May 9, 2011 (PLANSPONSOR.com) – A recent working paper published by the National Bureau of Economic Research critically analyzes previous attempts to explain conversions of government pension provision systems, or social security systems, to personal accounts.
Common rationales include: higher returns; improvements in domestic financial institutional development; improving labor supply and retirement incentives; and hedging demographic changes. In each case, the report authors contend, a politically-stable and transparent government could have achieved similar results within the traditional system.
In A Matter of Trust: Understanding Worldwide Public Pension Conversions, Kent Smetters and Walter E. Theseira point out that the traditional system also tends to have lower transaction costs, less adverse selection, and other costs.
Looking at the United States Social Security system by generation over time, the report noted that effective annualized rates of return have declined dramatically. The composite average U.S. worker who began to collect a benefit at age 65 in 1941 received a 36.5% effective annual rate of return on his pension contributions. In sharp contrast, a person born today into the mature U.S. Social Security system is projected to receive less than a 2% effective rate of return.
But, the report authors argue, the declining rate of return stems directly from pay-as-you-go financing itself: money flowing into the pension system gets distributed immediately as benefit payments to retirees. Early retirees receive a windfall that is matched in present value by payments made by future generations. Since these windfalls have already been consumed, there is no potential for recovering them. Increased returns only come from current generations sacrificing some of their consumption today, which they can do without privatization.
Looking at those countries that have converted their systems, the study found private credit indeed expanded in each country following reform -- except for Mexico and Argentina, both of which suffered currency and other financial crises. This evidence would seem to buttress the case for the hypothesis that domestic capital market development was a major influence in reform. Many reforming Latin American and Eastern European countries also instituted restrictions that prevented workers from investing their money abroad, also seemingly consistent with this hypothesis.
But, the report authors point to the fact that the post-reform rise in private credit tended to be sharper in Western European countries despite the smaller size of their pension reforms relative to the Latin American and Eastern European nations. Since most Western European countries already had sophisticated financial markets prior to reform, much of their increase presumably stemmed purely from increases in the amount of capital, since pension reforms likely had little impact on the relative reliance on equity financing. This result suggests that the increase in private credit in Latin American and Eastern European nations might also have been driven by the saving effect rather than by direct financial institution development. In addition, except Mexico and Argentina, the availability of private credit began to increase in most Latin American and Eastern European countries before the introduction of personal accounts. (Since the personal accounts are unlikely to have a large effect for several years, the effective pre-reform trend is even longer.) The introduction of personal accounts does not seem to increase the pre-reform trend in most countries, suggesting that other factors might also be playing an important role in the expansion of private credit, the authors concluded.