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23–925 2005

SIXTH IN A SERIES OF SUBCOMMITTEE HEARINGS 

ON PROTECTING AND STRENGTHENING 

SOCIAL SECURITY 

HEARING 

BEFORE THE

SUBCOMMITTEE ON SOCIAL SECURITY 

OF THE

COMMITTEE ON WAYS AND MEANS 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED NINTH CONGRESS 

FIRST SESSION 

JUNE 16, 2005 

Serial No. 109–24 

Printed for the use of the Committee on Ways and Means 

( 

ii 

COMMITTEE ON WAYS AND MEANS 

BILL THOMAS, California, Chairman 

E. CLAY SHAW, JR., Florida 

NANCY L. JOHNSON, Connecticut 

WALLY HERGER, California 

JIM MCCRERY, Louisiana 

DAVE CAMP, Michigan 

JIM RAMSTAD, Minnesota 

JIM NUSSLE, Iowa 

SAM JOHNSON, Texas 

PHIL ENGLISH, Pennsylvania 

J.D. HAYWORTH, Arizona 

JERRY WELLER, Illinois 

KENNY C. HULSHOF, Missouri 

RON LEWIS, Kentucky 

MARK FOLEY, Florida 

KEVIN BRADY, Texas 

PAUL RYAN, Wisconsin 

ERIC CANTOR, Virginia 

JOHN LINDER, Georgia 

BOB BEAUPREZ, Colorado 

MELISSA A. HART, Pennsylvania 

CHRIS CHOCOLA, Indiana 

DEVIN NUNES, California 

CHARLES B. RANGEL, New York 

FORTNEY PETE STARK, California 

SANDER M. LEVIN, Michigan 

BENJAMIN L. CARDIN, Maryland 

JIM MCDERMOTT, Washington 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

MICHAEL R. MCNULTY, New York 

WILLIAM J. JEFFERSON, Louisiana 

JOHN S. TANNER, Tennessee 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL POMEROY, North Dakota 

STEPHANIE TUBBS JONES, Ohio 

MIKE THOMPSON, California 

JOHN B. LARSON, Connecticut 

RAHM EMANUEL, Illinois 

SUBCOMMITTEE ON SOCIAL SECURITY 

JIM MCCRERY, Louisiana, Chairman 

E. CLAY SHAW, JR., Florida 

SAM JOHNSON, Texas 

J.D. HAYWORTH, Arizona 

KENNY C. HULSHOF, Missouri 

RON LEWIS, Kentucky 

KEVIN BRADY, Texas 

PAUL RYAN, Wisconsin 

SANDER M. LEVIN, Michigan 

EARL POMEROY, North Dakota 

XAVIER BECERRA, California 

STEPHANIE TUBBS JONES, Ohio 

RICHARD E. NEAL, Massachusetts 

ALLISON H. GILES, Chief of Staff 

JANICE MAYS, Minority Chief Counsel 

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records 

of the Committee on Ways and Means are also published in electronic form. The printed 

hearing record remains the official version. Because electronic submissions are used to 

prepare both printed and electronic versions of the hearing record, the process of converting 

between various electronic formats may introduce unintentional errors or omissions. Such occurrences are inherent in the current publication process and should diminish as the process 

is further refined. 

iii 

C O N T E N T S 

Page 

Advisory of June 9, 2005 announcing the hearing ................................................ 2 

WITNESSES 

U.S. government Accountability Office, Barbara D. Bovbjerg, Director, Education, Work force, and Income Security ............................................................ 5 

The World Bank, Estelle James ............................................................................. 16 

Cato Institute’s Project on Global Economic Liberty, Ian Vasquez ..................... 46 

Center for Economic Policy Research, Dean Baker .............................................. 60 

Organisation for Economic Co-operation and Development, Edward 

Whitehouse ........................................................................................................... 20 

Thomas A. Roe Institute for Economic Policy Studies, David C. John ............... 66 

TOR Financial Consulting, Limited, David O. Harris .......................................... 53 

Watson Wyatt Worldwide, Julia Lynn Coronado .................................................. 38 

SUBMISSIONS FOR THE RECORD 

Daniels, Margaret, Hurst-Euless-Bedford School District, Hurst, TX, statement ...................................................................................................................... 105 

Fransen, Marilyn, Rapid City, SD, statement ...................................................... 105 

Gathro, Ronald J., Springfield, MA, statement ..................................................... 107 

Hahn, Bruce, American Homeowners Grassroots Alliance, Arlington, VA, 

statement .............................................................................................................. 108 

[Pending.] .................................................................................................................

(1) 

SIXTH IN A SERIES OF SUBCOMMITTEE 

HEARINGS ON PROTECTING AND 

STRENGTHENING SOCIAL SECURITY 

THURSDAY, JUNE 16, 2005 

U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON WAYS AND MEANS, SUBCOMMITTEE ON SOCIAL SECURITY, Washington, DC. 

The Subcommittee met, pursuant to notice, at 10:00 a.m., in 

room B–318, Rayburn House Office Building, Hon. Jim McCrery 

(Chairman of the Subcommittee) presiding. 

[The advisory announcing the hearing follows:] 

2 

ADVISORY 

FROM THE COMMITTEE ON WAYS AND MEANS 

SUBCOMMITTEE ON SOCIAL SECURITY 

FOR IMMEDIATE RELEASE CONTACT: (202) 225–9263 

June 9, 2005 

No. SS–6 

McCrery Announces Sixth in a Series of 

Subcommittee Hearings on Protecting and 

Strengthening Social Security 

Congressman Jim McCrery (R–LA), Chairman, Subcommittee on Social Security 

of the Committee on Ways and Means, today announced that the Subcommittee will 

hold the sixth in a series of Subcommittee hearings on protecting and strengthening 

Social Security to hear the views of Members of the House. The hearing will take 

place on Thursday, June 16, 2005, in room B–318 Rayburn House Office 

Building, beginning at 10:00 a.m. or immediately following the conclusion 

of the full Committee hearing. 

In view of the limited time available to hear witnesses, oral testimony at this 

hearing will be from invited witnesses only. However, any individual or organization 

not scheduled for an oral appearance may submit a written statement for consideration by the Subcommittee and for inclusion in the printed record of the hearing. 

BACKGROUND: 

The United States is not alone in facing the challenges of providing retirement 

security for an aging population. The world is undergoing a demographic transformation. By 2050, the number of individuals aged 60 years and over will increase 

from 600 million to almost 2 billion, according to findings by the United Nations 

Second World Assembly on Aging. As a result, the proportion of people aged 60 

years and over is expected to double from 10 percent to 21 percent. 

Many countries have already addressed the financial pressures that an aging population places on their social security programs, by reducing growth of traditional 

‘‘pay-as-you-go’’ benefits, increasing tax revenues and creating personal accounts to 

help pre-fund future benefits. Policymakers in the United States can learn from the 

experiences of other countries by examining the effects of their choices on beneficiaries, public pension financing and their economies. While these choices are a reflection of a country’s culture, values and previously existing social insurance system, they also provide a broad array of tested options for consideration. 

In announcing the hearing, Chairman McCrery stated, ‘‘Many other nations face 

similar or even worse challenges, compared with the United States, in providing retirement security for seniors. Often these nations have updated their retirement systems by adding personal accounts to their programs, as well as modifying the benefit structure and taxes. As we examine options for strengthening Social Security 

for Americans, we can learn from what did or did not work well in other countries.’’ 

FOCUS OF THE HEARING: 

The Subcommittee will examine the experiences of other countries in reforming 

their social security systems, including the effect of their choices in modifying traditional benefits and designing personal accounts on individual’s benefits, social security financing, and the countries’ economies. 

3 

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS: 

Please Note: Any person(s) and/or organization(s) wishing to submit for the hearing record must follow the appropriate link on the hearing page of the Committee 

website and complete the informational forms. From the Committee homepage, 

http://waysandmeans.house.gov, select ‘‘109th Congress’’ from the menu entitled, 

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and ATTACH your submission as a Word or WordPerfect document, in compliance 

with the formatting requirements listed below, by close of business Thursday, June 

30, 2005. Finally, please note that due to the change in House mail policy, the U.S. 

Capitol Police will refuse sealed-package deliveries to all House Office Buildings. 

For questions, or if you encounter technical problems, please call (202) 225–1721. 

FORMATTING REQUIREMENTS: 

The Committee relies on electronic submissions for printing the official hearing record. As always, submissions will be included in the record according to the discretion of the Committee. 

The Committee will not alter the content of your submission, but we reserve the right to format 

it according to our guidelines. Any submission provided to the Committee by a witness, any supplementary materials submitted for the printed record, and any written comments in response 

to a request for written comments must conform to the guidelines listed below. Any submission 

or supplementary item not in compliance with these guidelines will not be printed, but will be 

maintained in the Committee files for review and use by the Committee. 

1. All submissions and supplementary materials must be provided in Word or WordPerfect 

format and MUST NOT exceed a total of 10 pages, including attachments. Witnesses and submitters are advised that the Committee relies on electronic submissions for printing the official 

hearing record. 

2. Copies of whole documents submitted as exhibit material will not be accepted for printing. 

Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material 

not meeting these specifications will be maintained in the Committee files for review and use 

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3411 TTD/TTY in advance of the event (four business days notice is requested). 

Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above. 

f 

Chairman MCCRERY. The hearing will come to order. Good 

morning, everyone. Welcome to our sixth Subcommittee hearing on 

protecting and strengthening Social Security. Today we will hear 

about changes that other countries have made to their Social Security promise as they, like us, cope with how both to ensure the retirement security of an aging population. Oliver Wendell Holmes, 

Sr., a physician and father of the great jurist, said, quote, ‘‘Knowledge and temper shouldn’t be much used until they are seasoned.’’ 

During our hearing this morning we will have the benefit of seasoned knowledge from around the world as we will hear from AusVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00007 Fmt 6633 Sfmt 6602 E:\HR\OC\23925.XXX 23925
4 

tralia, Chile, Sweden, the United Kingdom, and others with experience in making significance reforms to their Social Security systems. Each nation’s decisions are a reflection of their culture, values, and previously existing social insurance programs, and while 

the countries we will examine today have different economies and 

governmental structures from those of the United States, they face 

similar demographic changes. This gives us the opportunity to 

learn from their experiences what went well and what could be improved. 

All countries, like the United States, first had to decide whether 

or not to act in advance of a demographic crush that would eventually lead to a funding crisis in their Social Security program. They 

then faced the same basic choices we are now considering on how 

best to strengthen their Social Security programs, reduce promised 

benefits, increase taxes, or increase rates of return by prefunding 

future benefits. As we will hear today, dozens of countries decided 

to prefund benefits through personal accounts. They have taken a 

broad range of approaches in designing and financing the personal 

accounts, which gives U.S. policy makers a wealth of tested options 

from which to learn. We will also hear about the modifications 

other countries have made in the benefits and financing of their 

traditional defined benefit programs, and how the combination of 

all their choices have affected individual beneficiaries as well as 

their countries’ economies. I welcome our distinguished panel, some 

of whom have traveled great distances to appear before us today, 

and I look forward to hearing their views. Now, I would like to ask 

the Ranking Member of the Subcommittee, Mr. Levin, for his comments. 

Mr. LEVIN. Thank you very much, and we do have an impressive array, and I look forward to the testimony. It is very true the 

United States is not alone in having dealt with this problem and 

we need the experience of other nations. I hope as we do that we 

will also continue to look at the experience of our Nation. I think 

there is much to learn from how we have handled Social Security, 

and it is my judgment that our experience has shown that the Social Security system has worked very well and should not be replaced. As I look at the experience of other countries, I think that 

it does raise questions of risk, of cost, also of reduction in benefits. 

So, we are anxious to hear what you have to say and draw upon 

the experience of other countries. Remembering the benefits that 

have accrued to our Nation, I hope we don’t get lost in terms. As 

the Chairman knows, I think ‘‘prefunding’’ is now the word that is 

used instead of privatization, and we are very strong in our belief 

that privatization would be a serious mistake. So, let’s get on. We 

have one, two, three, four, five, six, seven, eight. You exceed the 

record for the size of the panel, and this is going to be a busy day 

here on the floor. So, our colleagues may move in and out as they 

have other obligations, but we look forward to your testimony and 

I am sure there will be some serious questions. Thank you. 

Chairman MCCRERY. Thank you, Mr. Levin. I do want to point 

out though that the two terms are not synonymous. ‘‘Privatization’’ 

and ‘‘prefunding’’ are not synonymous, and I think we will hear 

today that some countries have a blend of what you might term 

5 

privatization and a guaranteed benefit structure. So, I think we 

should wait and listen and try to learn from their experiences. 

Mr. LEVIN. All for it. 

Chairman MCCRERY. Not trying to characterize what we or 

anyone else is trying to do. With that we will begin this morning’s 

hearing. Our first witness is a familiar witness before the Committee on Ways and Means, Barbara Bovbjerg. Ms. Bovbjerg is a 

respected member of the bureaucracy here in our Nation’s Capitol. 

Believe it or not, there are those, and she is certainly one. She is 

the Director of Education, Work force, and Income Security for the 

U.S. government Accountability Office (GAO). Then we have Dr. 

Estelle James, Consultant and former Lead Economist at the 

World Bank; Edward Whitehouse, who is the Administrator, Social 

Policy Division, Organisation for Economic Co-operation and Development (OECD) in Paris, France; Julia Coronado, Senior Analyst 

with Watson Wyatt Worldwide; and Ian Vasquez, Director of the 

Cato Institute’s Project on Global Economic Liberty; David Harris, 

Managing Director, TOR Financial Consulting Ltd., Suffolk, United 

Kingdom (UK); Dean Baker, Co-Director of the Center for Economic and Policy Research; David John, Research Fellow at the 

Heritage Foundation. 

We are very pleased to have all of you with us this morning, and 

you have all submitted written testimony which will be included in 

its entirety in the record, and this morning we would ask that you 

summarize your written testimony in about 5 minutes. For those 

of you who may not be familiar with the process, there is a little 

machine on the front of your table and it is has got lights on it. 

The green light stays on about 4 minutes, then an amber light 

comes on, which will be on for about 1 minute; 4 plus 1 is 5. When 

the red light comes on that means your time is basically up, although I will certainly allow you a few extra moments if you are 

not finished rounding up your testimony. So, that is the procedure. 

Then, after each of you has testified, Members of the panel will ask 

questions that we would ask you to respond to. So, Ms. Bovbjerg, 

if you will begin. 

STATEMENT OF BARBARA D. BOVBJERG, DIRECTOR OF EDUCATION, WORKFORCE, AND INCOME SECURITY, U.S. GOVERNMENT ACCOUNTABILITY OFFICE 

Ms. BOVBJERG. Thank you very much, Mr. Chairman, and 

thank you for the kind words. I am really pleased that you have 

invited me here again today to discuss other countries’ experiences 

with public pension reform. Many countries, including the United 

States, are grappling with demographic change and its effect on 

their national pension systems and on their economies. Some nations have already undertaken pension reform, we may draw lessons from their experiences for the United States. Today I will 

present the preliminary results of our ongoing study for this Subcommittee of other nations’ pension reforms. Our work examines 

the 30 member countries of the OECD plus Chile, the Nation that 

pioneered the use of individual accounts. I have organized my remarks around potential lessons from three general types of public 

pension reform approaches: first, adjustments within existing payas-you-go (PAYGO) systems; second, the creation of dedicated reVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00009 Fmt 6633 Sfmt 6602 E:\HR\OC\23925.XXX 23925
6 

serves for advanced funding; and third, reforms involving the creation of individual accounts. 

First, lessons from changes to an existing system. Nearly all 

countries we studied have reduced benefits in their PAYGO systems as part of their reforms, and most have also raised contributions. Benefit reductions ranged from formula changes to reduced 

cost-of-living increases after retirement to creating a closer link between benefits and the contributions financing them. Contribution 

increases ranged from increasing contribution rates, to broadening 

the base on which contributions are levied, to increasing the number of years workers contribute. These changes were made to help 

ensure the financial stability of the existing system. At the same 

time, these countries took measures to ensure minimum retirement 

incomes. Most achieved this by providing a targeted means tested 

benefit. At least seven provided what they termed a basic retirement benefit of either a given amount per month or a minimum 

amount per year of contribution instead. Countries taking this approach were striving to achieve a careful balance between assuring 

benefit adequacy and maintaining incentives to work and save. 

Some like the UK retain such incentives by adopting so-called savings credits that allow retirees near the minimum pension level to 

retain a portion of any additional income they might earn. 

Let me turn now to countries’ use of pension reserve funds. 

Eighteen of the countries accumulate reserve funds, and one clear 

lesson is that early action matters. Establishing reserve funds well 

before they will be needed makes it substantially more likely that 

assets will accumulate in time to do some good. Also, somewhat obviously, walling off these assets solely for the purpose of financing 

retirement programs makes a difference. Succumbing to temptation 

to spend such reserves to fund other public priorities undermines 

their original purpose. 

Finally, lessons regarding individual accounts. Eleven of the 

countries we examined restructured their pensions to incorporate 

some form of individual accounts. A major challenge for such accounts was how to pay for them. All countries creating individual 

accounts also made changes to their PAYGO systems to help reduce transition costs and to use budget surpluses as well. The 

countries that allow workers to opt in and out of the accounts had 

difficulty estimating costs and had to make additional changes to 

both the accounts and the PAYGO programs to compensate. One 

lesson here involves the tradeoff between allowing workers to maximize returns and ensuring benefit adequacy. Some countries address this issue by setting a guaranteed rate of return. Although 

this approach has assured a level of income adequacy, it also resulted in limited investment diversification which then brings returns below levels they might have otherwise achieved. All countries that adopted individual accounts also provide some sort of 

minimum benefit guarantee, but the guarantee itself can provide 

an incentive for risky investment decisions and a disincentive for 

voluntary contributions. The experience of other nations with individual accounts also suggests the importance of effective regulation. Some countries learned the hard way that regulating individuals’ investment options was an important aspect of a program of 

accounts. Similarly, controlling fees and other administrative costs 

7 

1The OECD is a forum for the governments of 30 market democracies to work together on 

economic, social, environmental, and governance issues. The OECD works to promote economic 

growth, financial stability, trade and investment, technology, innovation, and development cooperation. 

that can erode account returns can help ensure the viability of such 

a system. 

In conclusion, the countries we studied adopted different approaches that varied with the characteristics of their existing pension systems and with their economic and political conditions. Reforms adopted in one country are thus not easily replicated in another or, if replicated, don’t necessarily lead to the same outcomes. 

Nonetheless, it is clear that effective reform requires cutting benefits, raising revenues, or both, and doing so well before the anticipated demographic changes take place. No matter what type of reform is undertaken, the sustainability of the pension system will 

depend on the health of the national economy. Reforms that offer 

incentives to postpone retirement, encourage employment and savings, and promote growth are most likely to produce an adequate 

and functionally sound system of retirement income over the longterm. That concludes my statement. I await your questions. 

[The prepared statement of Ms. Bovbjerg follows:] 

Statement of Barbara D. Bovbjerg, Director. Education, Workforce, and 

Income Security, U.S. Government Accountability Office 

SOCIAL SECURITY REFORM 

Preliminary Lessons from Other Countries’ Experiences 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here today to discuss our preliminary findings concerning other 

countries’ experiences with national pension reform. Many countries, including the 

United States, are grappling with demographic change and its effect on their national pension systems. With rising longevity and declining birth rates, the number 

of workers for each retiree is falling in most developed countries. A rising dependency ratio is straining the finances of national pension programs, particularly programs in which contributions from current workers fund payments to current beneficiaries—a form of financing known as ‘‘pay-as-you-go’’ (PAYG). Demographic and 

economic challenges are less severe in the U.S. than in many other developed countries—the birth rate is not as low, a greater number of older people stay in the labor 

force, and immigration continues to provide young workers. Yet projections show 

that the Social Security program faces a long-term financing problem. Because some 

countries have already undertaken national pension reform efforts to address demographic changes similar to those occurring in the U.S., we may draw lessons from 

their experiences. It is important to remember, however, that reforms in one country 

may not be easily replicated in another or may not lead to the same outcome. 

We are in the process of preparing a report covering the experiences of countries 

that may be applicable to our own debate over reforms to the U.S. Social Security 

program—the 30 members of the Organisation for Economic Co-operation and Development (OECD) plus Chile, the nation that pioneered the use of individual accounts.1 My remarks today are based on an ongoing study and our observations are 

preliminary. We are focusing on (1) adjustments to existing PAYG national pension 

programs, (2) the creation of national pension reserve funds to help finance PAYG 

pension programs, and (3) reforms involving the creation of individual accounts. 

To date our study has included interviews with, and analysis of materials provided by, officials and interest group representatives in Washington, D.C., Paris, 

and London. We met with pension experts and country specialists at the OECD as 

well as French and British experts, officials, and interest group representatives. We 

conducted our review in accordance with generally accepted government auditing 

standards. 

In summary, all OECD countries have, to some extent, reformed their national 

pension systems, and may offer lessons for the U.S. Countries’ experiences adjusting 

8 

2 In other countries, ‘‘social security’’ often refers to a wide range of social insurance programs, 

including health care, long-term care, workers’ compensation, unemployment insurance, etc. To 

generalize across countries, we use ‘‘national pensions’’ to refer to mandatory countrywide pension programs providing old-age pensions. We use ‘‘Social Security’’ to refer to the U.S. Old-Age, 

Survivors, and Disability Insurance Program since that is how the program is commonly known. 

PAYG national pension programs highlight the importance of considering how modifications will affect the program’s financial sustainability, its distribution of benefits, the incentives it creates, and public understanding of the new provisions. Nearly all of the countries we are studying reduced benefits, and most have also increased contributions, often by increasing statutory retirement ages. Countries with 

national pension reserve funds designed to partially pre-fund PAYG pension programs provide lessons about the importance of early action and effective management. Some funds that have been in place for a long time have accumulated significant reserves to strengthen the finances of national pension programs. Countries 

that insulate pension reserve funds from being directed to meet social and political 

objectives may be better equipped to fulfill future pension commitments. In addition, 

regular disclosure of fund performance supports sound management and administration, and contributes to public education and oversight. Countries that have 

adopted individual account programs—which may also help pre-fund future retirement income—offer lessons about financing the existing PAYG pension program as 

the accounts are established. Countries that have funded individual accounts by directing revenue away from the PAYG program while continuing to pay benefits to 

PAYG program retirees have expanded public debt, built up budget surpluses in advance of the reform, cut back or eliminated the PAYG programs, or some combination of these. Important lessons regarding the administration of individual accounts 

include the need for effective regulation and supervision of the financial industry 

to protect individuals from avoidable investment risks. In addition, public education 

is increasingly important as the national pension system becomes more complex. 

Background 

Social Security’s projected long-term financing shortfall stems primarily from the 

fact that people are living longer and having fewer children. As a result, the number 

of workers paying into the system for each beneficiary is projected to decline. This 

demographic trend is occurring or will occur in all OECD countries. Although the 

number of workers for every elderly person in the U.S. has been relatively stable 

over the past few decades, it has already fallen substantially in other developed 

countries. The number of workers for every elderly person in the U.S. is projected 

to fall from 4.1 in 2005 to 2.9 in 2020. In nine of the OECD countries, this number 

has already fallen below the level projected for the U.S. in 2020. This rise in the 

share of the elderly in the population could have significant effects on countries’ 

economies, particularly during the period from 2010 to 2030. These effects may include slower economic growth and increased costs for aging-related government programs. 

