?

Adding to the puzzle is that these reforms have taken on numerous shapes and sizes across the world. While, politically, the adoption of personal accounts are often linked to demographic concerns (for example, retirement of baby boomers in the United States), the actual evidence does not seem to support this motive for personal accounts. Indeed, the largest reforms occurred in less developed countries where future demographic problems are projected to be the least severe, including Chile (1981), Columbia (1993), Peru (1993), Mexico (1997), Bolivia (1997), El Salvador (1998), and Kazakhstan (1998). In each of these countries, the vast majority of the final expected retirement benefit is derived from income produced by assets held in...