Historically, developed countries have relied on some form of a PAYG program 

and have used a variety of approaches to reform their national pension systems.2

In many cases, these approaches provide a basic or minimum benefit as well as a 

benefit based on the level of a worker’s earnings. Several countries are preparing 

to pay future benefits by either supplementing or replacing their PAYG programs. 

For example, some have set aside and invested current resources in a national pension reserve fund to partially pre-fund their PAYG program. Some have established 

fully funded individual accounts. These are not mutually exclusive types of reform. 

In fact, many countries have undertaken more than one of the following types of 

reform: 

• Adjustments to existing pay-as-you-go systems. Typically, these are designed to create a more sustainable program by increasing contributions or decreasing benefits, or both, while preserving the basic structure of the system. 

Measures include phasing in higher retirement ages, equalizing retirement ages 

across genders, and increasing the earnings period over which initial benefits 

are calculated. Some countries have created notional defined contribution (NDC) 

accounts for each worker, which tie benefits more closely to each worker’s contributions and to factors such as the growth rate of the economy. 

• National pension reserve funds. These are set up to partially pre-fund 

PAYG national pension programs. Governments commit to make regular transfers to these investment funds from, for example, budgetary surpluses. To the 

extent that these contribute to national saving, they reduce the need for future 

borrowing or large increases in contribution rates to pay scheduled benefits. 

9 

3 Reserve funds act as budgetary devices, or ‘‘disciplinary’’ devices, especially where they have 

been recently created. They help contain expenditures. Such containment is needed to achieve 

sustainable fiscal surplus. 

Funds can be invested in a combination of government securities and domestic 

as well as foreign equities.3

• Individual accounts. These fully funded accounts are administered either by 

employers or the government or designated third parties. The level of retirement benefits depends largely on the amount of each person’s contributions into 

the account during their working life, investment earnings, and the amount of 

fees they are required to pay. 

We are applying GAO’s Social Security reform criteria to the experiences of countries that are members of the OECD as well as Chile, which pioneered individual 

accounts in 1981. We are assessing both the extent to which another country’s circumstances are similar enough to those in the U.S. to provide a useful example and 

the extent to which particular approaches to pension reform were considered to be 

successful. Countries have different starting points, including unique economic and 

political environments. Moreover availability of other sources of retirement income, 

such as occupation-based pensions, varies greatly. Recognizing this, GAO uses three 

criteria for evaluating pension reforms: 

• Financing Sustainable Solvency. We are looking at the extent to which particular reforms influence the funds available to pay benefits and how the reforms affect the ability of the economy, the government’s budget, and national 

savings to support the program on a continuing basis. 

• Balancing Equity and Adequacy. We are examining the relative balance 

struck between the goals of allowing individuals to receive a fair return on their 

contributions and ensuring an adequate level of benefits to prevent dependency 

and poverty. 

• Implementing and Administering Reforms. We are considering how easily 

a reform is implemented and administered and how the public is educated concerning the reform. 

Because each country is introducing reforms in a unique demographic, economic, 

and political context these factors will likely affect reform choices and outcomes. For 

instance, several European countries we are reviewing have strong occupation-based 

pension programs that contribute to retirement income security. In addition, some 

countries had more generous national pensions and other programs supporting the 

elderly than others. All countries also provide benefits for survivors and the disabled; often these are funded separately from old age benefit programs. Some countries are carrying out reforms against a backdrop of broader national change. For 

example, Hungary and Poland were undergoing large political and economic transformations as they reformed their national pension systems. All of these issues 

should be considered when drawing lessons. 

In addition to the adjustments that countries have made to their existing PAYG 

systems, many countries have undergone other changes as well, indicating that 

change may not be a one-time experience. (See table 1.) Understanding the outcomes of a country’s reform requires us to look at all of the changes a country has 

made. 

Table 1: Countries’ National Pension Reforms 

Groups of countries undertaking different types of reform a

Only adjustments to 

PAYG 

Adjustments to PAYG 

and National Pension 

Fund 

Adjustments to PAYG 

and Individual Ac- counts All Three Types 

Austria Belgium Australia Denmark 

Czech Republic b Canada Chile d Sweden 

Italy Finland Hungary Switzerland g

Germany c France Iceland e

Turkey Greece Mexico 

10 

Table 1: Countries’ National Pension Reforms—Continued 

Groups of countries undertaking different types of reform a

Only adjustments to 

PAYG 

Adjustments to PAYG 

and National Pension 

Fund 

Adjustments to PAYG 

and Individual Accounts All Three Types 

Ireland Poland 

Japan Slovak Republic 

Korea UK f

Luxembourg 

Netherlands 

New Zealand 

Portugal 

Norway 

Spain 

U.S. 

Source: OECD, International Social Security Association, and the Social Security Administration. 

aMember nations of the OECD and Chile. 

bThe Czech Republic’s defined contribution account program is not included as an ‘‘individual account reform’’ as it is a voluntary supplementary program. For a discussion of these accounts, see U.S. General Accounting Office, Social Security Reform: Information on Using a Voluntary Approach to Individual Accounts, 

GAO–03–309 (Washington, D.C.: Mar. 10, 2003), p. 46–54. cGermany’s Riester pension program is not included as an individual account reform because it is a supplement to the mandatory national pension program, rather than an alternative. For a discussion of these accounts, see U.S. General Accounting Office, Social Security Reform: Information on Using a Voluntary Approach to Individual Accounts, GAO–03–309 (Washington, D.C.: Mar. 10, 2003), p. 55–63. d Chile is not an OECD country, but was included in our study because it pioneered individual account reforms. e Iceland’s mandatory occupation-based pension program allows for the creation of defined contribution individual accounts as a complement to defined benefit pensions. However, in practice, employers have not yet established these. Voluntary supplementary individual accounts are also available. fThe UK requires either participation in a state earnings-related pension program or an approved alternative including individual accounts. gSwitzerland’s mandatory occupation-based pensions provide individual accounts that accrue credits at at 

least a minimum prescribed interest rate. 

Adjustments to Existing PAYG Programs Show Importance of Sustainability, Safety Nets, and Incentives to Work and Save 

The experiences of the countries that have adjusted their existing PAYG national 

pension programs highlight the importance of considering how modifications will affect the program’s financial sustainability, its distribution of benefits, the incentives 

it creates, and the extent to which the public understands the new provisions. 

PAYG Adjustments Prove Important to Financial Sustainability 

To reconcile PAYG program revenue and expenses, nearly all the countries we 

studied have decreased benefits and most have also increased contributions, often 

in part by increasing retirement ages. Generally countries with national pension 

programs that are relatively financially sustainable have undertaken a package of 

several far-reaching adjustments. The countries we are studying increased contributions to PAYG programs by raising contribution rates, increasing the range of earnings or kinds of earnings subject to contribution requirements, or increasing the retirement age. Most of these countries increased contribution rates for some or all 

workers. Canada, for example, increased contributions to its Canadian Pension Plan 

from a total of 5.85 percent to 9.9 percent of wages, half paid by employers and half 

by employees. Several countries, including the UK, increased contributions by expanding the range of earnings subject to contributions requirements. 

Nearly all of the countries we are studying decreased scheduled benefits, using 

a wide range of techniques. Some techniques reduce the level of initial benefits; others reduce the rate at which benefits increase during retirement or adjust benefits 

based on retirees’ financial means. 

• Increased years of earnings. To reduce initial benefits several countries increased the number of years of earnings they consider in calculating an average 

11 

lifetime earnings level. France previously based its calculation on 10 years, but 

increased this to 25 years for its basic public program. • Increased minimum years of contributions. Another approach is to increase the 

minimum number of years of contributions required to receive a full benefit. 

France increased the required number of years from 37.5 to 40 years. Belgium 

is increasing its minimum requirement for early retirement from 20 to 35 years. • Changed formula for calculating benefits. Another approach to decreasing the 

initial benefit is to change the formula for adjusting prior years’ earnings. 

Countries with traditional PAYG programs all make some adjustment to the 

nominal amount of wages earned previously to reflect changes in prices or 

wages over the intervening years. Although most of the countries we are studying use some kind of average wage index, others, including Belgium and France, 

have adopted the use of price indices. The choice of a wage or price index can 

have quite different effects depending on the rate at which wages increase in 

comparison to prices. We see variation in the extent to which wages outpace 

prices over time and among countries. • Changed basis for determining year-to-year increases in benefits. In many of 

the countries we are studying, the rate at which monthly retirement benefits 

increase from year-to-year during retirement is based on increases in prices, 

which generally rise more slowly than earnings. Others, including Denmark, 

Ireland, Luxembourg, and the Netherlands, use increases in earnings or a combination of wage and price indices. Hungary, for example, changed from the use 

of a wage index to the Swiss method—an index weighted 50 percent on price 

changes and 50 percent on changes in earnings. • Implemented provisions that provide a closer link between pension contributions and benefits. Countries that have adopted this approach stop promising 

a defined level of benefits and instead keep track of notional contributions into 

workers’ NDC accounts. Unlike individual accounts, these notional defined accounts are not funded. Current contributions to the program continue to be used 

largely to pay benefits to current workers, while at the same time they are credited to individuals’ notional accounts. When these programs include adjustments that link benefits to factors such as economic growth, longevity, and/or 

the ratio of workers to retirees, they may contribute to the financial sustainability of national pension systems. 

Several countries, such as Sweden and the UK, have undertaken one or more of 

these adjustments to their PAYG programs and have achieved, or are on track to 

achieve relative financial sustainability. Others, including Japan, France, and Germany, may need additional reforms to fund future benefit commitments. 

Maintenance of a Safety Net and Work and Saving Incentives Proved Important 

All of the countries have included in their reforms provisions to ensure adequate 

benefits for lower-income groups and put into place programs designed to ensure 

that all qualified retirees have a minimum level of income. Most do so by providing 

a targeted means-tested program that provides more benefits to retirees with limited financial means. Two countries—Germany and Italy—provide retirees access to 

general social welfare programs that are available to people of all ages rather than 

programs with different provisions for elderly people. 

Twelve countries use another approach to providing a safety net: a basic retirement benefit. The level of the benefit is either a given amount per month for all 

retirees or an amount based on years of contributions to the program. In Ireland, 

for example, workers who contribute to the program for a specified period receive 

a minimum pension. Chile set a minimum pension equal to the minimum wage— 

about one-quarter of average earnings as of 2005. In addition, several of the countries we are studying give very low-income workers credit for a minimum level contribution. Other countries give workers credit for years in which they were unemployed, pursued postsecondary education, or cared for dependents. 

In selecting between the many reform options, policy makers need to strike a 

careful balance among the following objectives: provide a safety net, contain costs, 

and maintain incentives to work and save. Costs can be high if a generous basic 

pension is provided to all eligible retirees regardless of their income. On the other 

hand, means-tested benefits can diminish incentives to work and save. The UK provides both a basic state pension and a means-tested pension credit. Concerned about 

the decline in the proportion of preretirement earnings provided by the basic state 

pension, some have advocated making it more generous. Others argue that focusing 

safety-net spending on those in need enables the government to alleviate pensioner 

poverty in a cost effective manner. However, a guaranteed minimum income could 

reduce some peoples’ incentive to save. In view of this disincentive, the UK adopted 

12 

an additional means-tested benefit that provides higher benefits for retirees near 

the minimum income level. This benefit, called the savings credit, allows low-income 

retirees near the minimum pension level to retain a portion of their additional income. However, any loss of income due to means-testing still diminishes incentives 

to save. Without changes to pension rules, the proportion of pensioners eligible for 

means-tested income is expected to increase to include almost 65 percent of retiree 

households by 2050. 

Implementation, Administration, and Public Education Are Important 

The extent to which new provisions are implemented, administered, and explained 

to the public may affect the outcome of the reform. Poland, for example, adopted 

NDC reform in 1999, but the development of a data system to track contributions 

has been problematic. As of early 2004, the system generated statements indicating 

contributions workers made during 2002, but there was no indication of what workers contributed in earlier years or to previous pension programs. Without knowing 

how much they have in their notional defined accounts, workers may have a difficult 

time planning for their retirement. Some governments have had limited success in 

efforts to educate workers about changes in provisions that will affect their retirement income. For example, a survey of women in the UK showed that only about 

43 percent of women who will be affected by an increase in the retirement age knew 

the age that applied to them. 

Early Action and Effective Management Help Make National Pension Reserve Funds Successful 

Another type of pension reform is the accumulation of reserves in national pension funds, which can contribute to the system’s financial sustainability depending 

on when the funds are created or reformed and how they are managed. Countries 

that chose to partially pre-fund their PAYG programs decades ago have had more 

time to amass substantial reserves, reducing the risk that they will not meet their 

pension obligations. A record of poor fund performance has led some countries to 

put reserve funds under the administration of relatively independent managers with 

the mandate to maximize returns without undue risk. 

Early Action Matters 

Establishing reserve funds ahead of demographic changes—well before the share 

of elderly in the population increases substantially—makes it more likely that 

enough assets will accumulate to meet future pension obligations. In countries such 

as Sweden, Denmark, and Finland, which have had long experiences with partial 

pre-funding of PAYG programs, important reserves have already built up. These resources are expected to make significant contributions to the long-term finances of 

national pension programs. Other countries that have recently created pension reserve funds for their pension program have a tighter time frame to accumulate 

enough reserves before population aging starts straining public finances. In particular, the imminent retirement of the baby-boom generation is likely to make it 

challenging to continue channeling a substantial amount of resources to these funds. 

France, for example, relies primarily on social security surpluses to finance its pension reserve fund set up in 1999, but given its demographic trends, may be able to 

do so only in the next few years. Similarly, Belgium and the Netherlands plan on 

maintaining a budget surplus, reducing public debt and the interest payments associated with the debt, and transferring these earmarked resources to their reserve 

funds. However, maintaining a surplus will require sustained budgetary discipline 

as a growing number of retirees begins putting pressure on public finances. 

Effective Management Can Contribute to Financial Sustainability 

Examples from several countries reveal that pre-funding with national pension reserve funds is less likely to be effective in helping ensure that national pension programs are financially sustainable if these funds are used for purposes other than 

supporting the PAYGO program. Some countries have used funds to pursue industrial, economic, or social objectives. For example, Japan used its reserve fund to support infrastructure projects, provide housing and education loans, and subsidize 

small and medium enterprises. As a result, Japan compromised to some extent the 

principal goal of pre-funding. 

Past experiences have also highlighted the need to mitigate certain risks that pension reserve funds face. One kind of risk has to do with the fact that asset buildup in a fund may lead to competing pressures for tax cuts and spending increases, 

especially when a fund is integrated in the national budget. For example, governments may view fund resources as a ready source of credit. As a result, they may 

be inclined to spend more than they would otherwise, potentially undermining the 

purpose of pre-funding. Ireland alleviated the risk that its reserve fund could raise 

13 

4 Australia’s national PAYG program consistently replaces approximately 25 percent of average wages (23 percent in 2005); Switzerland’s national PAYG program replaced approximately 

26 percent of average wages in 2005. 5 Additionally, increased government debt may crowd out private sector access to lending markets and dampen the economic growth individual accounts are meant to access. 

government consumption by prohibiting investment of fund assets in domestic government bonds. 

Another risk is the pressure that groups may exert on the investment choices of 

a pension reserve fund, potentially lowering returns. For example, Canada and 

Japan have requirements to invest a minimum share of their fund portfolio in domestic assets, restricting holdings of foreign assets to stimulate economic development at home. Funds in several countries have also faced pressure to adopt ethical 

investment criteria, with possible negative impacts on returns. In recent years, 

some countries have taken steps to ensure that funds are managed to maximize returns, without undue risk. Canada, for example, has put its fund under the control 

of an independent Investment Board operating at arm’s length from the government 

since the late 1990’s. Several countries, including New Zealand, have taken steps 

to provide regular reports and more complete disclosures concerning pension reserve 

funds. 

Individual Account Reforms Show the Importance of Funding Decisions 

and Ensuring Benefit Adequacy 

Countries that have adopted individual account programs—which may also help 

pre-fund future retirement income—offer lessons about financing the existing PAYG 

pension program as the accounts are established. Some countries manage this transition period by expanding public debt, building up budget surpluses in advance of 

implementation, reducing or eliminating the PAYG program, or some combination 

of these. In addition, administering individual accounts requires effective regulation 

and supervision of the financial industry to protect individuals from avoidable investment risks. Educating the public is also important as national pension systems 

become more complex. 

Approach to Funding Individual Accounts Affects Sustainability of National Pension System 

It is important to consider how different approaches to including individual accounts may affect the short-term and long-term financing of the national pension 

system and the economy as a whole. A common challenge faced by countries that 

adopt individual accounts is how to pay for both a new funded pension and an existing PAYG pension simultaneously, known as transition costs. Countries will encounter transition costs depending on whether the individual accounts redirect revenue 

from the existing PAYG program, the amount of revenue redirected, and how liabilities under the existing PAYG program are treated. 

The countries we are examining offer a range of approaches for including individual accounts and dealing with the prospective transition costs. Australia and 

Switzerland avoided transition costs altogether by adding individual accounts to 

their existing national pension systems, which are modest relative to those in the 

other countries we are studying.4 Some countries diverted revenue from the existing 

PAYG program to the individual accounts. The resulting shortfall reflects, in part, 

the portion of the PAYG program being replaced with individual accounts and the 

amount of PAYG revenue being redirected to fund the accounts. For example, transition costs may be less in countries such as Sweden or Denmark where the contribution to individual accounts is 2.5 percent of covered earnings and 1 percent, respectively, than for Poland or Hungary, which replaced a larger portion of the PAYG 

program. 

All of the countries we are reviewing also made changes to their PAYG program 

that were meant to help reduce transition costs, such as increasing taxes or decreasing benefits. In addition, Chile built a surplus in anticipation of major pension reform, and Sweden had large budget surpluses in place prior to establishing individual accounts. Countries also transfer funds from general budget revenues to help 

pay benefits to current and near retirees, expanding public borrowing. If individual 

accounts are financed through borrowing they will not positively affect national saving until the debt is repaid, as contributions to individual accounts are offset by increased public debt.5 For example, Poland’s debt is expected to exceed 60 percent 

of GDP in the next few years in part because of its public borrowing to pay for the 

movement to individual accounts. 

It is sometimes difficult for countries to predict their transition costs. In particular, countries that allow workers to opt in or out of individual account programs 

14 

6The countries we reviewed require a range of annuity options, including, for example, inflation indexed, joint and survivor, or gender-neutral. 

have had difficulty estimating costs. For example, Hungary and Poland experienced 

higher than anticipated enrollment from current workers in their individual account 

programs, leaving the existing PAYG program with less funding than planned. As 

a result, both countries had to make subsequent changes to their individual account 

and PAYG programs. 

Balancing Opportunities to Realize High Returns and Benefit Adequacy Is 

Important 

Countries adopting individual accounts as part of their national pension system 

have had to make trade-offs between giving workers the opportunity to maximize 

returns in their accounts and ensuring that benefits will be adequate for all participants. Some countries set a guaranteed rate of return to reduce certain investment 

risks and help ensure adequacy of benefits. These guarantees may, however, result 

in limited investment diversification with a potentially negative impact on returns. 

In Chile, for example, fund managers’ performance is measured against the returns 

of other funds. This has resulted in a ‘‘herding’’ effect because funds hold similar 

portfolios, reducing meaningful choice for workers. All the countries with individual 

accounts provide some form of a minimum guaranteed benefit so retirees will have 

at least some level of income. Some experts believe that a minimum pension guarantee could raise a moral hazard whereby individuals may make risky investment 

decisions, minimize voluntary contributions, or, as in the case of Australia where 

the minimum guarantee is means-tested, may spend down their retirement assets 

quickly. 

It is important to consider the payout options available from individual accounts, 

as these can also have substantial effects on adequacy of income throughout retirement. For example, an annuity payout option can help to ensure that individuals 

will not outlive their assets in retirement.6 However, purchasing an annuity can 

leave some people worse off if, for example, the annuities market is not fully developed, premiums are high, or inflation erodes the purchasing power of benefits. Several countries also allow for phased withdrawals, in some cases with restrictions, 

helping to mitigate the risk of individuals outliving their assets and becoming reliant on the government’s basic or safety-net pension. Some countries offer a lumpsum payment under certain circumstances, such as small account balances, and 

Australia allows a full lump-sum payout for all retirees. 

Effective Regulation, Implementation, and Education Can Protect Individuals 

Important lessons can be learned regarding the administration of individual accounts, including the need for effective regulation and supervision of the financial 

industry to protect individuals from avoidable investment risks. Some countries 

have expanded their permitted investment options to include foreign investments 

and increased the percentage of assets that can be invested in private equities. The 

experiences of countries we are studying also indicate the importance of keeping administrative fees and charges under control. The fees that countries permit pension 

funds to charge can have a big influence on the amount of income retirees receive 

from their individual accounts. Several countries have limits on the level and types 

of fees providers can charge. Additionally, the level of fees should take into consideration the potential impact not only on individuals’ accounts, but also on fund managers. In the UK, for example, regulations capping fees may have discouraged some 

providers from offering pension funds. To keep costs low, Sweden aggregates individuals’ transactions to realize economies of scale. 

Some countries’ experiences highlighted weaknesses in regulations on how pension funds can market to individuals. The UK’s and Poland’s regulations did not 

prevent problems in marketing and sales. Poland experienced sales problems, in 

part because it had inadequate training and standards for its sales agents, which 

may have contributed to agents’ use of questionable practices to sign up individuals. 

The UK had a widely-publicized ‘‘mis-selling’’ scandal involving millions of investors. 

Many opened individual accounts when they would more likely have been better off 

retaining their occupation-based pension. Insurance companies were ordered to pay 

roughly $20 billion in compensation. 

Countries’ individual account experiences reveal pitfalls to be avoided during implementation. For example, Hungary, Poland, and Sweden had difficulty getting 

their data management systems to run properly and continue to experience a substantial lag time in recording contributions to individuals’ accounts. In addition, 

15 

Hungary and Poland did not have an annuities market that offered the type of annuity required by legislation. 

Education becomes increasingly important as the national pension systems become more complex. It is particularly important for workers who may have to make 

a one-time decision about joining the individual account program. Several countries 

require disclosure statements about the status of a pension fund, and some provide 

annual statements. To help individuals choose a fund manager, one important component of these statements should be the disclosure of fees charged. Some countries 

have done a better job of providing fund performance information than others. For 

example, Australia requires its fund providers to inform members through annual 

reports clearly detailing benefits, fees and charges, investment strategy, and the 

fund’s financial position. In contrast, Hungary did not have clear rules for disclosing 

operating costs and returns, making it hard to compare fund performance. 

Concluding Observations 

Demographic challenges and fiscal pressure have necessitated national pension reform in many countries. Though one common goal behind reform efforts everywhere 

is to improve financial sustainability, countries have adopted different approaches 

depending on their existing national pension system and the prevailing economic 

and political conditions. This is why reforms in one country are not easily replicated 

in another, or if they are, may not lead to the same outcome. Countries have different emphases, such as benefit adequacy or individual equity; as a result, what 

is perceived to be successful in one place may not be viewed as a viable option somewhere else. 

Although some pension reforms were undertaken too recently to provide clear evidence of results, the experiences of other countries may suggest some lessons for 

U.S. deliberations on Social Security reform. Some of these lessons are common to 

all types of national pension reform and are consistent with findings in previous 

GAO studies. Restoring long-term financial balance invariably involves cutting benefits, raising revenues, or both. Additionally, with early reform, policy makers can 

avoid the need for more costly and difficult changes later. Countries that undertook 

important national pension reform well before undergoing major demographic 

changes have achieved, or are close to achieving, financially sustainable national 

pension systems. Others are likely to need more significant steps because their populations are already aging. 

No matter what type of reform is undertaken, the sustainability of a pension system will depend on the health of the national economy. As the number of working 

people for each retiree declines, average output per worker must increase in order 

to sustain average standards of living. Reforms that encourage employment and 

saving, offer incentives to postpone retirement, and promote growth are more likely 

to produce a pension system that delivers adequate retirement income and is financially sound for the long term. 

Regardless of a country’s approach, its institutions need to effectively operate and 

supervise the different aspects of reform. A government’s capacity to implement and 

administer the publicly managed elements of reform and its ability to regulate and 

oversee the privately managed components are crucial. In addition, education of the 

public becomes increasingly important as workers and retirees face more choices 

and the national pension system becomes more complex. This is particularly true 

in the case of individual account reforms, which require higher levels of financial 

literacy and personal responsibility. 

In nearly every country we are studying, debate continues about alternatives for 

additional reform measures. It is clearly not a process that ends with one reform. 

This may be true in part because success can only be measured over the long term, 

but problems may arise and need to be dealt with in the short term. The positive 

lessons from other countries’ reforms may only truly be clear in years to come. 

Mr. Chairman and Members of the Subcommittee, this concludes my prepared 

statement. I’d be happy to answer any questions you may have. 

GAO Contacts and Staff Acknowledgements 

For further information regarding this testimony, please contact Barbara D. 

Bovbjerg, Director, Education, Workforce, and Income Security Issues at (202) 512– 

7215. Alicia Puente Cackley, Assistant Director, Benjamin P. Pfeiffer, Thomas A. 

Moscovitch, Nyree M. Ryder, Seyda G. Wentworth and Corinna A. Nicolaou, also 

contributed to this report. 

f 

Chairman MCCRERY. Thank you, Ms. Bovbjerg. Dr. James. 

16 

STATEMENT OF ESTELLE JAMES, PH.D., CONSULTANT AND 

FORMER LEAD ECONOMIST, THE WORLD BANK 

Dr. JAMES. Thank you very much for inviting me. Over the past 

20 years, more than 30 countries, spread across Latin America, 

Eastern and Central and Western Europe, Australia, and Hong 

Kong, have added privately funded managed plans to their mandatory Social Security systems. They did this for several reasons: to 

prevent public costs from rising, to increase national saving, to improve work incentives and therefore to augment economic growth, 

as the previous speaker said. Contributions to the accounts range 

from 2.5 percent of wages in Sweden, to 12.5 percent in Chile, and 

they are projected to supply between 30 and 90 percent of total 

benefits. It varies a lot across countries. In this discussion I am 

going to consider both income streams that come from the personal 

accounts, as well as the traditional defined benefit, as part of the 

country’s Social Security system, so long as it is financed by taxes 

or mandatory contributions. In other words, I am defining Social 

Security as, in some sense, coming from these mandatory sources, 

whether it is the personal account or the defined benefit. I discuss 

how these countries financed the account, financed the transition, 

protected low earners and kept administrative costs low. 

I am going the summarize my four major points, and then I will 

go on as long as I have time to explain where they come from. The 

major lessons I draw are: first, in comparison with other countries, 

current and projected benefits from and contributions to the U.S. 

Social Security system are relatively low. We are at the low end of 

the spectrum. That leaves us with the question, do we want to 

maintain those scheduled benefits or cut them, and this is really 

the central question that we are faced with. To maintain the scheduled level of benefits will cost more money than we are paying now. 

That is going to be the case, I believe, whether we do it through 

the personal account part or the traditional part. However, I think 

we will get higher returns and better economic incentives from this 

extra money if it goes into personal accounts. This obviously implies funding the account mainly through a small add-on. Although 

most countries in Latin America and Eastern and Central Europe 

with funded private plans used a carve-out from existing payroll 

taxes, several OECD countries used the mandatory add-on, and our 

initial conditions have more in common with these OECD countries 

as I will explain in a minute. 

Second point, one reason why countries adopted personal accounts was to increase national saving and economic growth, making more goods and services available for everyone. This effect depends heavily on how the accounts and the transition are financed. 

National saving will increase if the accounts are funded by an addon or if they are funded by a carve-out whose transition costs are 

not primarily debt financed. Chile is a very good example. Chile financed the transition to personal accounts out of a surplus on the 

rest of its public budget, both initially and even to this very day, 

and extensive analysis shows that this is largely responsible for the 

increased national saving that has fueled Chile’s economic growth. 

Point number three: every country that has personal accounts also 

has a public safety net, so, it is certainly not an either/or proposition. The two definitely go together, and every country includes 

17 

a minimum pension, as the previous speaker indicated, to cushion 

financial and labor market risk. 

Point number four, accounts can be organized through the retail 

market, as in most of Latin America and Eastern and Central Europe, or through the institutional market, as in several other countries, and in the United States we have the Thrift Saving Plan, 

which is an often cited example. The institutional market has 

much lower administrative and marketing costs because it benefits 

from greater economies of scale and bargaining power. There is 

also a tradeoff, and the tradeoff is less worker choice and less insulation from political pressures. So, those are my four points, and 

I just want to go back now and explain how I came to these conclusions, where those points come from. 

First, the issue of funding the account through an add-on versus 

a carve-out. What did other countries do? Countries that include 

funded privately managed plans in their Social Security systems 

fall into two different groups: Latin America and Eastern and Central European countries on the one hand, and several OECD countries on the other hand. Now, in most Latin American and Eastern 

and Central European countries personal accounts were created 

during the nineties and early 2000s as a remedy for public systems 

that were already on the verge of insolvency, much further along 

than we are in this country. Payroll taxes were extremely high, 

often over 25 percent of wages. Tax evasion was also high. Workers 

retired well before age 60 and promised replacement rates were 

overly generous; for example, 70 to 80 percent of the worker’s 

wage. An add-on contribution for the accounts clearly was not an 

option for this group. The new accounts were funded by a carveout from the existing payroll tax, which was already too high. 

In contrast, several OECD countries, such as Australia, Switzerland, Netherlands, and Denmark, started out with relatively modest public benefits, not very different on average from benefits in 

the United States but more redistributive. They had a different 

structure. In addition, in these countries, employers have long provided pension plans, on a voluntary or collectively bargained basis, 

to about half the labor force. That also has some similarities to the 

United States. As an alternative to increased public expenditures 

on pensions and as a way to raise national saving, in the eighties 

and early nineties these countries decided to make funded employer-sponsored plans mandatory for virtually the entire labor 

force. In effect, these plans became part of the Social Security systems because they were mandated through an add-on for employers 

that didn’t already provide them. The add-on has reached 9 percent 

in Australia. The cost is actually higher in some of the other countries, and the combined target replacement rate is now 60 to 65 

percent, obviously higher than ours. 

Chairman MCCRERY. Dr. James, can you sum up so we can 

move on? We will get to a lot of this in questions. 

Dr. JAMES. Okay, sure. I will just say the old employer plans 

were mainly Defined Benefit (DB), but they are increasingly Defined Contribution (DC) and many employers are also shifting their 

old plans to DC, so, they are moving in the distribution of individual accounts. In terms of transition costs, the countries that 

used an add-on did not face transition costs because they added 

18 

money. The ones that used a carve-out did face transition costs, 

and they financed these costs by downsizing benefits and through 

a mix of fiscal stringency and debt finance. Chile, as I mentioned, 

ran a surplus on the rest of its budget to finance the transition. In 

fact, even today they spend 2 to 3 percent of their Gross Domestic 

Product (GDP) on phasing out the old system, but no debt financing. It all comes out of surplus on the rest of its budget, which has 

enhanced its national saving. All of these countries include a safety 

net and minimum pension, which may come from a minimum pension guarantee, a flat benefit, or a means tested benefit. There are 

different forms, but they all have some kind of minimum pension. 

Administrative costs, as I mentioned, can be reduced by using the 

institutional market. We find this in the employer-sponsored plans 

and in some smaller countries like Bolivia, Kosovo, Panama, whose 

costs are quite low. So, I think if this plan is structured through 

the institutional market we can keep our costs low too. 

[The prepared statement of Dr. James follows:] 

Statement of Estelle James, Ph.D., Consultant and Former Lead Economist, 

The World Bank 

Over the past 20 years more than 30 countries, spread across Latin America, 

Eastern, Central and Western Europe, Australia and Hong Kong, have added funded privately managed plans to their mandatory social security systems. They did 

this to prevent public costs from rising, to increase national saving and to improve 

work incentives. Contributions to the accounts range from 2.5% of wages in Sweden 

to 12.5% in Chile and they are projected to supply between 30 and 90% of total benefits. In this discussion I consider both income streams—that coming from the personal accounts as well as the traditional defined benefit—as part of the country’s 

social security system, so long as it is financed by taxes or mandatory contributions. 

I discuss how these countries funded the accounts, financed the transition, protected 

low earners and kept administrative costs low. The major lessons I draw are: 

1. In comparison with other countries, current and projected benefits from and 

contributions to in the U.S. social security system are relatively low. We need 

to decide whether we wish to maintain or to cut the scheduled level of mandatory retirement income—this is our central question. To maintain the scheduled level of social security benefits will cost more money than we are paying 

now, whether we do it through the personal account part or the traditional 

part. We will get higher returns and better economic incentives from this extra 

money if it goes into personal accounts—but this implies funding the accounts 

mainly through a small add-on. Although most countries in Latin America and 

Eastern and Central Europe with funded private plans used a carve-out from 

existing payroll taxes, several OECD countries used a mandatory add-on. Our 

initial conditions have more in common with these OECD countries. 

2. One reason why countries adopted personal accounts was to increase national 

saving and economic growth—therefore more goods and services for everyone. 

This effect depends heavily on how the accounts and the transition are financed. National saving will increase if the accounts are funded by an add-on 

or by a carve-out whose transition costs are not debt-financed. Chile financed 

its transition out of a surplus on the rest of its public budget—and extensive 

analysis shows that this is largely responsible for the increased saving that has 

fueled Chile’s economic growth. 

3. Every country that has personal accounts also has a public safety net, including a minimum pension, to cushion financial and labor market risk. 

4. Accounts can be organized through the retail market, as in most of Latin 

America and Eastern and Central Europe, or through the institutional market, 

as in several other countries and in the Thrift Saving Plan in the U.S. The 

institutional market has much lower administrative and marketing costs because it benefits from greater economies of scale and bargaining power (but the 

trade-off is less worker choice and less insulation from political pressures). 

1. Funding the accounts through an add-on versus a carve-out 

Countries that include funded privately managed plans in their social security 

systems fall into two different groups: Latin America and Eastern and Central EuVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00022 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
19 

rope, on the one hand, and several OECD countries, on the other hand. In most 

Latin American and Eastern and Central European countries personal accounts 

were created during the 1990’s and early 2000’s as a remedy for public systems that 

were already on the verge of insolvency. In these countries payroll taxes were extremely high (often over 25% of wages), tax evasion was also high, workers retired 

well before age 60 and promised replacement rates were overly generous—for example, 70–80% of the worker’s wage. An add-on contribution for the accounts clearly 

was not an option for this group. The new accounts were funded by a carve-out from 

the existing payroll tax, which was already too high. 

In contrast, several OECD countries, such as Australia, Switzerland, Netherlands 

and Denmark, started out with relatively modest public benefits—not very different, 

on average, from benefits in the U.S., but more redistributive. In addition, in these 

countries employers have long provided pension plans, on a voluntary or collective 

bargained basis, which covered about half the labor force. As an alternative to increased public expenditures on pensions and as a way to raise national saving, in 

the 1980’s and early 1990’s these countries decided to make funded employer-sponsored plans mandatory for virtually the entire labor force. In effect, these plans became part of their social security systems, through an add-on for employers that 

didn’t already provide them. The add-on has reached 9% in Australia, more in the 

other countries, and the combined target replacement rate is now 60–65%. The old 

employer plans were mainly defined benefit but the new ones are mostly defined 

contribution and many employers are also shifting their old plans to defined contribution (that is, to individual accounts). 

I believe this add-on strategy for financing individual accounts would be the best 

for us too, except that I would organize it through workers, not employers, and I 

would aim for a much smaller add-on (of about 2%). This would hold our total benefit roughly where it is projected to be now, while allowing the traditional part of 

the system to become smaller and remain solvent. 

2. Transition costs 

The OECD countries did not face transition costs, because they did not divert 

money, they added-on. The Latin American and Eastern-Central European countries 

did face transition costs. They financed these costs in part by downsizing benefits 

and by a mix of fiscal stringency and debt finance. The transition has been intensively studied in Chile. Chile cut its obligations by raising retirement age substantially. It accumulated a budget surplus ahead of time to cover its early transition 

costs. The government is still paying 2–3% of GDP per year for the remnants of the 

old system, but it does so entirely by generating a surplus in the rest of its budget. 

In other words, no public debt finance is involved. Financing the transition without 

increasing the public debt is the major reason why Chile has increased its national 

saving, which in turn has increased its rate of economic growth. 

If we in the U.S. want to use pension reform as a way to increase national saving, 

either we must use an add-on or we must come up with a plan for transition finance 

that does not depend heavily on enlarging the public debt. Otherwise, we will be 

canceling out the increased private saving with increased public dissaving. 

3. Minimum pension and other safety nets 

All these countries include a safety net and guarantees to protect low earners. 

Every one of them has a minimum pension of some sort—examples are a minimum 

pension guarantee in Chile, a flat benefit that goes to every older resident in the 

Netherlands, or a widespread means—and asset-tested benefit in Australia. This 

cushions the risk from the accounts and from the labor market. In Switzerland, 

Mexico and Estonia the safety net rises with years of contributions, to bolster work 

incentives. 

4. Administrative costs—retail versus institutional market 

Most of the countries in Latin America and Central-Eastern Europe used the retail market to put workers into funds. But some countries, such as Bolivia, Panama 

(civil service) and Kosovo, have experimented with the institutional market. Large 

employer funds in the OECD also use the institutional market. 

In the retail market pension fund managers can freely enter the industry, they 

establish a direct relationship with workers, and administrative costs tend to be relatively high, because of high marketing costs, diseconomies of dealing with many 

small accounts and price-inelasticity of demand in retail financial markets. Costs 

start out well over 10% of assets. Even though they fall steeply with asset growth, 

in countries as advanced as the UK they still exceed 1%, which will reduce final 

pensions by 20%. 

In contrast, in the institutional market records are usually centralized, the money 

in small accounts is aggregated, and a competitive bidding process is held to choose 

20 

a limited number of fund managers, among whom workers can choose. Administrative costs are cut by 2/3, because scale economies and bargaining power are larger 

and marketing costs are smaller. There is a trade-off of course—less choice for workers and greater danger of political pressure, if the bidding is organized by government. Sweden tries to mimic the fees of the institutional market while keeping the 

greater choice of the retail market, but it does so by imposing price controls. The 

institutional model is used by the U.S. Thrift Saving Plan and it was recommended 

by the President’s Commission for our individual account system. I think this is appropriate for a system with many small accounts. After 7–8 years, administrative 

costs in this system would be.3%, which is lower than in other countries and also 

lower than in most mutual funds in our country. 

f 

Chairman MCCRERY. Thank you, Dr. James. Mr. Whitehouse. 

STATEMENT OF EDWARD WHITEHOUSE, ADMINISTRATOR, SOCIAL POLICY DIVISION, ORGANISATION FOR ECONOMIC CO– 

OPERATION AND DEVELOPMENT, PARIS, FRANCE 

Mr. WHITEHOUSE. Thank you. I shall try and be briefer. It is 

a great pleasure to be here, and I think it is very useful for this 

Committee to look at the international experience. As the previous 

speakers have said, there is a vast amount of experience on structural pension reform around the world, and I think there are some 

lessons that can be learned for the United States. As both of the 

previous speakers have pointed out, the starting point is rather different in the United States than it was in the countries of Latin 

America and Eastern Europe. To start with, the target benefit level 

under Social Security is relatively low. It promises about a 50-percent replacement rate after a full career. That compares with about 

65 or 70 percent in the rest of the OECD countries, which was the 

target of the starting point in the Latin American and Eastern European countries as well. So, the carve-out question is rather different when you have a much bigger starting point in your public 

pension system than it is when the starting point is as it is in the 

United States. 

In the first part of my written testimony, I put the U.S. pension 

scheme into an international context to try and show how the target benefit level compares with comparable countries, and also to 

look at income distribution analysis, which shows that currently, 

pensioners in the United States look to be doing quite well. Their 

incomes are quite large relative to most of the population as a 

whole. However, there is an issue of pension or prosperity, that on 

a standard international definition, 20 percent of older people in 

the United States are classed as poor, and that is double the average for the 30 rich countries who are members of the OECD, which 

is around 10 percent, and it is very much higher than countries 

such as France, Germany, and Britain, which have a much lower 

old age poverty rate. So, I think an issue that perhaps should be 

addressed in Social Security reform is thinking about what to do 

about poorer pensioners. 

As far as personal accounts go, one major issue which Dr. James 

touched on, is this question of the administrative expenses, and we 

found particularly in Latin America there has been—in the early 

years of reform this has been very controversial—extremely large 

marketing expenses; rather wasteful competition between different 

pension providers who are essentially offering the same product, 

21 

1 Edward Whitehouse, a British national, works in the Social Policy Division of the OECD Secretariat in Paris. He is co-author of the recent report, Pensions at a Glance, a comprehensive 

study of pension systems in the 30 OECD countries (OECD, 2005). He has advised numerous 

governments on pension reform, including Hungary and Poland, and has written many studies 

of the pension system in the United Kingdom (such as Dilnot et al., 1994 and Whitehouse, 1998). 

He previously worked as co-editor of the World Bank’s Pension Reform Primer, a resource for 

people designing and implementing pension reforms around the world. 

This testimony represents a personal view and commits neither the OECD Secretariat nor any 

of its member governments. 

Edward Whitehouse, ELS/SPD, OECD, 2 rue Andre ́ Pascal, 75775 Paris Cedex 16, France. 

Telephone: +33 1 45 24 80 79. Fax: + 33 1 45 24 90 98. E-mail: edward.whitehouse@oecd.org. 

because the portfolios of the different funds are very similar, the 

marketing being the sole reason for people to switch often between 

funds. There are very obvious ways the United States can avoid 

falling into that trap of this wasteful competition. Dr. James mentioned the Thrift Saving Plan (TSP). I am not sure that that can 

be a direct model for a personal account system because the TSP 

is for Federal Government employees, so, there is only one employer. When we are dealing with personal accounts, we are dealing with a multitude of employers, and so, I think something like 

TIAA–CREF might be a better example. Clearly, the United States 

is in a much better position in terms of its financial markets for 

organizing a system of personal accounts than was, for example, 

Chile or the countries of Eastern Europe, where capital markets 

there could best be described as nascent in times of reforms. There 

is a corollary of that, which is that therefore, the benefits to the 

U.S. economy of such a reform are commensurately lower. It is 

easier to organize, but the capital market development, which is so 

important in Latin America, so important in Eastern Europe, is already there. You have the most advanced capital market there is, 

already. So, the wider economic effects are likely to be smaller in 

the reform in the United States than they are in other countries. 

The final issue I address in the written testimony is a rather 

complex one which I will try and summarize in 30 seconds. It is 

this issue of who is covered by the reform and what are the terms 

of trade for people switching to the new personal accounts. In reading the proposals of the President’s Commission on Strengthening 

Social Security, people are likely to be offered a choice of where 

they can take some of their contributions out of Social Security and 

put them into their personal account, and then their Social Security benefits are reduced by that amount of contribution plus an interest rate. How that interest rate is set is going to be crucial to 

whether or not these personal accounts will actually work. Set the 

interest rates too high, no one is going to choose that option. Set 

the interest rate too low, and you have a huge fiscal problem. As 

I explained in detail in the written testimony, the UK made a very 

grave mistake when it introduced the individual accounts/pension 

option, because it gave people far too large an incentive to switch 

to the new individual account. So, I look forward to answering your 

questions. Thank you. 

[The prepared statement of Mr. Whitehouse follows:] 

Statement of Edward Whitehouse, Administrator, Social Policy Division, 

Organisation for Economic Co-operation and Development, Paris, France1

Countries around the world need to reform pension systems to meet demographic 

challenges and to reflect changes in labor markets and industrial, economic and soVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00025 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
22 

2Ongoing work is extending the analysis to include people with long absences from the labor 

market due to caring for children or long-term unemployment. 

cial structures. There are valuable lessons to be learned from other countries’ experiences. But the inherent complexity of pension systems has, in the past, hampered 

effective transmission of policy experiences across borders. 

This testimony is in four parts. The first puts the United States’ pension system 

in an international context. It uses three kinds of evidence: calculations of pension 

entitlements at an individual level, comparisons of older people’s incomes with the 

rest of the population and how public pension spending is likely to develop. 

The second part looks at structural pension reforms that have introduced some 

kind of mandatory ‘individual accounts’ (defined-contribution pension plans) as a 

substitute for all or part of public, earnings-related pensions. These have now been 

introduced by 10 countries in Latin America and more than 10 in Eastern Europe. 

The third part of the testimony investigates an important but often overlooked 

feature of fundamental pension reform. Are the new defined-contribution accounts 

mandatory or voluntary? Which age groups are covered? If there is a choice, what 

are the terms of trade between remaining only in the public pension program and 

switching to a mixed public/private pension? 

The issue of administrative charges for defined-contribution pensions is addressed 

in the fourth part. How large are these fees in different countries? What policies 

can help keep charges low? 

1. The pension system of the United States in an international context 

There are three main approaches to comparing pension systems between countries. The most common is the ‘fiscal’ approach, which looks at current and prospective pension expenditures. This is useful for assessing the financial sustainability 

of a retirement-income system, but it gives only the total for pension spending and 

is silent on how that spending is distributed among older people. The second method 

is income-distribution analysis. This compares the incomes of today’s older people 

with the incomes of the population as a whole. This is a backward-looking measure, 

since the incomes of today’s pensioners depend on past rules of the pension system 

and past economic conditions. The third method is a microeconomic approach, calculating prospective pension entitlements for today’s workers. Unlike fiscal projections, this looks explicitly at the distribution of pensions among workers of different 

characteristics. Unlike income-distribution analysis, it is forward-looking, assessing 

the pension promises made to today’s workers under today’s rules. 

Microeconomic approach 

The OECD recently published the first comprehensive, microeconomic analysis of 

pension entitlements in the report Pensions at a Glance (OECD, 2005). This first 

report (in what is hoped will be a biennial series) calculated prospective pensions 

of full-career workers at different levels of earnings.2 The analysis includes all mandatory sources of retirement income: resource-tested benefits (including social assistance), basic and minimum pensions, public, earnings-related schemes and mandatory private schemes (both defined-benefit and defined-contribution). The calculations use common macroeconomic and financial assumptions to isolate the effect of 

pension-system design from these other factors. The parameters used are those applying in 2002, although subsequent reforms that have been legislated are assumed 

to be fully in place. The results, therefore, show the long-term stance of the pension 

system. 

The two charts below (Figure 1) show the ‘net replacement rate’. This is the pension, net of any income taxes and contributions due, divided by individual earnings, 

again net of taxes and contributions. Both charts show selected countries: OECD 

(2005) provides data for all 30 member countries of the OECD. 

The left-hand panel shows the net replacement rate for a full-career with earnings 

equal to the economy-wide average each year. The highest net replacement rate is 

in Luxembourg, where the pension entitlement is calculated to be 110 percent of 

earnings when working. At the other end of the scale, the lowest net replacement 

rate is in Ireland, where it is 37 percent. The OECD average net replacement rate 

for an average earner is 69 percent. The replacement rate in the United States is 

low: along with Ireland and the United Kingdom shown in the charts, only Korea, 

Mexico and New Zealand have lower net replacement rates at this earnings level. 

The right-hand panel shows the position of a low earner. The OECD average replacement rate at half-average earnings is 84 percent. This is higher than the replacement rate for an average earner because most OECD countries, the United 

States included, have redistributive pension systems. At this earnings level, the replacement rate in the United States is 61 percent. This is the lowest among the 

23 

OECD countries apart from Mexico and the Slovak Republic. Countries with wholly 

flat-rate pensions, such as Ireland, with means-tested public schemes, such as Australia, or with predominantly flat-rate systems, such as the United Kingdom naturally have a large difference between the replacement rate at average and at low 

earnings. The main reason that low earners have very low pensions in the United 

States, despite the progressive benefit formula in social security, is the low value 

of the safety-net benefit. The means-tested program, supplemental security income 

(SSI), provides a minimum income worth 20 percent of average earnings. The safety-net retirement income across all 30 OECD countries is worth nearly 30 percent 

of average earnings (on average). 

Figure 1. Prospective net replacement rate for full-career worker 

Average earnings 


Insert offset folio 23925a.001
24 

3The average contribution rate is taken from the Employee Benefits Research Institute/Investment Company Institute (EBRI/ICI) survey of 401(k) plans. OECD (2005) provides details 

of the modeling for Canada and the United Kingdom and calculations for a typical defined-benefit plan for the United States. It also includes a sensitivity analysis of the results. 4See also Disney and Whitehouse (2001, 2002). 

5The low measure of relative incomes of older people in Australia reflects the fact that many 

withdrawals from private pensions are in the form of lump sums rather than income streams. 

Half-average earnings 

Source:OECD (2005) 

In countries with low mandated pension replacement rates, there is space for voluntary retirement-income provision to develop. In Canada, the United Kingdom and 

the United States, for example, both company and individual pensions are widespread. The chart for the average earner therefore shows the entitlements under a 

‘typical’ pension plan for these three countries. In Canada and the United Kingdom, 

this is a defined-benefit plan. For the United States, it is a 401(k), into which the 

worker and his employer are assumed to pay contributions of the national average 

(9.5 percent of earnings).3 With these voluntary programs, the replacement rates for 

these three countries look rather closer to continental Europe. But these replacement rates are conditional on having a full-career covered by a voluntary plan. The 

issue then turns to the following questions. Are some people saving enough in defined-contribution schemes? Do people have significant gaps where they are not covered by a voluntary, private pension? How will the penalty to changing jobs in defined-benefit plans affect retirement incomes? 

Income-distribution analysis 

Figure 2 shows two charts that summarize the information relating to older people in the OECD’s latest cross-country study of income distribution (Fo ̈rster and 

Mira d’Ercole, 2005).4 Again, selected countries are presented here while the original paper provides information for many more. 

The left-hand panel shows the net income of 66–75 year olds as a proportion of 

the net income of the population as a whole. The OECD average is 87 percent. In 

the United States, the figure is the highest of the OECD countries at 97 percent. 

Most of the OECD countries are clustered closely together. One reason that the 

United States performs well on this measure, while mandatory replacement rates 

under social security are so low, is due to voluntary, private pension provision. But 

the main reason is due to the importance of labor-market income in the United 

States, even among these 66–75 year olds. Earnings make up 30 percent of the 

gross income of this age group in the United States. In most of Europe, this figure 

is only around 10 percent. Australia, Canada and New Zealand lie between the two, 

with around 20 percent of gross income of older people coming from earnings.5


Insert offset folio 23925a.002
25 

These are not measured in income-distribution analysis. This is also an important factor in Ireland and the United Kingdom, although to a more limited extent. 

The right-hand panel shows the old-age poverty rate for the same, selected countries. This is defined as the percentage of 66–75 year olds with an income below 

half the population median. In addition to Australia and Ireland (shown in the 

chart), only Greece, Mexico and Portugal have a higher old-age poverty rate than 

the United States. The OECD average (11 percent) is nearly half the rate in the 

United States. This reflects the low value of SSI relative to safety-net incomes for 

older people in other OECD countries and narrow coverage of low-income workers 

by private pensions. 

Figure 2. Income distribution measures 

Relative incomes of older people 


Insert offset folio 23925a.003
26 

Old-age poverty rate 

Note: all incomes are household incomes adjusted for household composition using 

an ‘equivalence scale’ 

Source: Fo ̈rster and Mira d’Ercole, 2005 

Fiscal projections 

The OECD has also compared the effects of aging on a range of public spending 

programs. The chart below (Figure 3) looks at public spending on pensions alone. 

Public pension expenditure in 2000 averaged 7.5 percent of gross domestic product 

(GDP) across 21 countries. (Other countries’ data are available in Dang, Antolı ́n and 

Oxley, 2001.) 

Italy had the highest spending on this measure, nearly double the OECD average. 

Australia’s spending, at 3 percent (less than half the average) was the second lowest. The United States spent around the same as the United Kingdom, around 4.5 

percent of GDP. The arrows show how spending will change between 2000 and the 

projected peak (between 2030 and 2050). Italy’s series of pension reforms have reduced the growth rate of pension spending. It is expected to peak at 16 percent of 

GDP, less than in France or Germany (on the policies in place in 2000). The peak 

in the United States is estimated to be 6 percent of GDP, compared with an OECD 

average of 10 percent. 


Insert offset folio 23925a.004
27 

Figure 3. Current and projected pension spending 

Note: peak values are in 2050, except Italy and the United Kingdom (2030), France 

and the United States (2035) and Netherlands (2040) 

Source: Dang, Antolı ́n and Oxley (2001) 

2. International experience of introducing individual accounts 

Some 25 countries around the world have now introduced individual accounts as 

a substitute for all or part of their public, pay-as-you-go pension schemes. The 

spread of these schemes through Latin America from the mid 1990s and through 

Eastern Europe in the years since then is quite dramatic. Many more countries are 

at various stages of the reform process, including Lebanon and Ukraine. 

It is important to note that these reformed pension systems are very diverse, despite the common theme of individual accounts. Bolivia, Chile, El Salvador and Mexico, for example, have shifted nearly all retirement-income provision to the definedcontribution plans (although all of them retain publicly provided minimum pensions. 

In contrast, Argentina retains a large basic scheme (expected to provide around twothirds of total pension benefits in the long term). Costa Rica and Uruguay retain 

earnings-related public schemes (which are likely to provide more than three-quarters of total benefits). All countries in Eastern Europe retain public, earnings-related plans as a complement to the new defined-contribution schemes. The balance 

between the two again varies. Half or more of pension benefits in the long term are 

likely to come from the funded component in Croatia, Latvia and Poland, compared 

with a third in Hungary and 16 percent in Bulgaria, for example. 

Differences in the relative role of public and private provision in these new pension systems also arise because of differences in the size of the mandatory contribution. In Bulgaria, for example, the contribution is just 2 percent of earnings and it 

is 2.5 percent in Sweden. Contribution rates in Latvia and Lithuania were initially 

set low (2 and 2.5 percent respectively), but are planned to increase over time to 

10 and 5.5 percent respectively. In Latin America, total contributions (including survivors’ and disability insurance and administrative charges) exceed 10 percent of 

earnings in Chile, Colombia and El Salvador. 

The mandatory contribution to the superannuation guarantee in Australia is 9 

percent. Contribution rates are also fairly high in Hungary (8 percent), Poland (7.3 

percent) and the Slovak Republic (9 percent). The minimum contribution to personal 

pensions in the United Kingdom (for individuals choosing that option) varies with 

age, from 3.8 to 9 percent. Again, the other elements of the pension system differ. 

In Australia, for example, the individual accounts were added onto the public, 

means-tested pension. In the United Kingdom, those choosing the personal-pension 

option are also entitled to public basic and means-tested pensions. 


Insert offset folio 23925a.005
28 

Table 1. The spread of defined-contribution pension schemes: Latin 

American, Eastern Europe and beyond 

3. Coverage of individual-accounts schemes 

The transition from a public-sector, pay-as-you-go pension system into one in 

which individual, privately managed pension accounts form part of the mandatory 

retirement-income system does not directly affect those receiving pensions at the 

time of the reform. Nevertheless, such a reform could affect all current and future 

workers. A critical policy choice, therefore, is whether current and future workers 

should be allowed, encouraged or forced to switch part of their pension provision to 

the new private element. There is a spectrum of possible policy options. At one end, 

all workers, including new labor-market entrants, might be allowed choose to stay 

in the pay-as-you-go system or switch part of their contribution to the funded plan. 

At the other end of the spectrum, rights in the old scheme are frozen and all new 

rights of all workers are earned in the defined-contribution, funded plan. In between 

are policies where only some workers must join the new funded element, usually 

defined by age. 

The experience of 19 reforming countries (Table 2) covers the full spectrum of possible outcomes. However, this masks some important differences. In Mexico, for example, people who contributed to the old system can switch back to the public 

scheme on the day they retire. So there is an implicit guarantee that the return on 

investment in the private scheme is at least as large as the (implicit) return on contributions to the public plan. As new labor market entrants are not offered the same 

guarantee, Mexico’s policy is probably closer to those of Chile or Hungary than to 

those of Bolivia and Kazakhstan. Switching back to the public plan is also possible 

indefinitely in Colombia and the United Kingdom and for a limited period in Argentina, Hungary and Poland. 

Who should be covered by structural pension reform? 

It is readily apparent from Table 2 that most countries have focused the pension 

reform on younger people. Among the Latin American countries Chile, El Salvador 

and Uruguay all required new labour-market entrants (and in the last two, younger 

workers) to switch. Similar policies were adopted throughout Eastern Europe and 

in Sweden. 

There are three main reasons why restricting switching to younger people is a 

sensible policy. First, changing the pension entitlements for older workers is difficult, because they have made their labour-market and savings decisions based on 

the expectation that the current system will remain. They can not retrospectively 

change these decisions to reflect the change in the pension system. 

Secondly, the compound-interest effect means that defined-contribution pensions 

put greater weight on earlier years’ contributions than accruals in earnings-related 

schemes (such as social security). With only a short period for investment returns 


Insert offset folio 23925a.006
29 

6See Disney and Whitehouse (1992a,b) and Whitehouse (1998). 7See Disney, Palacios and Whitehouse (1999) and Palacios and Whitehouse (1998). 

to accumulate, there is less point in older workers switching. This is strongly reflected in people’s behavior during structural pension reforms. In the United Kingdom, for example, around 25 percent of 20-34 year olds took out a personal pension 

in 1987/88, compared with 10 percent of 35–49 year olds and virtually no one over 

age 50.6 There was a similar pattern in Latin America, with switching rates of 80– 

90 percent among under 35s in Argentina, Chile and Colombia. Among 50 year olds, 

just under half switched in Argentina and Chile and less than 10 percent in Colombia.7 The results from Eastern Europe also confirm this. 

Thirdly, restricting the switch to a smaller group of workers means that it is possible to afford to divert a larger slice of contributions into the new individual accounts. With fewer accounts with larger balance, the administrative costs can be 

kept lower. 

Table 2. Rules for voluntary and mandatory switching in 

structural pension reforms 

Country Mandatory 

switching 

Voluntary 

switching No switching Option to return 

Latin America 

Argentina entire labor force yes, for 2 years 

Bolivia entire labor force no 

Chile new entrants current labor 

force (during 

first five years 

of operation) 

no 

Colombia entire labor force yes, indefinitely 

El Salvador labor force <36 labor force 36–55 

(f¥50) during 

first 12 months 

labor force >55 

(f>50) 

no (yes during 

first 18 months 

after introduction) 

Mexico entire labor force yes, indefinitely 

(not for new 

entrants) 

Peru entire labor force yes, for 2 years 

Uruguay labor force <40, 

higher income 

? no 

Eastern Europe/Central Asia 

Bulgaria labor force <40 

Croatia labor force <40 labor force 40–50 

(during first 

year of operation) 

labor force >50 

Estonia new entrants labor force <61, 

those 56–60 

can join until 

10/2002 

labor force >60, 

>55 after 10/ 

2002 

30 

8See Disney and Whitehouse (1992a,b) and Whitehouse (1998). 

Table 2. Rules for voluntary and mandatory switching in 

structural pension reforms—Continued 

Country Mandatory 

switching 

Voluntary 

switching No switching Option to return 

Hungary new entrants entire labor force 

(during first 20 

months of operation), <30 

again from 01/ 

2003 

yes, until 12/ 

2003 (also for 

new entrants 

of 2002), indefinitely in 

case of disability 

Kazakhstan entire labor force no 

Latvia labor force <30 labor force 30–49 labor force >49 

Poland labor force <30 

(except for agriculture) 

labor force 30–50 

(only during 

first year of operation) 

labor force >50 no 

Romania labor force 20+ 

years before 

retirement 

labor force 10–20 

years before 

retirement 

Slovakia new entrants current labor 

force (during 

first 18 months 

of operation) 

Other 

Sweden labor force <45 labor force <45 no 

UK entire labor force yes, indefinitely 

Source: Palacios and Whitehouse (1998), European Commission (2003), OECD (2001, 2002, 2005), Chlon 

(2000) and Acun ̃ a (2005) 

What should the ‘terms of trade’ be for people choosing to switch? 

The terms of trade under which people can exchange pay-as-you-go pension rights 

for contributions to their individual pension account is a fundamental design issue. 

The United Kingdom, for example, made a very serious mistake in setting these 

terms of trade, underestimating the incentive given to younger workers to switch. 

This also meant that the government seriously underestimated the numbers that 

would switch.8 The government forecast 300 000 would take out personal pensions, 

and a contingency plan allowed for a maximum of 500 000. In the end, 3.2 million 

people switched in 1987/88. As described above, switching rates were strongly related to age, just as the incentive structure would suggest. 

The financial implications were substantial. Between 1988/89 and 1995/96, the 

government paid λ17.7 billion into people’s personal pension accounts ($32 billion 

at today’s exchange rate). Actuarial estimates put the long-run saving on pay-asyou-go benefits at £9.2 billion. The net cost—£8.5 billion, $15 billion—arises because 

the government did not adjust the payment into personal pensions to reflect different returns at different ages until 1996. With age-related rebates, the annual net 

cost was cut from £1.8 billion to £0.5 billion a year. It is now probably around zero. 

However, the opposite risk is also possible: that the terms of trade are set so that 

it is not worth most people switching. This would undermine the whole reform. 

There is a difficult balance to be struck between successful reform and financial prudence. 

31 

9This section summarises the analysis of Whitehouse (2000a,b,c, 2001). See also James et al. 

(2000) and Shoven (2000). 

4. Administrative charges for defined-contribution pensions around the 

world9

The issue of administrative charges for defined-contribution pensions has become 

central to pension-reform debates in many countries. How can we measure administrative charges? How large are they in practice? How can governments keep them 

low? 

Countries’ different approaches to charges 

Table 3 summarizes different countries’ policies on charges. At the top are the 

systems with the least regulation on charges. Countries lower down impose direct 

regulations on the structure or level of charges or regulate industry structure with 

important indirect effects on charges paid. 

Measuring charges 

Measuring the price of financial services is more difficult than comparing the cost 

of other goods or services. Providers can levy many different kinds of fees. There 

are examples of both one-off and ongoing charges. Some fees are proportional and 

some are fixed rate. Some are levied on contributions, some on the value of assets 

in the fund, some on investment returns. 

These different kinds of charge accumulate and interact in complicated ways over 

the lifetime of membership of a pension plan. This leads to the second problem: how 

to summarize these charges in a single number to compare charge levels both between different providers in a single country and across countries. 

The measure of administrative charges most familiar to investors and policy-makers alike is the ‘reduction in yield’. This adds together all the charges over the lifetime of a pension policy, and expresses them all as a percentage of assets. An alternative approach is to measure charges as a proportion of contributions. This is the 

same as calculating the charges over the lifetime of the fund as a proportion of the 

balance accumulated at retirement. This second measure is known as the ‘reduction 

in premium’ or the charge ratio. 

Table 3. Strategies on administrative charges for pensions 

Source: Whitehouse (2000a,b,c; 2001) 


Insert offset folio 23925a.007
32 

International comparisons 

Figure 4 summarizes data on charges for 13 countries with mandatory funded 

pension systems. Even very similar pension systems with similar approaches to 

charges deliver very different levels of fees in practice. Among Latin American countries with individual accounts systems, the average charge ratio varies from under 

15 percent in Colombia to nearly 25 percent in Argentina. Looking at all systems, 

average charges range from under 10 percent in Bolivia to 35 percent in Australia’s 

retail superannuation funds. As noted above, the three cheapest systems offer very 

limited choice of provider and/or investments. As a rule-of-thumb, a charge ratio of 

20 percent over a 40-year pension plan equals a reduction in yield of 1 per cent. 

Figure 4. Paying for pensions: the charge ratio for individual accounts in 

13 countries 

Note: charge ratio: total charges over the lifetime of the pension as percentage of 

accumulated balance at retirement. The calculations assume 40 years’ contributions and 3.5 percent annual real return. Australia: ‘collective’: industry-wide 

funds; ‘individual’: ‘master trusts’ (provided by financial-services companies) 

Source: Whitehouse (2000a,b,c; 2001) 

Charges levied by different providers 

Most studies of administrative fees for pensions look only at the average. But the 

average disguises a huge range of different charge levels between different providers. Figure 5 shows the distribution of charges in three countries. In the United 

Kingdom, the cheapest funds levying 15 percent of contributions and the most expensive, 35 percent. The range in Mexico is 17 to 37 percent. Even in Argentina, 

with the narrowest range, charges vary between 23 and 36 percent, meaning that 

the most expensive fund costs over 50 percent more than the cheapest. 

These large ranges raise a difficult question: why do consumers choose expensive 

funds? Improved levels of service, for example, are unlikely to explain such a large 

differential. There is evidence in the United Kingdom that funds with higher 

charges perform better, but the out-performance is insufficient to offset the higher 


Insert offset folio 23925a.008
33 

charge burden on typical pension policies. Perhaps some consumers fail to take 

proper account of the burden of charges. The most likely reason, particularly in 

Latin America, is excessive marketing (see below). 

Figure 5. Distribution of charge ratios across funds: Argentina, Mexico and 

United Kingdom 

Source: Whitehouse (2000a,b,c, 2001) 


Insert offset folio 23925a.009
34 

Policy options for charges 

1. No regulation 

An important assumption of the calculations above is that charges remain constant until pensions are withdrawn. But pension providers’ revenues, especially 

from charges on fund assets, are back-loaded while expenses are front-loaded because of set-up costs. Also ‘learning by doing’ and the consolidation of the pension 

fund industry in most reforming countries might put downward pressure on costs 

over time. 

Most mandatory funded pension systems were introduced within the last five or 

ten years. But reforms in Chile and the United Kingdom have been in place for 

longer. Average charges have declined in both countries (Figure 6): by almost one 

half in Chile (from 30 to 15.5 percent) and one sixth in the United Kingdom (from 

27.5 to 23.5 percent). If other countries follow this pattern of declining charges over 

time, then the charge ratio measures above, which assume constant charges, are 

over-stated. 

Figure 6. Evolution of average pension administrative charges, Chile and 

United Kingdom 

Source: Whitehouse (2000a,b,c, 2001) 

2. Improve disclosure 

Measuring the impact of charges on pension fund returns is very complicated. The 

minimum government policy should therefore be a requirement for funds to disclose 

charges in a standard format. This will help consumers make informed comparisons 

between different funds. Regulators can make the task easier by producing ‘league 

tables’ of charges. The supervisory authorities in Latin America regularly provide 

comparative information on different pension fund managers, and the Financial 

Services Authority in the United Kingdom has issued data on the charges for a wide 

range of financial products. 

A second step to bring charges to consumers’ attention is to levy charges on top 

of (rather than out of) mandatory contributions. This encourages shopping around 

because charges reduce current net income rather than future pension benefits. 

Four Latin American countries have adopted this approach. A related issue is ensuring that whoever pays the charges makes the choice of pension provider. In Australia, employers choose the superannuation fund, but the charges are effectively 

borne by their employees in the form of a reduction in the money flowing into their 

funds. There is a potential ‘agency’ problem because employers pick the pension 

while employees pay the pension charges. 

The third policy related to disclosure is educating consumers about the effect of 

charges on their investments. For example, over the life of a pension policy, a 

charge of 1 percent of assets per year adds up to a charge ratio of 20 percent. Few 

investors appear to be aware of the major impact that fees can have. 


Insert offset folio 23925a.010
35 

3. Facilitating comparison of charges 

By ensuring all providers stick to a common charge structure, it is easier to compare fees between them. Unregulated charging regimes can be very complex and 

confusing. A regulated fee structure, in contrast, can mean there is a single ‘price’ 

that consumers can compare across providers. And a single proportional charge, on 

assets or contributions, means that the relative cost of choosing a different provider 

does not vary with earnings or contributions. 

The important policy option for governments taking this route is the type of 

charge to be permitted. There are four features of the two charges important in 

making this choice. 

The first is the time profile of charge revenues. Fees on contributions generate 

more up-front revenues than fees on assets (Figure 7). This allows providers to cover 

their start-up costs more quickly. This might boost competition by encouraging more 

entrants to the pension market when the system is established. 

Figure 7. Pension funds’ revenue streams under different types of charge 

Source: Whitehouse (2000a,b,c, 2001) 

A second issue is the incidence of the levies across different types of consumer. 

If there are fixed costs per member—and the evidence suggests that these are sizeable—then levies on assets redistribute from people with large funds to people with 

fewer assets in their plan. Older workers, with larger funds on average, would crosssubsidize younger workers, for example. Contribution-based charges redistribute 

from people with high levels of contributions (typically higher earners) to people 

with low levels of contributions. 

Indeed, there would be no revenues from people who do not contribute. This might 

be because they have lost their job, withdrawn from the labor force or moved into 

the informal sector of the economy. But pension providers would still have to bear 

the cost of administering these people’s funds. Asset-based fees ensure a continuing 

flow of revenues from non-contributors, but this means that the fees bear more 

heavily on people who withdraw from work early. 

Finally, a charge on fund value encourages providers to maximize assets, both by 

attracting funds from other providers and, more importantly, by maximizing investment returns. 

The choice between the asset-based and contribution-based approach is finely balanced. Unsurprisingly, different countries have taken different options. Levies on 

contributions are the norm in Latin America, while the United Kingdom has opted 

for asset-based fees. The government’s main arguments were fund managers’ performance incentives and the continuing revenue stream from members suspending 

contributions. 


Insert offset folio 23925a.011
36 

10See Iglesias and Palacios (2000) and Palacios (2002). 

4. Ceilings on charges 

Quantitative restrictions on charges are rare. Only El Salvador, Kazakhstan, Poland, Sweden and the United Kingdom, in the new stakeholder plans, have such 

limits. 

The problem with this approach is the risk that governments set the ‘wrong’ ceiling. Too high a limit would be ineffectual. Too low a ceiling might mean that fund 

managers could not cover their costs. This will restrict competition and choice. It 

could even lead to the failure of weaker providers, undermining public confidence 

in the system. Ceilings all too often become a de facto minimum charge as well as 

the legal maximum. Price competition, beyond meeting the regulatory requirement, 

would be curtailed. 

The experience with the new stakeholder pensions in the United Kingdom has, 

however, been encouraging. Providers initially said that the 1 percent ceiling would 

be too low. However, a number entered the market, a few even undercutting the 

ceiling. 

5. Treatment of low earners 

A common reason for any regulation of charges is to protect low-income workers. 

This is particularly important in mandatory funded pension schemes. It would be 

manifestly unfair if low earners saw most or even all of their contributions eaten 

up in charges. 

Regulating charge structures can provide a significant degree of protection. Limiting fees to proportional charges (either on assets or contributions) means that 

there are no fixed charges, which bear disproportionately on the low-paid. Nevertheless, most countries provide a minimum pension guarantee, a universal flat-rate 

pension or social assistance incomes in retirement. People with persistently low 

earnings are unlikely to build up a funded pension above the minimum level. 

A sensible solution is to exempt low paid workers from the requirement to contribute to a funded pension or to allow them to opt out. The United Kingdom, for 

example, will aim the new stakeholder schemes at people earning more than 55 percent of average earnings. Australia excludes workers on less than 15 percent of average pay, and has plans to allow people earning between 15 and 30 percent of the 

average to opt out. 

An alternative approach is to cross-subsidize low-paid workers’ accounts directly. 

The Mexican government ensures a contribution of at least 5.5 percent of the minimum wage. Coupled with a tax-credit system that boosts the incomes of low-paid 

workers, this encourages Mexicans into the formal sector. Together, these policies 

promote broader coverage of the pension system. A second advantage of direct subsidies is that they make the redistribution from higher-paid to lower-paid workers 

transparent. 

6. Alternative institutional structures 

The pension plans discussed above are mainly decentralized: people choose between a range of competing pension fund managers. An alternative approach is 

some sort of collective mechanism. 

Australia’s collectively provided industry funds, for example, charge just one third 

of the price of funds that single employers buy from financial-services companies. 

Australian experts have proposed that this intriguing gap reflects ‘a difference in 

governance, historical ethos, institutional practices and industry structure.’ Industry 

funds, with a captive membership, have no need for marketing or a sales network. 

And information, services and investment choice tend to be more limited in the industry funds than they are in the retail sector. 

A step further is to move to a single, publicly managed fund. However, research 

has shown that public management has typically led to poor returns. Even with 

good management, the state as a large shareholder raises corporate governance concerns that are very difficult to resolve.10 Centralized record-keeping (as in Latvia 

and Sweden, for example) can, nevertheless, reduce costs. 

Another institutional means of keeping costs low is to ‘piggy-back’ on existing 

structures. For example, employer pension plans in the United Kingdom have been 

able to contract out of the public, earnings-related scheme since it was introduced 

in the late 1970s. The United States already has a large, employer-based pension 

infrastructure, including 401(k)s. Costs might be lower if individual accounts were 

merged with these plans. Such a policy would, however, require careful attention 

to the regulation and supervision of these plans, particularly 401(k)s. 

37 

7. Restricting choice of funds 

The main cost of strict regulation of charges is the reduction in pension members’ 

choice. Low-cost regimes, such as the thrift savings plan (TSP) for federal employees 

in the United States, offer only a small range of funds, often indexed to avoid the 

extra cost of active management. (TSP charges are also low because the scheme only 

deals with one employer.) Bolivia offered no choice of fund initially and only a choice 

between two funds after a few years. 

This restriction of choice has a cost. Pension members are unable to choose investments that suit their preferences. For example, older members might want to invest 

more conservatively than younger people, but both can be constrained by a ‘one-sizefits-all’ fund. 

The counterpart to restricted choice is limits to competition, which might result 

in poorer service and performance than a deregulated, decentralized market. 

8. Avoid excessive marketing costs 

The Latin American pension reforms have been, to varying degrees, plagued by 

excessive marketing costs. Pension funds have competed fiercely to persuade people 

to switch between them. Given that the portfolios of the different funds were, until 

recently, highly uniform, there was little economic reason for this churning of members. More recent reformers have sought to avoid this problem. In Sweden, for example, the contribution to the new individual accounts is only 2.5 percent. There 

was therefore a risk that administrative expenses could eat up a substantial proportion of these contributions. Individuals can choose to invest there money in any mutual fund. But record-keeping is centralized (which might also cut costs) and fund 

managers do not know who their members are (so reducing the inventive for excessive marketing expenditure). 

9. Promote consolidation 

The potential for economies of scale in managing pension funds has important 

consequences for public policy on charges and industry structure. The evidence, unfortunately, is inconclusive. Figure 5 showed the very broad distribution of charges 

across providers in three countries with mandatory funded pension systems. Despite 

this variability, there is no relationship between fund size and charges. 

Various studies have suggested anything from under 100,000 to 500,000 members 

as the minimum to achieve efficient scale. In mutual fund markets, which share 

many of the features of pension markets, some studies have suggested that the fall 

in costs with size comes to a halt once funds reach $0.5 billion. Others suggest this 

could be as high as $40 billion. 

Currently available evidence does not demonstrate that highly centralized approaches to managing funded pensions will significantly reduce costs. And the potential gains must be balanced against the cost of stifling competition, which in the 

medium term should act as a spur to innovation and cost control. 

Conclusion 

Governments should, at the very least, ensure clear and transparent disclosure 

of charges so that people can compare different companies’ fees. A program of financial education that spells out the large impact charges have on pension values would 

also be useful. There is a good case also for regulation of the structure of charges, 

which can significantly ease comparisons between providers. However, imposing a 

ceiling on charge levels has the risk that limits are set at the wrong level, discouraging entry to the pensions market and reducing competition. 

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a funded pension system’, Pension Reform Primer series, Social Protection Discussion Paper no. 9812, World Bank, Washington, D.C. 

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f 

Chairman MCCRERY. Thank you, Mr. Whitehouse. Ms. Coronado. 

STATEMENT OF JULIA LYNN CORONADO, SENIOR RESEARCH 

ANALYST, WATSON WYATT WORLDWIDE 

Ms. CORONADO. Thank you, Mr. Chairman. I will be talking 

about Sweden’s reform. Like most industrialized nations, Sweden 

39 

has a public pension system that is financed on a pay-as-you-go 

basis. A rapidly aging population implied a projected discrepancy 

between payroll tax revenue and benefit payments that was twice 

the country’s GDP in 1996. Prior to reform, the Swedish system 

paid out benefits according to an aggressive DB formula, and on 

average replaced about 75 percent of pre-retirement earnings at 

age 65. The primary impetus for reform was to achieve a system 

whose financing was stable given demographic uncertainties and 

economic fluctuations. Given the high level of payroll taxes in Sweden, a consensus emerged that the macroeconomic implications of 

balancing the system through an increase in the payroll tax were 

decidedly undesirable. To create a sustainable system, policy makers sought to balance social protection of the vulnerable with the 

need for a tight link between contributions and benefits, in order 

to provide appropriate economic incentives and to enhance the efficiency of the system. 

The new public pension system in Sweden is a DC scheme funded mainly on a PAYGO, with a small funded component. A 16 percent payroll tax funds a notional DC account on behalf of each 

worker. The account is notional in the sense that there are not separate accounts for each worker, and benefits are funded through 

current payroll tax revenue. The account grows with payroll tax 

contributions as well, at a rate of return that is based, in large 

part, on the growth rate of average wages. Upon retirement, the 

balance in the notional account is converted to an annuity. In addition to the notional account, workers contribute 2.5 percent of their 

wages to an individual account administered by the government 

and through which workers can invest in any 5 of over 700 mutual 

funds of their choosing. Upon retirement, the participant can 

choose to convert their balance in the individual account to either 

a fixed or variable rate annuity that is purchased directly from the 

government. 

A number of macroeconomic stabilizers are built into the rate at 

which benefits accrue. If the system is in actuarial balance then 

the accounts are credited annually with the growth rate in average 

wages. However, the growth in average wages does not necessarily 

reflect the growth in the contribution base if cohorts are either 

growing or shrinking. Thus, in the event that an actuarial deficit 

or surplus opens up, policymakers have built in the ability to deviate from average wage indexation. Upon retirement, the annuity 

rate will depend on the expected survival probabilities for each cohort so that participants bear the risk of future improvements in 

life expectancy through lower replacement rates, although the government continues to bear the risk for changes in mortality after 

retirement. Thus, the reform transfers much of the economic and 

demographic uncertainties directly into benefit levels, leaving the 

financing of the system remarkably robust to changing economic 

conditions. 

In exchange for this added uncertainty, participants have much 

more flexibility in how they take their retirement benefits. Retirement can be taken as early as 61, but participants will realize a 

steadily higher replacement rate the longer they work. This is a far 

more powerful incentive in a DB system, as the replacement rate 

increases not only with the actuarial adjustments to benefits, but 

40 

also with the added pension rates earned through more years of 

contributions and returns. Benefits in the notional and individual 

accounts do not have to be claimed at the same time and workers 

can claim full or partial benefits in either, so that retirement in 

Sweden will likely evolve in a much more varied process across individuals and cohorts. 

The individual accounts are administered by a new government 

agency that acts as a record keeper, a clearinghouse for investment 

transactions, a broker on investment fees, and the sole provider of 

annuities. The Swedish administrative model was designed to 

avoid the high costs in other public pension systems. Once the 

funds have been allocated to the accounts, employees can choose a 

maximum of 5 from over 700 mutual funds. Sweden opted for a relatively unrestricted choice as a way of encouraging competition, allowing for diversification in a relatively small country, and mitigating the potential for political interference in investment management. In addition to allowing for risk taking, however, facing 

such a vast number of choices is potentially overwhelming to investors. Yet, in the first round of investment choices made by investments in 2000, more than two-thirds of participants made active 

choices choosing on average three-and-a-half funds of different 

types. 

I am running out of time so, let me skip to this. We can get to 

more of the individual details of the individual accounts in questions. Just another key point to make is that the government negotiates a fee structure with the participating mutual funds. On average, this has resulted in an expense ratio of 61 basis points of assets. This is much higher than the six basis point expense ratio in 

the TSP, however the system is in a startup phase. The system is 

currently projecting an expense ratio of 30 basis points in 10 years. 

So, what can the United States learn from the Swedish experience 

is, at first blush, passing the uncertainty on to benefit levels may 

seem draconian, but it should be kept in mind that Sweden had an 

extremely high level of benefits prior to reform. The post reform replacement rates are much more comparable to the current U.S. Social Security system. Sweden has also taken the approach of partially funding retirement benefits, which will have positive macroeconomic ramifications going forward. Finally, their design for the 

individual account tier deserves a very detailed examination should 

the United States pursue such a policy. The centralized clearinghouse model balances costs with private market incentives and 

seems to be very promising. That concludes my remarks. I will take 

questions. 

[The prepared statement of Ms. Coronado follows:] 

Statement of Julia Lynn Coronado, Senior Research Analyst, Watson Wyatt 

Worldwide 

Sweden’s Public Pension Reform: Lessons for the United States 

Overview of the Swedish Reform Process 

Like most industrialized nations, Sweden had a public pension system established 

in the early part of last century that was financed on a pay-as-you-go basis (PAYG), 

meaning that current payroll taxes funded the benefits of current retirees. Such a 

system was made feasible by a growing population in which the generations of 

young outnumber the elderly by a considerable margin. However also in concert 

with most other industrialized nations, Sweden saw a sea change in the demoVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00044 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
41 

1 2005 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance 

and Disability Insurance Trust Funds. 

graphics of its populations in the latter part of the century. As shown in Table 1, 

life expectancies in Sweden have risen considerably while birth rates have declined. 

The ratio of elderly to young has already more than doubled as a result. Sweden’s 

population has aged more rapidly than the U.S. with a ratio of elderly to young that 

is closer to Japan’s. A rapidly aging system places pressure on PAYG pension 

schemes as the working population has to pay higher taxes to finance a given level 

of benefits for the ever larger cohorts of elderly. 

Table 1—Selected Demographic Characteristics Placing Pressure 

on 

PAYG Social Security Systems 

Life Expectancy 

at Birth 

Fertility 

Rate 

Ratio of Elderly 

to Youth* 

1950 2010 1950 2010 1950 2010 

Sweden 71.8 81.1 2.21 1.34 0.51 1.34 

United States 68.9 79.2 3.45 1.93 0.37 0.69 

Japan 63.9 83.3 2.75 1.43 0.17 1.62 

Source: United Nations, World Population Prospects (2000). 

*Ratio of people over 60 to people under 20. 

The aging population implied a projected discrepancy between payroll tax revenue 

and benefit payments. In 1996 the projected actuarial deficit of the system was estimated at $500 billion, or twice the countries GDP. It was projected that the payroll 

tax would have to rise from just under 20 percent to something in the neighborhood 

of 30 percent to fund promised benefits. This compares with the current projected 

unfunded liability in the U.S. Social Security system of $11 trillion over an infinite 

horizon, or 1.2 percent of GDP. In the absence of any changes to the system, the 

payroll tax in the United States would have to rise from the current rate of 12.4 

percent to a projected 18 percent by 2079.1

Table 2—Timeline of the Swedish Social Security Reform 

1984 A commission is appointed to study options for reforming the social security 

system. 

1990 The commission presents its recommendations, including keeping the basic 

structure of the system intact, raising the retirement age and requiring 

more years of work to qualify for a full benefit. 

1991 The government changes hands. A new commission is appointed with a mandate for more fundamental reforms. 

1994 The second commission presents its recommendations; essentially a blueprint 

for the reform eventually enacted. These are approved ‘‘in principle: by 

Parliament and a working group is established to draft the necessary legislation. 

1998 Parliament passes most of the legislation for the reform. 

2000 The first investment choices by participants are processed for the individual 

account component of the system. 

Source: Annika Sunden, ‘‘How Will Sweden’s New Pension System Work?’’ Center for Retirement Research 

Issue Brief 3, 2000, Boston College, and Edward Palmer, Testimony Before the Subcommittee on Social Security of the House Committee on Ways and Means (2001). 

Hence, Sweden was under considerable pressure to address the projected shortfall 

in its public pension system. The process of reform began in 1984 with the appointment of a commission to study options and issues for achieving balance. This commission reported its findings to Parliament in 1990. The report favored keeping the 

basic defined benefit framework intact while reducing benefits through increasing 

42 

2See Annika Sunden, ‘‘How Will Sweden’s New Pension System Work?’’ Center for Retirement 

Research Issue Brief 3, 2000, Boston College. 3 Interim Report of the President’s Commission to Strengthen Social Security, August 2001. 

the retirement age and requiring more years in the labor force for a full benefit. 

In 1991, however, the government changed hands and the new coalition government 

favored more fundamental changes to the system. A new commission was appointed 

to review the situation, and this group presented its recommendations to Parliament 

in 1994. These were passed ‘‘in principle’’ and a working group was named to write 

the necessary legislation. The main package of legislation required to establish the 

new system was passed in 1998. The lengthy reform process in Sweden reflected the 

need for broad political support to reform such a comprehensive system. 

The Swedish Social Security System Prior to Reform 

Prior to the reform, the system was financed through payroll taxes and paid out 

benefits according to a progressive defined benefit formula. Taxes were collected and 

benefits paid out in a two-tier structure that separated the social insurance and retirement saving functions of the system. The first tier was a non-means tested flat 

benefit that was designed to provide a basic floor of support and was funded 

through a nearly 6 percent payroll tax levied on employers. This first tier was fairly 

generous providing a benefit in 1995 that was equal to roughly 18 percent of the 

average wage rate. The second tier of benefits was explicitly earnings-related and 

was meant to function as retirement saving by replacing a similar fraction of preretirement earnings above the first tier of benefits. It was based on a participant’s 

highest 15 years of earnings and required 30 years of earnings to qualify for a full 

benefit. It was financed by a 13 percent payroll tax on employers. Taken together, 

the two tiers of benefits implied a progressive benefit structure since the first tier 

replaced a higher fraction of earnings for lower income workers. On average the system replaced over 70 percent of pre-retirement earnings. 

The primary impetus for reform was to achieve a system whose finances were stable given demographic uncertainties and economic fluctuations. Given the high level 

of payroll taxes in Sweden, a consensus emerged that the macroeconomic implications of balancing the system through an increase in the payroll tax were decidedly 

undesirable. To create a sustainable system, policymakers sought to balance social 

protection of the vulnerable with a need for a tighter link between contributions and 

benefits in order to provide appropriate economic incentives and enhance the efficiency of the system. Along these lines, a number of other inequities and inefficiencies were identified that policymakers sought to address through the redesign of the 

system. Two perceived shortcomings of the system are of note in comparing the 

Swedish reform to the situation in the United States. 

The first of these were problems associated with the fact that benefits in Sweden 

were indexed to prices rather than wages. The result of price indexing was volatility 

of replacement rates through economic cycles when wages grew either more slowly 

or more rapidly than prices. In addition, because benefits were paid up to a ceiling 

that was also indexed to prices, over time real wage growth implied that the system 

was evolving into a flat benefit system and the link between taxes paid and benefit 

received was eroding. It is worth noting that current proposals for price indexing 

benefits in the United States would also likely result in volatility in replacement 

rates and lead the system toward a flat benefit structure. 

The second perceived shortcoming of the Swedish social security system prior to 

reform worth noting is that the system, which features a formula designed to result 

in a progressive replacement rate, was not considered to be as progressive in practice. This owed largely to the use of the 15 highest earning years in determining 

the benefit level, a formula that redistributes from those with long working lives 

and flat earning profiles who are typically lower wage workers, to those with shorter 

work histories and steeper earnings profiles.2 Such capricious redistribution has 

also been noted in the current U.S. social security system by the President’s Commission to Strengthen Social Security. A number of research papers have shown 

that, owing to the spousal benefit and the lack of distinction between households 

and individuals, the current system in the U.S. does more redistribution between 

high and low earners within households than across households.3 Policymakers in 

Sweden made transparency of redistribution a priority in the reform effort. 

The Swedish Public Pension System Post Reform 

The new public pension system in Sweden is a defined contribution scheme funded mainly on a PAYG basis with a small funded component. A 16 percent payroll 

tax levied equally on employers and employees funds a notional account (NDC) on 

behalf of each worker. The account grows with payroll tax ‘‘contributions’’ as well 

43 

4The central government does bear risk through the pension subsidy for lower wage workers 

and earnings credits granted to stay at home parents and unemployed, both of which are financed with general revenues and can fluctuate with changing demographic and economic conditions. 5See discussion in Edward Palmer ‘‘The Swedish Pension Reform Model: Framework and 

Issues’’ (2001). 6See R. Kent Weaver ‘‘Design and Implementation Issues in Swedish Individual Accounts’’ Social Security Bulletin vol 6 no 4 (2004). 

as a rate of return based in large part on the growth rate of average wages. Upon 

retirement the balance in the NDC is converted to an annuity using an assumed 

1.6 percent real average salary growth rate and the expected life expectancy for the 

cohort. After retirement benefits will be adjusted for salary growth that differs from 

1.6 percent. In addition to the NDC, workers contribute 2.5 percent of wages to an 

individual account administered by the government and through which workers can 

invest in any 5 of over 650 private investment funds of their choosing. Upon retirement the participant can choose between a fixed or variable rate annuity that is 

purchased directly from the government. 

A number of macroeconomic stabilizers are built into the rate at which benefits 

accrue. If the system is in actuarial balance then the accounts are credited annually 

with the growth rate in average wages. However the growth in average wages does 

not necessarily reflect the growth in the contribution base if cohorts are growing or 

shrinking. Thus, in the event that an actuarial deficit or surplus opens up, policymakers have built in the ability to deviate from average wage indexation. In addition, balances are adjusted upward each year to credit surviving members of a cohort with the balances of the deceased and downward for administrative costs. Upon 

retirement, the annuity rate will depend on the expected survival probabilities for 

each cohort so that the beneficiaries bear the risk of future improvements in life 

expectancy through lower replacement rates, although the government continues to 

bear the risk for changes in mortality after retirement. Thus the reform transfers 

much of the economic and demographic uncertainties directly into benefit levels 

leaving the financing of the system generally quite robust to changing economic conditions.4

In exchange for this added uncertainty, participants have much more flexibility 

in how they take their retirement benefits. Retirement can be taken as early as 61 

but participants will realize a steadily higher replacement rate the longer they 

work. This is a more powerful incentive in a defined benefit system as the replacement rate increases not only with the actuarial adjustment as in a defined benefit 

system, but also with the added pension rights earned through more years of contributions and returns. Benefits in the NDC and the individual accounts do not have 

to be claimed at the same time and workers can claim full or partial benefits in the 

both the NDC and from the individual accounts so that retirement will likely evolve 

into a much more varied process across individuals and cohorts. 

The individual accounts are administered by a new government agency that acts 

as a record-keeper, a clearinghouse for investment transactions, a broker on investment fees, and the sole provider of annuities. The Pension Premium Agency takes 

requests for allocations and trades, aggregates them and submits them in bulk to 

the participating mutual funds much as private pension plans in the U.S. currently 

manage their defined contribution accounts. The mutual funds thus do not have any 

information on individual participants. The Swedish administrative model was designed to avoid the high costs in other public pension systems with individual accounts such as Chile and the U.K.5 Contributions are collected through the government tax authority so as to minimize the burden on employers. Employers remit the 

entire payroll tax and the money is allocated to individuals accounts approximately 

18 months later when income tax statements are filed and reconciled. In the interim 

the funds are invested in a government bond fund. 

Once the funds have been allocated to the accounts, employees can choose a maximum of five funds from over 700 funds representing 85 fund companies currently 

registered to participate in the Swedish system. Some of these funds are highly specialized in particular sectors or countries allowing for substantial risk taking by participants. Sweden opted for relatively unrestricted choice as a way of encouraging 

competition, allowing for diversification in a relatively small country, and mitigating 

the potential for political interference in investment management.6 In addition to 

allowing for risk taking, however, facing such a vast number of choices is potentially 

overwhelming to investors. Yet in the first round of investment choices made by investors, more than two thirds made an active choice with the average participant 

selecting 31⁄2 funds of different types. In addition, surveys have indicated that many 

44 

7Weaver (2004). 

8Steven A. Nyce and Sylvester J. Schieber, The Economic Implications of Aging Societies: The 

Costs of Living Happily Ever After, Cambridge University Press (2005). 

of those who did not make an active choice did so intentionally as they preferred 

to invest in the default fund. 

Such a high level of active participation was facilitated by a massive media campaign by both the government and private mutual fund companies. Investors received, and will receive annually, a catalog of all the funds and their characteristics 

as well as educational materials on investing. Subsequent years have featured substantially lower levels of active participation. This is part because the new participants are generally young new entrants to the labor force, but is also possibly influenced by the very poor stock market returns of recent years combined with the relatively positive performance of the default fund and the lack of intense media 

focus.7 Because the agency that administers the funds must pass the cost of investor 

education on through higher fees, it does not have the incentive to provide extensive 

education materials. While participants receive the catalog of funds and a personal 

statement each year, the level of information in the media has declined substantially years following the start-up. This raises the broader issue of who should be 

responsible for financial education in a system where all members of society are required to participate in financial markets. 

Another key issue in an individual account system is the design of the default 

fund. In Sweden the default fund is a broadly diversified equity fund. If active 

choices by new entrants remain low, this fund will manage an increasingly large 

pool of assets. This fund was set up to have an independent professional staff and 

has achieved competitive returns at low costs to date. However the fund decided 

independently to refrain from investing in particular companies based on international labor and environmental concerns and politicians have publicly criticized 

the fund for its lack of Swedish investments so that the potential for political influence on investment choices is already apparent. 

Among private funds, the government negotiates a fee structure with participating mutual funds that is designed to discourage participation by high fee funds 

and encourage the selection of low fee funds by participants. Participants to date 

have paid administrative fees of 22 basis points of assets and investment fees averaging 39 basis points of assets for a total expense ratio of 61 basis points. Expenses 

are thus quite a bit higher than the 6 basis point expense ration the Federal Employee Thrift Savings Plan which is frequently cited as a potential model for the 

U.S. in administering individual accounts. Nor does it represent a substantial improvement over the Chilean and British models. However the system is in its startup phase and so expense ratios will decline as a fraction of assets under management as balances increase. In year 2020 the administrative fee is projected to be 

5 basis points and the asset management fee 25 basis points. The Swedish experience does indicate that the first generations in the new system of individual accounts can disproportionately bear the start-up costs. 

Lessons for the United States 

If people continue to retire at the same ages they have in recent decades, the combination of longer life expectancies and lower fertility rates imply the likelihood of 

slower rates of improvement in our standards of living. Changes to PAYG public retirement programs become the mechanism for allocating the resulting economic disappointment.8 Sweden faced the fiscal challenges of its aging population head on 

through a massive scaling back of benefits. While at first blush this may seem draconian, it should be kept in mind that Sweden provided an extremely high level of 

benefits prior to reform, providing replacement rates at age 65 upwards of 75 percent. Through the process of reform Sweden created a system with a much clearer 

link between contributions and benefits that eliminated disincentives for labor supply at older ages. In the future, the likely outcome of Sweden’s system is that people 

will postpone retirement in order to maintain their standards of living. This increase in labor supply will have positive implications for macroeconomic stability. 

One concern is that such a reduction in benefits should be clearly communicated as 

such. The Swedish government does send out a yearly statement, ‘‘the orange envelope’’ giving all individuals a forecast of their future pension. It is important in a 

pension program that benefit generosity is clearly understood by participants in 

order that they can make their personal saving decisions accordingly. Nearly 90 percent of Swedes are covered by employer-sponsored pensions and so most participants already have a vehicle for any additional saving they wish to undertake. It 

also remains to be seen whether the automatic stabilizers that ensure the financial 

45 

stability of the system through adjustments in benefits will be politically sustainable in the long run. 

Sweden has also taken the approach of partially funding retirement benefits in 

the public system through the establishment of individual accounts. This will also 

have positive macroeconomic ramifications going forward. The costs of the public 

system will be reduced over time as benefits will be partially funded through compound interest and more capital will be channeled into productive use in the private 

sector. 

Sweden’s design for their individual account tier is certainly worth a detailed examination should the U.S. pursue such a policy. The centralized clearinghouse 

model has much to recommend it in terms of cost efficiencies over the long run. It 

is difficult at this early stage in the Swedish system to draw conclusions about the 

investment choices of participants, however issues surrounding the design of default 

options and investor education are not easily resolved and the Swedish example 

may provide valuable lessons about what policies are and are not effective. Indeed 

the Swedish government recently appointed an inquiry to review ways to reduce the 

number of funds, evaluate communication and administrative and investment costs 

among other elements of the system. They will submit their final report this fall. 

Table 3—Comparison of Swedish and U.S. Social Security Systems 

Sweden United States Current 

System Pre-Reform Post-Reform 

Taxes 19% payroll 16% payroll for notional 

defined contribution 

account 

+ 2.5% deposited into 

individual account 

+ approximately 1% 

payroll worth of general revenue 

12.4% 

Benefits Non means tested flat 

Benefit equal to 

roughly 18 % of average wage rate 

Earnings related pension calculated using 

15 highest earning 

years indexed for inflation and requiring 

30 years of earnings 

for full benefit 

Normal retirement age 

of 65. Early retirement age of 60. 

Provided an average 

single worker with a 

replacement rate 

around 70+ percent of 

pre-retirement earnings 

Benefits based on the 

balances in the notional defined contribution account and 

the individual account. 

A guaranteed pension 

paid directly from the 

states budget is available at age 65 to people earning on average below 45 percent 

of the average wage. 

Full benefits require 

that the individual 

been living in Sweden 

for 40 years. 

Retirement can be as 

early as 61. 

Under intermediate assumptions provides 

an average single 

earner with a replacement rate around 46 

percent at age 65. 

Progressive benefit formula related to earnings calculated on 35 

years of a participant’s highest earnings indexed to average wage growth and 

requiring 10 quarters 

of earnings for a full 

benefit. 

Normal retirement age 

phasing to 67. Early 

retirement age of 62. 

Provides an average 

single worker with a 

replacement rate of 

about 40 percent of 

pre-retirement earnings. 

46 

Table 3—Comparison of Swedish and U.S. Social Security 

Systems—Continued 

Sweden United States Current 

System Pre-Reform Post-Reform 

System 

Finances 

Payroll tax rate would 

have to rise to approximately 30 percent to fund promised 

benefits 

Payroll tax fixed. Benefits and general revenue contribution 

fluctuate to balance 

system. 

Payroll tax will have to 

rise to roughly 18 

percent to fund currently legislated benf 

efits. 

Chairman MCCRERY. Thank you, Ms. Coronado. Mr. Vasquez. 

STATEMENT OF IAN VASQUEZ, DIRECTOR, PROJECT ON 

GLOBAL ECONOMIC LIBERTY, CATO INSTITUTE 

Mr. VASQUEZ. I appreciate the opportunity to testify today 

about the Chilean private pension system, especially because it has 

become the model for countries doing the same thing around the 

world or considering doing such reform. In 1981, Chile became the 

first country in the world to replace its bankrupt PAYGO pension 

system with an investment-based privately managed system of individual retirement accounts. Chile’s pioneering reform created a 

fully funded system whose principal features are individual choice, 

clearly defined property rights, and the private administration of 

accounts. By linking effort and reward, the reform offers proper investment and work incentives, and that has contributed to Chile’s 

impressive rates of growth. It is said that the reform itself is probably responsible for up to a quarter of the increase in the growth 

rate and up to a third of the increase in savings rates in the country. Today, 95 percent of Chilean workers have joined the system. 

The pension funds have accumulated assets of some $58 billion, 

which represent about 75 percent of Chilean GDP, and the average 

real rate of return on the pension funds has been 10.24 percent. 

The way the system operates is clear and simple. Every month 

workers deposit 10 percent of the first $22,000 of earned income in 

their own individual pension savings accounts, which are then 

managed by specialized fund administration companies of their 

choice. These companies invest the workers’ savings in a portfolio 

of bonds and stocks that are subject to regulations, and at retirement, use the funds in their accounts to purchase annuities or 

make programmed withdrawals, or they can take a combination of 

the two. The government provides a safety net for those workers 

who, at retirement, do not have enough funds in their accounts to 

provide a minimum pension. 

The reform itself had clear and simple rules when it began. 

Workers already in the labor force were given a choice to join the 

new system or to remain in the old. Those who chose to switch to 

the private system were given ‘‘recognition bonds’’ that reflected 

past contributions to the public pension program and that are paid 

by the government when the worker retires. New entrants into the 

labor force were required to join the new pension system, thus 

eventually ending the unsustainable PAYGO system. The benefits 

47 

1 I thank Jacobo Rodrı ́guez from whose work I have borrowed liberally and with permission. 2 Jacobo Rodrı ́guez, ‘‘Chile’s Private Pension System at 18: Its Current and Future Challenges,’’ Cato Institute Social Security paper no. 17, 1999, p. 3. 

of those already retired were not affected. In the new private system, workers have become owners of the means of production, or 

‘‘worker capitalists,’’ as Jose Pinera, the architect of the program, 

likes to say. This is a real paradigm shift in Chile because it reflects a move from a consumption-based system to an investmentbased system, and has depoliticized a large part of the Chilean 

economy. 

Critics of the system, however, often point to high administrative 

costs, the lack of portfolio choice, low participation rates, and so on. 

Some of these criticisms are misinformed. Some are highly misleading. Some were a reflection of over-regulation within the system itself. For example, administrative costs in Chile are 0.66 percent of assets under management, and this compares favorably to 

the U.S. mutual fund industry, where the costs are more than 1 

percent. Another criticism sometimes heard is that the coverage 

under the new system is low. In fact, in Chile about 30 percent of 

the working population is self-employed and not required to join 

the system. By any measure, coverage in the new system is more 

complete than coverage under the old system, as I show in a graph 

in my written testimony. 

As the system has matured, Chilean authorities have taken important steps to liberalize the pension system further. The most 

important structural reform of recent years has been the introduction of multiple investment funds. The pension fund companies 

now can offer five different funds to each worker that range from 

very low risk to high risk, and this has the advantage of allowing 

workers to make prudent changes to the risk profile of their portfolios as they get older. Other reforms have taken place to continue 

to improve the system, and I think others can be introduced. One 

of the most important reforms to the system that I would suggest 

is liberalizing the commission structure even more, so that pension 

fund companies can charge different rates to different customers. 

In summary, the Chilean private pension system is a success story 

by any measure and deservedly continues to be the model for rich 

countries and poor countries around the world. 

[The prepared statement of Mr. Vasquez follows:] 

Statement of Ian Vasquez, Director, Project on Global Economic Liberty, 

Cato Institute 

Mr. Chairman and members of the Subcommittee, I appreciate the opportunity to 

testify today on Chile’s private pension system, especially since it has become the 

model for countries around the world that have reformed their public pension systems or are considering doing so.1

In 1924 Chile was the first country in the hemisphere to implement a state-run 

retirement system. In 1981, Chile became the first country in the world to replace 

its bankrupt pay-as-you-go pension system with an investment-based privately managed system of individual retirement accounts. The problems that are currently putting pressure on workers and public retirement programs in so many countries also 

plagued Chile’s government-run system, ultimately making it fiscally unviable: payroll taxes were high and saw large increases, the implicit debt of the public system 

was over 100 percent of GDP, the ratio of workers to retirees saw a significant and 

continuous decline, and the government was contributing to more than a third of 

the public pension system’s revenues.2

48 

3For detailed statistics of the Chilean pension system, see the website of the Superintendencia 

de AFPs, the Chilean government regulator of the private pension system, www.safp.cl. 4Ministry of Finance, Chile. 

Chile’s pioneering reform addressed the above problems by creating a fully funded 

system whose principal features are individual choice, clearly defined property 

rights, and the private administration of accounts. By linking effort and reward, the 

reform offers proper investment and work incentives, and has contributed to Chile’s 

impressive growth rates. 

Since the private pension system was implemented, labor force participation, pension fund assets, and benefits have increased. Today, 95 percent of Chilean workers 

have joined the system; the pension funds have accumulated assets of some $58 billion, amounting to more than 75 percent of Chilean GDP; and the average real rate 

of return on the pension funds has been 10.24 percent.3

The Chilean Private Pension System 

Every month workers deposit 10 percent of the first $22,000 of earned income in 

their own individual pension savings accounts, which are managed by the specialized pension fund administration company of their choice.(There are currently six 

competing pension fund companies in Chile.) Those companies invest workers’ savings in a portfolio of bonds and stocks, subject to government regulations on the specific types of instruments and the overall mix of the portfolio. Fund managers can 

invest up to 30 percent of the portfolio overseas, a measure that allows workers to 

hedge against currency fluctuations and country risk. At retirement, workers use 

the funds accumulated in their accounts to purchase annuities from insurance companies. Alternatively, workers make programmed withdrawals from their accounts 

(the amount of those withdrawals depends on the worker’s life expectancy and those 

of his dependents); or a worker can choose temporary programmed withdrawals with 

a deferred lifetime annuity. 

The government provides a safety net for those workers who, at retirement, do 

not have enough funds in their accounts to provide a minimum pension. But because the new system is much more efficient than the old government-run system 

and because, to qualify for the minimum pension under the new system, a worker 

must have at least 20 years of contributions, the cost to the taxpayer of providing 

a minimum pension funded from general government revenues has so far been 

small—about 0.1 percent of GDP.4 (Of course, that cost is not new; the government 

also provided a safety net under the old program.) Those who have not contributed 

for 20 years and have not accumulated sufficient funds to meet the minimum pension can apply for a lower welfare-type pension. 

When the reform began, workers already in the labor force were given a choice 

to join the new system or remain in the old. Those who chose to switch to the private system were given ‘‘recognition bonds’’ that reflected past contributions to the 

public pension program and that are paid by the government upon a worker’s reaching the legal retirement age. New entrants into the labor force were required to join 

the new pension system, thus eventually ending the unsustainable pay-as-you-go 

system. The benefits of those already retired and receiving a pension at the time 

of the reform were not affected. 

The transition to the private system was financed in a number of ways. It should 

be noted that the net economic costs of moving from an unfunded pay-as-you-go system to a fully funded system are zero. That is to say, the total funded and unfunded 

debt of a country does not change by moving from an unfunded system to a funded 

one. There is, however, a cash flow problem when moving toward a fully funded retirement system. In the case of Chile, transition costs can be broken down into three 

different parts. First, there is the cost of paying for the retirement benefits of those 

workers who were already retired when the reform was implemented and of those 

workers who chose to remain in the old system. That makes up by far the largest 

share of the transition costs at present. These costs will decline as time goes by. 

Second, there is the cost of paying for the recognition bonds given to those workers 

who moved from the old system to the new in acknowledgement of the contributions 

they had already made to the old system. Since these bonds will be redeemed when 

the recipients retire, this cost to the government will gradually increase as transition workers retire (but will eventually disappear). It is worth stressing that these 

are new expenditures only if we assume that the government would renege on its 

past promises. The third cost to the government is that of providing a safety net 

to the system, a cost that is not new in the sense that the government also provided 

a safety net under the old pay-as-you-go system. 

To finance the transition, Chile used five methods. First, it issued new government bonds to acknowledge part of the unfunded liability of the old pay-as-you-go 

49 

5See Jose ́ Pin ̃ era, ‘‘Liberating Workers: The World Pension Revolution,’’ Cato’s Letter no. 15, 

2001. 6 Rube ́n Castro, ‘‘Seguro de Invalidez y Sobrevivencia: Que ́ Es y Que ́ Le Esta ́ Pasando,’’ 

Documento de Trabajo no. 5, Superintendencia de AFP, May 2005, p.12. 

system. Second, it sold state-owned enterprises. Third, a fraction of the old payroll 

tax was maintained as a temporary transition tax. That tax had a sunset clause and 

is zero now. Fourth, it cut government expenditures. And, fifth, pension privatization and other market reforms have contributed to high growth in Chile, which in 

turn has increased government revenues, especially those coming from the value 

added tax. 

In sum, the transition to the new system has not been an added burden on Chile 

because the country was already committed to paying retirement benefits. On the 

contrary, the transition has actually reduced the economic and fiscal burden of 

maintaining an unsustainable system. 

In the new private system, workers have become owners of the means of production, or ‘‘worker capitalists,’’ in the words of Jose ́ Pin ̃ era, Chile’s former minister of 

labor and social security who implemented the reform.5 This paradigm shift from 

a consumption to an investment-based system has positively impacted the country’s 

political economy by reducing class conflict and depoliticizing a large part of Chilean 

economy. 

Commonly Heard Criticisms of the Chilean System 

Critics of the Chilean system, however, often point to high administrative costs, 

lack of portfolio choice, and the high number of transfers from one fund to another 

as evidence that the system is inherently flawed and inappropriate for other countries, including the United States. Some of those criticisms are misinformed. For example, administrative costs are less than 1 percent of assets under management, 

a more favorable figure than management costs in the U.S. mutual fund industry. 

Other criticisms are highly misleading. To the extent the criticisms are valid, shortcomings in the private system typically result from excessive government regulation. 

In Chile pension fund managers compete with each other for workers’ savings by 

offering lower prices, products of a higher quality, better service or a combination 

of the three. The prices or commissions workers pay the managers are heavily regulated by the government. For example, commissions must be a certain percentage 

of contributions regardless of a worker’s income. As a result, fund managers are prevented from adjusting the quality of their service to the ability (or willingness) of 

each segment of the population to pay for that service. That rigidity also explains 

why the fund managers have an incentive to capture the accounts of high-income 

workers, since the profit margins on those accounts are much higher than on the 

accounts of low-income workers. 

The product that the managers provide—that is, return on investment—is subject 

to a government-mandated minimum return guarantee (a fund’s return cannot be 

more than 2 or 4 percentage points, depending on the type of fund, or 50 percent 

below the industry’s average real return in the last 36 months). That regulation 

forces the funds to make similar investments and, consequently, have very similar 

portfolios and returns. 

Thus, the easiest way for a pension fund company to differentiate itself from the 

competition is by offering better customer service, which explains why marketing 

costs and sales representatives are such an integral part of the fund managers’ overall strategy and why workers often switch from one company to another. 

The following is a closer look at some of the more frequently heard criticisms of 

Chile’s private pension system. 

‘‘The Administrative Cost are Too High’’ 

Critics often claim that the commissions that workers pay to the pension funds 

are exorbitant. The often-cited figure of 18–20 percent represents administrative 

costs as a percentage of current contributions, which is not how administrative costs 

are usually measured. This figure is usually obtained by dividing the commission 

fee, which is on average equivalent to 2.37 percent of taxable wages, by the total 

contribution (10 percent plus the commission). This calculation fails to take into account that the 2.3 percent includes the life and disability insurance premiums 

(about 0.95 percent of taxable wages on average 6) that workers pay, which are deducted from the variable commission, and thus overstates administrative costs as 

a percentage of total contributions. 

The proper way to measure administrative costs is as a percentage of assets under 

management. In Chile, the administrative costs of the private pension system are 

50 

7Superintendencia de AFP, The Chilean Pension System (Santiago: Superintendencia de AFP, 

2003), p. 154. 8 Asociacion AFP, ‘‘The AFPs Charge Lower Commissions Than Other Institutions, Both Local 

and Foreign,’’ Research Series paper no. 42, June 2004, available at www.afp-ag.cl. 9Salvador Valde ́s, ‘‘Las Comisiones de las AFPs ®Caras o Baratas?’’ Estudios Pu ́blicos, Vol. 

73 (Verano 1999): 255–91. 10 Congressional Budget Office, Social Security Privatization: Experiences Abroad, sec. 2, p. 7 

(January 1999). 11 Rau ́l Bustos Castillo, ‘‘Reforma a los Sistemas de Pensiones: Peligros de los Programas 

Opcionales en Ame ́rica Latina.’’ In Sergio Baeza and Francisco Margozzini, eds., Quince An ̃ os Despue ́s: Una Mirada al Sistema Privado de Pensiones (Santiago, Chile: Centro de Estudios 

Pu ́ blicos, 1995), pp. 230–1. However, comparing the administrative costs of the old system with 

those of the new one is inappropriate, because the underlying assumption when making that 

comparison is that the quality of the product (or the product itself) being provided is similar 

under both systems, which is certainly not the case in Chile. 12The Chilean Pension System, pp. 120–23. 13 Asociacio ́n AFP. 

0.66 percent of assets managed.7 The Chilean pension fund administrators’ association calculates that the commissions the industry charges are 0.63 percent of assets 

under management, far lower than such fees charged by other fund managers including U.S. mutual funds that charge about 1.38 percent.8

Prior to the above findings, others have calculated similarly low administrative 

costs. Chilean economist Salvador Valde ́s estimated the average annual cost of the 

AFP system to be equivalent to 0.84 percent of total assets under management over 

the life cycle of the worker.9 The Congressional Budget Office estimated in 1999 

that the administrative costs of private retirement accounts in Chile ‘‘can be equivalently expressed as 1 percent of assets.’’ 10 When administrative costs are compared 

to the old government-run system, the criticism is even less convincing. Chilean 

economist Rau ́l Bustos Castillo has estimated the costs of the new system to be 42 

percent lower than the average costs of the old system.11

To the extent that such administrative costs are still considered too high, that is 

the result of government regulations on the commissions the AFPs can charge and 

on the investments these companies can make. The existence of a ‘‘return band’’ prevents investment product differentiation among the different AFPs. As a result, the 

way an individual AFP tries to differentiate itself from the competition is by offering 

better service to its customers. One way to provide better service would be to offer 

a discount on the commission fee to workers who fit a certain profile—e.g., workers 

who have maintained their account for an extended period of time or who contribute 

a certain amount of money to their accounts; however, government regulations do 

not allow that. Those regulations state that the AFPs may only charge a commission 

based on the worker’s taxable income and expressed as a percentage of that income. 

‘‘The Coverage Under the New System is Low’’ 

Critics also say that some 30–40 percent of Chilean workers are not participating 

in the private system. Although the number of Chileans participating in the private 

system is actually greater than the work force (some Chileans affiliated to the private system have left the work force), only about 61 percent of those participating 

in the employed work force regularly contribute to their private accounts. According 

to the Chilean pension fund regulatory agency, that method of calculation underestimates real coverage because it counts only workers who have contributed in a particular month even though other workers who made contributions in previous 

months will also receive benefits from the system. Including workers who have contributed within the past year, coverage in the private system amounted to 69.7 percent of the work force, which is greater than that of the previous public system in 

the four years prior to the reform. From 1976–1980, coverage under the old system 

‘‘averaged 67 percent of the workforce, with a clear downward trend.’’ 12

Others have also found that coverage in the private system is greater than that 

of the old system. Measuring coverage as those who contribute on a regular monthly 

basis, the percentage of the employed work force covered in the private system 

(more than 60 percent) is superior to the coverage of the old system before reform 

(54 percent in 1980) and it has been increasing. See graph below.13

Several factors explain why coverage is not higher in Chile. The self-employed, 

who represent about 30 percent of the work force, are not required to participate 

in the private system. Only about 6 percent of the self-employed contribute on a regular basis. Workers who are unemployed also do not contribute to the system (the 

unemployment rate has been between 8–10 percent in Chile in the past five years.) 

Moreover, of the 3.4 million people affiliated with the private pension system, 1.44 

million—including students or women who have stopped working to care for chilVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00054 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
51 

14 Ibid. 15 Robert Holzmann, Truman Packard, and Jose Cuesta, ‘‘Extending Coverage in Multipillar 

Pension Systems: Constraints and Hypotheses, Preliminary Evidence and Future Research 

Agenda,’’ in Robert Holzmann and Joseph E. Stiglitz, eds. New Ideas About Old Age Security 

(Washington: World Bank, 2001), p. 454; and Asociacio ́n AFP. 16Ministry of Finance and Asociacio ́n AFP, ‘‘The AFP System: Myths and Realities,’’ August 

2004, available at www.afp-ag.cl. 

dren, for example—are not currently in the work force.14 There is also a large informal economy, which is typical of developing countries. Lastly, the evidence suggests 

a strong relationship between economic development and the level of coverage 

around the world (higher per capita incomes correlate with higher coverage).15

In short, the level of coverage under the system does not reflect negatively on the 

private pension system itself. To the extent that coverage could improve, factors not 

inherent to the private system, such as rigidities in the labor market and the size 

of the informal economy, would have to be addressed by other public policies. In addition, only beginning around the year 2025, when the first generation of workers 

who have contributed during their entire working lives begins to retire, will it be 

fair to compare the private system with the old system. 

‘‘Too Many Workers Will Depend on the Minimum Pension and the System 

Will Impose Large Costs’’ 

The Chilean finance ministry estimates that the average number of minimum 

pensions that it will be supplementing per month in 2005 will be 65,000. The costs 

of doing so are minimal and currently stand at 0.1 percent of GDP. Part of the reason that the cost is low is that the government does not provide the full amount 

of the minimum pension since a worker has some assets in his/her account. On average, the government provides 20–30 percent of the capital needed to finance the 

minimum pension. Indeed, the public cost of financing pensions, most of which is 

made up of meeting the obligations of the old system, is projected to continue falling 

(see Table 1).16

Table 1: Civil Social Security Deficit Forecast 

Year Public 

Pensions 

Recognition 

Bonds 

Welfare 

Pensions 

Minimum AFP Pensions 

Total 

2002 3% GDP 1.2% GDP 0.4% GDP 0.1% GDP 4.7% GDP 

2010 2% GDP 1.2% GDP 0.4% GDP 0.27% GDP 3.87% GDP 


Insert offset folio 23925a.012
52 

17 Asociacio ́n AFP; the rates of return assumed are 3 percent, 5 percent, and 7 percent. 

Table 1: Civil Social Security Deficit Forecast—Continued 

Year Public 

Pensions 

Recognition 

Bonds 

Welfare 

Pensions 

Minimum 

AFP 

Pensions 

Total 

Difference ¥1% GDP 0% GDP 0% GDP 0.17% GDP ¥0.83 GDP 

REDUCTION OF FISCAL SPENDING ON PENSIONS: ¥0.83% OF GDP 

(Source: Ministry of Finance: Budget Department, Macroeconomic Aspects of the Draft Law for the Public 

Sector, 2002; and Asociacio ́n AFP) 

It is estimated that the percentage of members affiliated to the private pension 

system that will receive government supplements for the minimum pension (only 

those who have contributed 20 years are eligible) will vary between 1.9 and 10.5 

percent depending on the rates of return.17

‘‘Workers Change Pension Fund Administration Companies Too Frequently’’ 

Because of investment regulations and rules on fees and commissions, product differentiation is low. Thus companies compete by offering gifts or other incentives for 

workers to switch to their companies. Switchovers increased dramatically from 

1988, the year when the requirement to request in person the change from one AFP 

to another was eliminated, until 1997, when the government reintroduced some restrictions to make it more difficult for workers to transfer from one AFP to another. 

The number of transfers in 1998–2000 decreased to less than 700,000, less than 

500,000, and slightly more than 250,000, respectively, from an all-time high of almost 1.6 million in 1997. Transfers have since fallen to about 228,000 per year. 

Liberalizing the Chile’s Private Pension System 

It is clear that some of the regulations mentioned above have become outdated 

and may negatively affect the future performance of the system. Fortunately, Chilean authorities have taken some important steps in addressing the challenges of a 

more mature system. 

The most important structural reform in recent years is the introduction of multiple investment funds. Up until 2000, the pension fund management companies 

could only manage one fund. That year, the regulatory framework was changed to 

allow the AFPs to offer a second fund, invested only in fixed income instruments. 

That reform proved to be insufficient, as very few workers decided to switch their 

savings from the diversified fund to the fixed-income one. Indeed, consumer demand 

for the fixed-income fund was negligible. What was needed was to let pension fund 

management companies manage more than one variable-income fund. 

Chilean authorities finally adopted this reform in early 2002 when they instituted 

a rule that mandated AFPs to offer 5 different funds that range from very low risk 

to high risk. One advantage of having several funds administered by the same company is that that could reduce administrative costs if workers were allowed to invest 

in more than one fund within the same company. This adjustment also allows workers to make prudent changes to the risk profile of their portfolios as they get older. 

For instance, they could invest all the mandatory savings in a low-risk fund and 

any voluntary savings in a riskier fund. Or they could invest in higher risk funds 

in their early working years and then transfer their savings to a more conservative 

fund as they approached retirement. Table 2 shows the maximum percentages of equity investment allowed in each fund: 

Table 2 

Maximum Percentage Allowed Mandatory Minimum Percentage 

Fund A 80% 40% 

Fund B 60% 25% 

Fund C 40% 15% 

Fund D 20% 5% 

53 

18 If financial institutions were allowed to establish one-stop financial supermarkets, where 

consumers could obtain all their financial services if they so chose, the duplication of commercial 

and operational infrastructure could be eliminated and administrative costs could be reduced. 

Table 2—Continued 

Maximum Percentage Allowed Mandatory Minimum Percentage 

Fund E Not Allowed Not Allowed 

The introduction of a family of funds is an important step and consumers are behaving as one would expect—that is, by diversifying their investments across the 

menu of funds. Other steps that have been taken in the recent past include: 

• The lengthening of the investment period over which the minimum return guarantee is computed to 36 months from 12 months and the widening of the band 

from 2 to 4 percentage points for some type of funds; • The further liberalization of the investment rules, so that workers with different tolerances for risk can choose funds that are optimal for them; and • The expansion of consumer choice with the signature of a bilateral accord with 

Peru that allows workers from those two countries to choose the pension system 

with which they want to be affiliated. 

Other specific steps that Chilean regulators should take to ensure the continuing 

success of the private pension system include: Liberalizing the commission structure 

to allow fund managers to offer discounts and different combinations of price and 

quality of service (which would introduce greater price competition and possibly reduce administrative costs to the benefit of all workers); letting other financial institutions, such as banks or regular mutual funds, enter the industry; 18 giving workers the option of personally managing their accounts through the world wide web; 

and reducing the moral hazard created by the government safety net by linking the 

minimum pension to the number of years (or months) workers contribute. 

Those adjustments would be consistent with the spirit of the reform, which has 

been to adapt the regulatory structure as the system has matured and as the fund 

managers have gained experience. In summary, the Chilean private pension system, 

despite minor shortcomings, is a success story by any measure and deservedly continues to be the model for rich and poor countries around the world that are considering reforming their retirement systems. 

f 

Chairman MCCRERY. Thank you, Mr. Vasquez. Mr. Harris. 

STATEMENT OF DAVID O. HARRIS, MANAGING DIRECTOR, TOR 

FINANCIAL CONSULTING, LIMITED, SUFFOLK, UNITED KINGDOM 

Mr. HARRIS. Thank you, Mr. Chairman, for the opportunity to 

testify before you and your colleagues today on the Australian pension model and the lessons that can be learned by the United 

States in respect of the continued examination of Social Security 

reform and options around the world. As a former resident of the 

Washington area in the late nineties who has an interest in Social 

Security, I am heartened that Social Security is again a prominent 

issue for the Administration and Congress to consider. 

Mr. Chairman, achieving Social Security reform in the United 

States, as you and your colleagues would be aware, is not an easy 

problem to resolve. In the UK, where I am now a resident, Prime 

Minister Blair and his cabinet equally grapple with the fundamental need to engineer successful pension reforms to their first 

and second pillars, which my friend David John from the Heritage 

Foundation will elaborate on. Grasping the thorny nettle of Social 

Security or pension reform is largely driven by the sobering reality 

that, in the future, legislative bodies will have to either increase 

54 

taxes or cut benefits to maintain Social Security and pension promises. Yet, for Australia, a longtime friend of the U.S. whose citizens 

share much in common, the need and implementation of major Social Security reforms has already occurred as a priority. It is interesting to note it was promoted by trade unions and the Social 

Democratic Labor Party then in government who embraced in the 

eighties the need to compel its work force to save a certain percentage of their income for retirement purposes. 

It is important to note that in 1993 only 40 percent of the work 

force was covered by some voluntary retirement saving, with only 

$32 billion Australian dollars held in pension assets. In effect, the 

second pillar pension retirement system in the mid-eighties was 

transformed through contributions partly funded by centralized 

wage deferrals. Individual retirement accounts blossomed out of a 

landscape where many workers simply did not have access to retirement accounts. Today, 26.2 million individual retirement accounts exist for the 9.2 million workers. 

Under the first pillar of the Australian retirement model, individuals are provided with Social Security, which is equivalent to 26 

percent of my mother’s average total weekly earnings. My mother’s 

view of retirement: if she paid her taxes she would be entitled to 

an old-age pension. In the eighties the government, in an effort to 

contain the future costs of pensions, introduced an income to assets 

test and, with the combination of compulsion, began to address the 

issue of fundamental Social Security reform. Three percent was 

considered by the then Labor government as simply not enough. An 

expansion of the compulsory contribution system was managed 

eventually, in 1992 and 1993, through the taxation system. The 

then government proposed a system whereby employers would contribute 9 percent, individuals 3 percent, and government would 

provide a 3 percent uplift for lower income workers. 

In 1996, the Labor government moved into opposition and the 

new Conservative Liberal Coalition retained only the policy of seeing employers contributing nine percent of individual salaries into 

retirement accounts. Today, Australians, on top of making contributions of 9 percent on a compulsory basis, contribute two to 

three percent of their salary on a voluntary basis in retirement accounts. As Trevor Matthews, chief executive officer of Standard 

Life UK, who, as an Australian, formerly ran a leading life insurer, 

said, Australian pension reforms were achieved through working 

with political, economic, and commercial realities in order to solve 

Australia’s aging population. Achieving consensus among stakeholders was critical to its success. 

There are many myths that surround the Australian retirement 

model, Mr. Chairman, which I have highlighted in my written testimony. Simply put, Australia moved away, like Chile and Switzerland, from voluntary retirement savings to compelling and providing limited incentives to workers to save for their retirement. 

Today $495.4 billion U.S. dollars are held in pension assets for over 

9 million workers. Seventeen percent of these assets are invested 

abroad, with the primary source of investment being in the United 

States. 

Yet, no international pension model is perfect. Australia needs to 

address a plethora of individual retirement accounts that have 

55 

1 Australian Bureau of Statistics, 1998 Year Book Australia (Canberra, Australia: AGPS, 

1998), p215. 

grown up. Every worker has nearly three individual accounts on 

average. With respect to taxes, the contributions are taxed, the investment returns on the fund are taxed, and the fund flows going 

out of the retirement account are taxed. This approach is unique 

to Australia, and some of your colleagues may consider rather immoral. In conclusion, some of the lessons the United States can 

learn from Australia include her Labor and trade union support for 

Social Security reform, the need for incentives to low-income workers and the self-employed, an effective communication and education campaigning transition, but also a cost effective regulation, 

and the ability to contain administrative cost structures for the 

growth in individual retirement accounts. Once again, thank you 

for the invitation from this Generation Xer to appear before you 

today. 

[The prepared statement of Mr. Harris follows:] 

Statement of David O. Harris, Managing Director, TOR Financial 

Consulting Limited, 1996 AMP Churchill Fellow, Suffolk, United Kingdom 

Mr. Chairman, I am very pleased to appear to discuss social security reform in 

Australia. As each year passes the need for reform becomes more pressing for many 

countries as populations rapidly age. Moreover, generous promises linked with social 

security programs will make it inevitable that radical reforms will have to be considered. This may mean cutting benefits or increasing retirement contributions via 

taxation. I’ve described compulsory retirement saving as being the equivalent to the 

great white shark for those who know they have to deal with the rising tide of ageing. They don’t want to confront compulsion but they know that it is ‘out there’. 

Only three countries rely heavily on private mandatory saving policies for retirement, these include Australia, Switzerland and Chile.1 Australia faced the challenge 

13 years ago. Not only did we survive, we succeeded. The Australian retirement 

model offers clear proof that radical pension reform can be achieved and benefit an 

entire nation. Women, minority groups and ’blue collar’ workers, in particular, have 

seen significant benefits flow to them from having the ability to manage their own 

retirement savings. 

The U.S. has had its own success in generating capital through individual saving. 

But it has not avoided the current questions around retirement saving: what will 

be ‘sufficient’ and what financial instruments will provide it? No-one in the past, 

when economic and social systems were being formed, could have anticipated the 

rapid ageing of populations throughout the world. 

An overview of Australian retirement system 

Australia and the UK stand out as countries that have faced up to the discomfort 

of significant retirement reforms. Both have taken the route of a more fully funded, 

defined contribution system but their approaches have differed in terms of politics, 

or government and the role of organized labor and business. These three vested interests, individually or combined, can encourage or discourage reform. 

This fact was well understood when Australia reformed its retirement system in 

1987 and 1992. In 1983 the Australian Labor Party led by Bob Hawke MHR came 

to power. The ALP was determined to deregulate Australia’s economy so as to compete more effectively on a world level. A vital ingredient in achieving this goal was 

a significant reduction in wage growth. 

The ALP is fundamentally a social democratic party based on largely collectivist 

principles. It has strong links with the trade union or organized labor movement 

through the Australian Council of Trade Unions (ACTU). Superannuation was provided through traditional employer-sponsored plans on a voluntary basis. Surprisingly perhaps it was the trade union movement which began the momentum for 

changing Australia’s retirement system. They saw increasing superannuation coverage as a major priority. 

The Old Age Pension was seen as an important source of income for retirees who 

have limited resources to sustain themselves in retirement. Its impact on Australia’s 

GDP is seen in Table 2. Many older Australians who retired in the past failed to 

56 

1 Australian Bureau of Statistics, 1998 Year Book Australia (Canberra, Australia: AGPS, 

1998), p215. 2Sue Taylor, ‘Australia’s Mandatory Occupational Superannuation Regime: An Evaluation of 

Opposing Claims—Is it a Policy Built on Justice, Fairness and Security in the Public Interest 

or the Entrenchment of the Power and Privilege of Politically Effective Interest Groups?’, (Melbourne, Australia: 1999 Colloquium of Superannuation Researchers, July 8–9 1999), p5. 

build up sufficient retirement savings; a common perception was that they were entitled to an old age pension after paying taxes all their working life and this view 

was encouraged by many governments. In the 1980s, however, the Commonwealth 

Treasury and the Federal Government were not happy with the direction of expenditure on the first pillar of Australia’s retirement framework. This concern was compounded by the demographic picture for the next century where the percentage of 

the population aged over 65 was expected to rise from 15% of the population to 23% 

by 2030 and the percentage aged over 85 was expected to more than double from 

around 2%. 

The newly elected Federal Government began by ensuring the long-term viability 

of the Old Age Pension at its then current level. Maximum payments, by the mid 

1980s, were determined through a comparatively stringent income and asset tests. 

The full pension payment now represents approximately 26% of male total average 

weekly earnings. Maximum payments per fortnight are calculated on a flat basis 

and are reduced accordingly, based on income and asset tests. This shift required 

a strong political resolve. More through timing than luck, though, a popular Federal 

Government with trade union support was able to convince the nation of the problems Australia would confront in the future if it did nothing about addressing its 

aging population. This was best summarized in the Better Incomes: Retirement into 

the Next Century statement which expressed a commitment to ‘maintain the age 

pension as an adequate base level of income for older people’ but went on to state 

that persons retiring in the future would require a standard of living consistent 

with that experienced whilst in the workforce.1

Before the introduction of mandated, second pillar, superannuation accounts, the 

coverage of superannuation was limited to roughly 40 percent of the Australian 

workforce. Typically, those covered were employed in middle class, ‘white collar’ jobs 

where women and people from minority groups were under-represented. The trade 

union movement set about convincing the Federal Government that the level of superannuation coverage needed to be extended, via compulsory contributions into individual accounts. Many of the younger trade union officials argued for a more comprehensive system of retirement provision that in effect required all workers to be 

proactive in contributing and managing their own retirement needs. Some had 

noted the successes of the national provident funds, as seen in Malaysia and Singapore. 

Significant dissatisfaction also existed amongst the labor movement over the extent and coverage of non-management or ‘blue collar’ workers. Moreover the union 

movement also realized that comprehensive wage increases were becoming increasingly difficult to successfully negotiate and that deferred savings benefits may be 

an alternative to simply striving for an increase in workers pay. By the mid 1980s 

the union movement had shifted its stance whereby it would play a more direct and 

active role in the day-today operations of superannuation, via industry funds. These 

industry funds, grouped around a particular economic sector of the Australian economy, brought union and employer representatives together as trustees to manage 

the administration and investment of many thousands of individual retirement accounts. The increasing involvement of the union movement challenged some industry participants’ views that administration and investment decisions would be distorted in favor of policies that stressed mutuality rather than economic reality. 

There was another reason for the trade union movement’s interest in pensions. 

Between August 1986 and August 1996, the level of trade union membership declined from 46 percent to 31 percent. This coupled with the decline in traditional 

union-based industries, such as heavy manufacturing, reinforced the unions’ enthusiasm for reforms they felt would increase their profile and relevance. 

By 1986 circumstances were ideal for the introduction of a widespread employment-based retirement incomes policy. The government insisted that it was in the 

‘‘public-interest’’ to have a national, compulsory, employment-related retirement income scheme in place 2 Award superannuation, set at 3% of an individual’s yearly 

income, was introduced. This was paid by the employer in the form of a wage increase granted by the Conciliation and Arbitration Commission, a Federal Government body. Newly created industry funds, sponsored by employer and employee orVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00060 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
57 

ganizations in one or more industries, were established to receive the 3% award contributions. 

A further 3% round of award superannuation was made in 1990–91 before the 

government acted more decisively on reform. In August 1991 the Government’s indicated its intention to introduce a Superannuation Guarantee Levy from July 1 1992. 

The Superannuation Guarantee Charge Act 1992 requires all employees to contribute to a complying superannuation fund at a level that increased from 3% p.a. 

in 1992 to 9% per annum by July 1, 2002. Although support for the reforms was 

substantial, some opposition was expressed by then Australian Democrats (a minor 

‘left leaning’ political party) leader Senator Kernot who favored a single, government-controlled, national portable system, similar to that of a national provident 

fund. But the Government’s proposed legislation quickly generated wide acceptance 

through working in ‘partnership’ with organized labor, business interests and industry associations. 

The use of government inquiries or private sector research helped to highlight the 

inadequacies of Australia’s level of retirement system provision. These inquiries 

were seen to be delivering independent views or recommendations and the Federal 

Government felt vindicated in implementing a mandated retirement system. 

Another means by which the Federal Government was able to engineer significant 

change to the retirement system was through an effective public education campaign in 1994–1995, co-ordinated by the Australian Taxation Office. The total cost 

of the campaign was $AUS 11 million and the message was that the new retirement 

system would not only benefit the individual but the nation as a whole. With a controlling majority in the Lower House (House of Representatives) and minority parties holding the balance of power in the Upper House (Senate), no real effective 

delays in the reforms were encountered. The Senate Select Committee on Superannuation, a parliamentary appointed committee was used by the government to 

hear, interpret or receive objections to the planned reforms and this encouraged a 

spirit of ‘consensus’ to be generated amongst many stakeholders of differing political 

ideologies. 

Finally the existence of well established professional industry associations in the 

form of the Life Insurance Federation of Australia (LIFA), now the Investment & 

Financial Services Association (IFSA), and the Association of Superannuation Funds 

of Australia (ASFA), ensured that the consequences of proposed reforms could be 

simulated and understood by superannuation industry participants and bureaucrats 

alike. Unlike in Chile, where individual retirement account reforms created a totally 

new financial infrastructure, much of the superannuation infrastructure in Australia already existed under the voluntary system. Stakeholders and vested interests 

like life insurance companies supported the reforms based on self interest but also 

recognized how the existing financial infrastructure would be well placed to implement the government’s retirement proposals. 

Australian business saw the reforms in terms of nurturing the capital market and 

the level of national saving. Some concerns were raised over the active involvement 

of trade unions in the day to day operations of superannuation funds but these concerns were alleviated through adjustments in regulatory settings. A major concern 

for business, after the broadening of compulsion in 1992, was that increased costs 

would be levied on employers as contributions lifted to 9 percent by 2002. Larger 

business interests in many cases offered such contributions already on voluntary 

basis through their in-house corporate superannuation funds, but small business 

strongly opposed the reforms arguing principally that the increased cost burden 

linked with an expanded retirement provision would cause many business failures. 

In fact business played only a moderate role in supporting the government’s reform 

agenda and this was co-ordinated, in part, by large financial providers who would 

develop or modify the financial infrastructure of such mandated retirement accounts. 

Table 1: Details of the Prescribed Superannuation Requirements 

Linked with the Mandated Second Pillar 

Employer’s Prescribed Rate of 

Employee Support (%) 

July 1 1997–June 30 1998 6 

July 1 1998–June 30 1999 7 

July 1 1999–June 30 2000 7 

58 

Table 1: Details of the Prescribed Superannuation Requirements 

Linked with the Mandated Second Pillar—Continued 

Employer’s Prescribed Rate of 

Employee Support (%) 

July 1 2000–June 30 2001 8 

July 1 2001–June 30 2002 8 

July 1 2002–03 and subsequent years 9 

In March 1996, the Labor Federal Government lost office and was replaced by a 

conservative, Liberal Coalition Government under Prime Minister John Howard. It 

had been the intention of the Australian Labor Party to further expand the compulsory nature of superannuation by gathering a 3 percent contribution from individual 

workers and providing an additional 3 percent to certain workers who met pre-defined income criteria. In total this would have meant that many workers’ individual 

superannuation contribution accounts would have been receiving total contributions 

of 15 percent. Treasury estimates suggest that over a forty-year period these contributions would translate out to be approximately 60 percent of salary on retirement. 

The impact of compulsion 

The criticisms levelled at Australia’s pension system, usually by those who are 

looking at it from the outside, belong to what I’ve called the 7 Myths. Typically 

these run along the lines of: 

1. Compulsion in Australia started a recession; 

2. Australia had a successful voluntary second pillar pension framework (so why 

move to compulsion?); 

3. After compulsion net savings fell; 

4. The industry made free with fees and charges; 

5. Australians make free with their retirement savings—spend the lot and then 

fall back on the State pension; 

6. Compulsion was introduced for ideological reasons by the a union backed Labor 

Government rather than as an answer to socio-economic need; 

7. The second pillar savings level of 9% is insufficient to replace income. 

None of these myths is borne out by the facts. In fact pension adequacy has been 

improved in the second pillar and Australia has been proofed against future demographic change. Expensive Defined Benefit plans, the supposed gold standard of 

some politicians and Employee Benefit Consultancies (EBCs) have become all but 

extinct. At September 2004 the breakdown of benefit structures included 297,327 accumulation funds, 182 defined benefit plans and 309 hybrid plans. At the same time 

superannuation coverage of all workers has been maintained at a level of 88%. 

Compulsion has dramatically raised retirement savings and improved the future 

prospects of baby boomer and Generation X retirees. Comparatively low administration costs, wide investment choice and minimal mis-selling have protected consumers from detriment. 

One of the reasons why Australia has been so successful in keeping administrative costs low and avoiding the problems associated with mis-selling is through effective and cost efficient regulation. Strict rules govern how superannuation policies 

are sold and switched. Moreover consumers are required to receive minimum levels 

of information about the superannuation products at the time of sale and also on 

a regular basis. Increasingly superannuation account holders are being provided 

with greater investment choices. Some retail funds for example offer between 5–7 

investment choices, and proposed legislation by the Federal Government will force 

employers to offer choice of funds. Additionally, specialized administration companies have developed services that allow superannuation fund trustees to outsource 

much of their investment and administrative functions. This intense competition 

has led, in part, to returns being maximized and administrative fees being minimized. 

Sound regulation, transparency and significant improvements in the competency 

levels of distributors eg. financial advisers and financial planners, has raised public 

confidence in the retirement system and nurtured a steady increase in the level of 

voluntary contributions made into superannuation accounts. The Australian government has announced that it will encourage lower income families and workers to 

bolster their retirement savings via government co-contributions by widening the 

59 

3Statistics, Superannuation Trends September 2004 Australian Prudential Regulation Authority. 

eligibility criteria for the Government’s co-contribution scheme (whereby the Government matches an eligible member’s after-tax superannuation contributions dollar 

for dollar, up to a prescribed annual maximum, and subject to an income test). 

Total superannuation assets held by 9.2 million workers now stand at nearly $649 

billion 3 ($US495.4) for just over 9 million workers compared with $32 billion in 

1993. A large percentage of them are invested in equities (49%), interest bearing 

securities (16%) and 17% or $108 billion are invested in overseas equities. 

Administration costs do continue to be a sensitive issue within the Australian political and financial services environment. These costs can vary widely between the 

types of superannuation funds found in Australia. An authoritative survey, conducted by the Association of Superannuation Funds of Australia (ASFA), estimated 

that an average of $1.28 ($US0.97) per member per week was made for overall administration costs in 1999–2000. It should be noted that this figure has declined 

from $1.66 ($US1.27) per week two years earlier. Expressed in another way, costs 

as a percentage of assets in June 2000 were calculated to be 1.29%. 

Table 2: Projected future state spending on pensions as a 

percentage of GDP 

1995 2000 2010 2020 2030 2040 2050 

Australia 2 .6 2 .3 2 .3 2 .9 3 .8 4 .3 4 .5 

Canada 5 .2 5 .0 5 .3 6 .9 9 .0 9 .1 8 .7 

France 10 .6 9 .8 9 .7 11 .6 13 .5 14 .3 14 .4 

Germany 11 .1 11 .5 11 .8 12 .3 16 .5 18 .4 17 .5 

Italy 13 .3 12 .6 13 .2 15 .3 20 .3 21 .4 20 .3 

Japan 6 .6 7 .5 9 .6 12 .4 13 .4 14 .9 16 .5 

Netherlands 6 .0 5 .7 6 .1 8 .4 11 .2 12 .1 11 .4 

New Zealand 5 .9 4 .8 5 .2 6 .7 8 .3 9 .4 9 .8 

UK 4 .5 4 .5 5 .2 5 .1 5 .5 4 .0 4 .1 

United States 4 .1 4 .2 4 .5 5 .2 6 .6 7 .1 7 .0 

Source: OECD, cited in Johnson (1999). 

What we could have done better 

Australia has pursued an independent line on taxation of superannuation and one 

I find hard to agree with. Contributions are taxed at a rate of 15 percent, along with 

possible additional taxation of 15 percent for members earning over a certain 

threshold. A further 15 percent is levied on the investment income of each superannuation fund and finally the benefits can be subjected to varying tax treatment 

of between 0–30%, depending on timing of the contributions. As you can see the 

Commonwealth Treasury’s faith in the politicians getting taxation revenues back 

from retirees’ retirement nest eggs was very low when this taxation approach was 

adopted in 1992. Continual change to the way superannuation is taxed has caused 

much confusion for plan participants and trustees and industry associations are 

pushing for a comprehensive review. 

Another negative feature is the sheer volume of accounts. Workers have an average of three, I have four. A new plan for a new job has created unnecessary duplication and administrative cost. Many funds are now seeking to streamline the transfer 

process by administration protocols. 

It has to be said that the system has not delivered benefits to current pensioners 

whose circumstances have deteriorated over the past 10 years. A state pension indexed to prices and pegged at 26% of male total average weekly earnings has reduced their purchasing. The full benefit of compulsory superannuation reforms will 

not ‘crystalise’ until well into this century. 

60 

What next? 

Around 30% of employees in Australia already have fund choice and the Choice 

of Fund Act 2004 will give a further 40% of employees this freedom from 1 July 

2005. Employers can meet their obligations under the Act by entering into a certified agreement with their employees. If workers do not choose a fund, employers 

must make contributions to a fund that satisfies the requirement to offer a minimum level of life insurance cover. The level of insurance premiums will not be regulated. Employers will give their workers a standard choice form which will provide 

basic information and highlight what should be considered before a fund is selected 

such as: level of fees and charges and the type of investments a fund offers. 

The Howard government’s reason for choice of funds is partly ideological in my 

view but is described as providing a more flexible and adaptable retirement system—one of the benefits should be portability—and more appropriate for flexible 

workplace arrangements which allow workers to reduce their hours as they approach retirement and to work beyond 65. The new legislation will allow people to 

access their superannuation from their preservation age without having to retire 

and it will allow them to develop strategies in transition to retirement for example 

working part-time and supplementing their income with some of their superannuation. It is not intended to enable people to dissipate their superannuation savings before retirement, however, and the Government is taking measures to ensure 

that savings are drawn down in a regular and orderly way. 

The government has announced further measures to encourage lower income families and workers to bolster their retirement savings via government co-contributions which match after-tax superannuation contributions dollar for dollar up to a 

prescribed annual maximum and subject to an income test. 

Lessons for the U.S. 

As indicated, lessons do exist for the U.S. in regard to how Australia has addressed its ageing populations and they can be summarised in five major points: 

• Partnership with the trade unions 

• Incentives for low income workers and the self-employed 

• Information and education 

• Cost effective regulation 

• Contained administrative costs under the creation of numerous individual retirement accounts 

And, finally, persuading all stakeholders that change had to happen and that it was 

for the benefit of the nation as a whole. 

f 

Chairman MCCRERY. Thank you, Mr. Harris. Dr. Baker, you 

must feel a little bit like General Custer, but I invite you to wade 

in. I assure you, you will survive the hearing. 

STATEMENT OF DEAN BAKER, PH.D., ECONOMIST AND CODIRECTOR, CENTER FOR ECONOMIC AND POLICY RESEARCH 

Dr. BAKER. Well, thanks. I appreciate the opportunity, but 

given the relative merits of the argument I figure it is a balanced 

panel. 

Chairman MCCRERY. So did General Custer. 

Dr. BAKER. I expected better. I would like to make four main 

points about the lessons I can get from various efforts of privatization around the world: first, that we could say it increases risk as 

opposed to the guaranteed benefits product by current systems. 

Second, the universal experience has been that of it increasing administrative costs by a factor or 20, 30 or 40, so, very huge increase 

in administrative costs. Thirdly, the programs are not popular with 

workers, and the evidence on this that I am looking to is the increase in participation rates, or I should say lack of increase of participation rates in the developed world in response to privatization, 

which was the main purpose of the reforms, and that turns out to 

61 

have been very limited, if any at all. Fourth, transition costs are, 

in fact, borrowing. We can’t tell the functional market. What we 

can tell them, but they won’t believe, is that it will be repaid with 

later benefits in 30 or 40 years, and there is evidence on that. 

So, to go through each of those in turn, first off, the increase in 

risk. This is sort of straightforward. We have two basic types of 

risk we can talk about. One is bad investment choices. The best example here is probably in England where we had the mis-selling 

scandal there in early 1990, where a lot of financial companies 

made promises they couldn’t deliver on. You also have the problem 

that in many cases people take too little risk which, say, under 

President Bush’s proposal, would guarantee they would lose because they would not compensate themselves for the money they 

would put into those accounts. What has been proposed as a 

counter by many people is that they will educate workers, as in 

Chile. For example, they actually have education classes on their 

accounts in their high school. As an economist, we ordinarily like 

to think there is an opportunity cost in time. I don’t know that is 

the best use of a single mother’s time in the evening to be studying 

Chile’s accounts rather than spending time with her kids, or if we 

are talking about in schools, I don’t know if it is better they spend 

time studying their accounts rather than learning math, science, or 

language competency. That is a judgment that would have to be 

made. 

The second type of risk, of course, is timing risk. Markets have 

ups and downs, nothing we can do the about that. In Chile, one of 

their government ministers actually suggested people delay their 

retirement for a few years because the market had temporarily depressed accounts. President Bush’s proposal says we will shift people out of stocks into bonds at 55. I am sorry to say this, but that 

just changes the risk that the market will be down when you are 

55 rather than when you are 65. Same story, so, there is no way 

around that. 

The second point, the cost. Lots of evidence on this. The administrative costs of these accounts are 15 to 20 percent of the money 

that goes into them. There is a really big confusion on this. President Bush’s commission said that they could do it for 30 basis 

points, 30 cents. It is important to understand it is 30 cents, threetenths of 1 percent, of the stock. A dollar might be in that account 

for 40 years. If your taxes or administrative costs are three-tenths 

of a cent on that dollar, after 40 years that is 12 percent. Okay, 

so, the average administrative costs any administrator would get 

would still be 6 percent, about 12 times the cost of the current system. So, as I say, the existing cost, if we look at systems that exist 

in the world, are in the order of 30 to 40 times, 15 to 20 percent 

of the money that is put into the system. I should also point out 

that annuities have a cost estimated at 15 to 20 percent. These are 

very large expenses. If we applied them to the U.S. system, we 

would be talking about somewhere in the order of $75 billion a 

year being wasted on administrative expenses, if the whole system 

were done through a privatized system like that in Chile. President 

Bush’s commission said that a government run system could be 

much more efficient than the market. Perhaps that is true, but 

62 

even then we are still talking about a system that would cost us 

10 to 15 times as much as the current system. 

My point about the systems not being popular, again, if we look 

at participation rates in the countries that did reforms, World 

Bank did a study on this. In Latin America, in most cases, there 

were very low increase in participation rates. The other point, very 

interesting on this, in Chile where we have the best model, as you 

heard here, a very high percentage of the workers appear to be targeting the minimum benefit. That is very interesting because most 

workers are voting with their feet for a DB system in the middle 

of a DC system. I take this as evidence it is not terribly popular. 

The last point I want to make is, that financing transition costs 

is borrowing. President Bush has argued, or his staff has argued, 

that it is okay that we run large deficits to finance the transition 

because they will be repaid 30 or 40 years out with lower benefits. 

We could look around the world. No country has attempted to finance this transition purely through borrowing. We had the model 

of Chile where they actually ran very large surpluses, 4 percent of 

GDP. That would be equivalent of $500 billion a year in the United 

States. Perhaps the closest example to President Bush’s model is 

Argentina where they did not make adequate cuts in other expenses or adequate increases in other taxes, and as you may remember, Argentina defaulted on its debt in 2001. It is worth pointing out that if Argentina had not privatized its system and that 

money had continued to go to the government, Argentina would 

have had a balanced budget in 2001, the year it defaulted. So, long 

and short, I will summarize by saying, I don’t think the record is 

terribly successful. I think we do have a very successful system 

here, and I would suggest that we use great caution too in looking 

into any reform. Thank you. 

[The prepared statement of Mr. Baker follows:] 

Statement of Dean Baker, Ph.D., Economist and Co-Director, Center for 

Economic and Policy Research 

Mr. Chairman and Members of the Subcommittee: 

I want to thank the Subcommittee for inviting me to testify on the experiences 

of other countries who have privatized their Social Security systems. At this point 

there are a large number of countries, mostly in the developing world, who have 

partially or completely privatized their Social Security systems. There are four basic 

generalizations that can be made based on the experiences of these countries: 

1) Privatization invariably increases risks for workers. These risks take three 

forms: the timing of the worker’s retirement, the risk associated with the worker’s choice of assets, and the risk of having a low income during a working lifetime. The latter point refers to the fact that most traditional Social Security 

systems, including the system in the United States, are designed to be redistributive to low-wage earners. A system based strictly on individual accounts 

is not redistributive, although redistributive features can be added to the system. 

2) Privatized systems vastly increase the administrative costs of operating a Social Security system. The most efficient privatized systems have annual administrative costs for the retirement program that are 30 to 40 times as high as 

the current system in the United States. When the costs of annuities are included, financial intermediaries can take as much as 30 cents of every dollar 

placed in the system. 

3) Privatized systems have not proved very popular with the workers they are 

supposed to benefit. One of the main reasons for introducing defined contribution systems in developing countries is that a privatized system was supposed 

to extend coverage to the large segment of the workforce employed in the inforVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00066 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
63 

mal sector, most of whom were not covered by the traditional Social Security 

system. There has been little change in participation rates in the countries 

with privatized Social Security system. In most cases, the vast majority of 

workers have voted with their feet against the privatized systems by opting not 

to participate. 

4) Financial markets view borrowing to cover transition costs as real borrowing. 

The Bush administration has argued that the transition costs associated with 

switching from the current Social Security system to a system of private accounts should not be viewed as real debt, since the borrowing would be associated with lower Social Security benefits in the future. The evidence from other 

countries is that financial markets focus on current balance sheets, not speculation about benefit levels in the distant future. Every country that has 

privatized their Social Security system has attempted to at least partially fund 

the transition with a combination of tax increases and spending cuts. Argentina, which defaulted on its debt in 2001, is the most prominent example of 

a country that failed to take adequate steps to offset the cost of the cost of its 

transition. 

I would also add the additional observation that private accounts do not by themselves increase national wealth. This is important in the context of promoting private accounts as a way to increase returns to retirees. Since private accounts do not 

actually increase wealth, at best they can be a mechanism for redistributing money 

from the working population to retirees. If Congress intends to redistribute money 

from workers to retirees, then there are arguably more efficient mechanisms to accomplish this goal. 

I will elaborate on each of these points in turn. 

Risk 

Countries that have privatized their Social Security systems have subjected retirees to all three forms of risk noted above, the risk of market timing, the risk associated with asset choice, and the risk of low income during a working lifetime. In the 

first case, it is a basic fact about financial markets that they are volatile. Even if 

the average return on equities exceeds the return on riskless assets, there is considerable variation in this return. In Chile, the longest standing experiment with a 

privatized system, a government minister recommended that workers delay their retirement for a few years after a downturn in the national stock market. 

There is no way to avoid this market timing risk. The Bush administration’s suggestion that workers be forced to switch out of stocks approximately 10 years before 

retirement does little to change the story. If the market plunges just before a worker 

reaches this switch date, then he or she is almost as bad off as if the plunge occurred just before his or her retirement. 

A second sort of risk is associated with the choice of asset. This risk can result 

from a worker either being too conservative or taking too much risk with their accounts. Many workers are ill-informed about financial markets and may only feel 

comfortable holding very safe assets with low returns. In the case of the proposal 

President Bush outlined in his State of the Union Address, this could result in 

workers losing money on their individual accounts, since they would lose more from 

their Social Security benefit than they would gain from the investments in their accounts. 

Workers can also engage in speculative investments that end up losing money. 

This happened to some extent in England where there was a ‘‘mis-selling scandal’’ 

in the mid-nineties. Many financial firms had sold accounts to workers by promising 

returns on the accounts that workers would not actually realize. The British government eventually forced these firms to make good on these promises. In some cases, 

where firms had gone out of business, the government was forced to pick up itself 

the cost of fulfilling these promises. 

These risks can be minimized by restricting choice. If the government gives workers a very narrow range of options, then the risk of bad asset selection is reduced. 

(Of course, this assumes that the government knows better than individual workers 

how best to invest their money.) 

In principle, insofar as workers are too conservative with their investment choices 

because they are ill-informed about financial markets, the problem can be addressed 

with better education. However, this raises two additional problems. First economists usually believe that time has an opportunity cost. Time that workers spend 

learning about financial markets is time that they could have spent with their children or on other activities. If we are designing a system that requires that tens of 

millions of workers get additional education on financial markets, then we have decided that this is the best use of their time. (In Chile, the schools now have sessions 

that teach people about the retirement system. This means that time that could 

64 

1Gill, I, T. Packard, and J. Yermo, 2005, Keeping the Promise of Social Security in Latin 

America, Stanford, CA: Stanford University Press. 

have been spent developing math, science, or language skills is instead being used 

to teach people how to manage their Social Security accounts.) 

The other problem with trying to educate workers on their retirement investments 

is that it is not clear who should be doing the educating. Many of the country’s top 

financial advisors were recommending that people invest in stock even at the peak 

of the nineties bubble. It is not clear that advice from such experts would be beneficial to most workers. 

Finally, a system of private accounts, by itself, is not redistributive to low wage 

workers. This means that if a mechanism is not put in place to ensure that workers 

who put little into these accounts because of low earnings, still have an adequate 

retirement income, then many low wage earners could end up as losers. While most 

countries with privatized systems have put some sort of minimum benefit in place, 

this is not universally the case. For example, Peru does not have a minimum benefit 

in its system. 

It is also important to realize that putting a redistributive mechanism in place 

today, does not guarantee that it will be there twenty or thirty years in the future. 

Any redistributive mechanism attached to private accounts will always be subject 

to political risk. The intention of the designers of the system will matter little if political support does not exist to retain redistributive mechanisms in the future. 

Expenses 

There is now a large body of research that shows that the administrative costs 

of a privatized system of individual accounts vastly exceeds the costs of a centralized defined benefit system like the one in the United States. The administrative 

costs of the Chilean system have averaged close to 15 percent of the money placed 

in the accounts each year, while the cost of the British system have averaged close 

to 20 percent. Administrative costs are much greater in these systems because of 

the costs associated with servicing an individual account, the costs associated with 

marketing to individuals, and the profits of the firms who administer these accounts. 

In addition to the annual costs associated with operating these accounts, there are 

also costs associated with turning the accounts into annuities at retirement (which 

is not generally required). Research indicates that insurance companies charge between 10 and 20 percent of the value of a sum to convert it to an annuity. Roughly 

half of this fee is associated with the adverse selection that results when 

annuitization is not mandatory. (Only relatively long-lived individuals are likely to 

buy annuities.) The other half is due to the administrative costs and profits of the 

financial firms that issue annuities. 

A single centralized system of accounts (which does not exist in any of the countries that have opted for privatization) could in principle lower costs, especially if 

it minimized workers’ choices in selecting investments and switching between investments. President Bush’s Social Security commission estimated that a bare-bones 

centralized system would cost roughly ten times as much as the current system. 

(There has been considerable confusion about this point because of how the commission framed its cost estimate. The commission estimated that the administrative 

cost would be 0.3 percent of the stock of money in an account. This means that the 

fee on a dollar placed in an account would be 0.3 percent for each year that dollar 

is in the account. Some dollars will be in an account for forty years, while some dollars placed, in the account just before a worker retirees, will be there for just a short 

time. If a dollar is a worker’s account for an average of twenty years, then this 0.3 

percent fee will be paid twenty times, making a total administrative cost of 6.0 percent, compared to a cost of just 0.5 percent on the dollar placed in the Social Security system.) 

President Bush’s commission also argued that a centralized government run system can radically reduce the cost of issuing annuities. While a centralized system 

may in principle be vastly more efficient than the current market system, there 

would still be a problem of adverse selection in any system where buying annuities 

is optional, as President Bush has proposed. This means that a worker with an average life-span could expect to lose between 5 and 10 percent of their money under 

such a system, compared to what they would receive with an actuarially fair annuity. 

Popularity 

The World Bank recently completed a study of the privatized Social Security systems in Latin America.1 One of the main criticisms of these systems is that they 

65 

have not substantially increased participation over the rates achieved under the traditional defined benefit systems. The argument that these systems would increase 

participation claimed that workers view their current Social Security contribution 

as a tax, whereas they would see their contribution to a private account in a different light. The fact that participation has changed little after privatization, in 

some cases not even growing more rapidly than what would have been expected if 

past trends had continued, indicates that workers do not view contributions to these 

accounts very differently than they do contributions to the traditional defined benefit system. 

It is worth noting that in Chile, the most developed system, a large percentage 

of the workers target the minimum benefit. This minimum benefit allows any worker who has been in the system for twenty years to turn over their account to the 

government, and then get a guaranteed benefit that is tied to the value of the minimum wage. In effect, these workers are voting with their feet for a defined benefit 

system. 

Transition Costs 

In the short-term, the switch from a traditional pay-as-you-go Social Security system to a defined contribution system implies a large increase in the government deficit, since the same benefits must still be paid to current retirees, even though the 

government is collected much less in Social Security contributions. Every country 

that has opted to privatize its Social Security system has attempted to at least partially cover these transition costs by reducing its deficit, or building up a surplus, 

with some combination of tax increases and spending cuts. For example, the Chilean 

government increased the size of its annual surplus to 4 percent of GDP (the equivalent of a surplus of $500 billion in the United States in 2005) at the point where 

it implemented its privatization plan. 

They felt the need to cut their deficits or increase their surpluses precisely because these governments did not believe that the financial markets viewed their implicit commitments to pay Social Security benefits in the distant future as being the 

same as actual government debt. The one important example of a government that 

did not take sufficient steps to offset the borrowing needed to finance its Social Security privatization was Argentina. In 2001, it was paying real interest rates of 

more than 20 percent on its debt, because lenders did not have faith in the government’s ability to pay off its debt. 

By contrast, in 1994, the year Argentina put its privatization plan in place, the 

country was generally regarded as one of the most creditworthy countries in the developing world. Had it not been for the privatization of its Social Security system, 

Argentina would have been running balanced budgets between 1994 and 2001. 

The United States is approaching the question of Social Security privatization at 

a time when it faces much larger deficits than any of the other countries that have 

gone this route. The experience of Argentina suggests that it is likely to face a very 

high price in financial markets if it does not couple privatization with large tax increases and/or spending cuts. 

National Wealth and Privatization 

No economist believes that the United States would be increasing national wealth 

if it borrowed $200 billion a year and invested this money in the stock market. It 

is possible that this will reallocate income, as the government can benefit from the 

gap between the return on equities and the interest paid on government bonds, but 

this is not creating additional wealth for the country as a whole. Similarly, it cannot 

increase national wealth if it borrows $200 billion a year and hands $2,000 a year 

to 100 million families and tells them to invest it in the stock market. This would 

simply be changing the allocation of national income. 

This is important to recognize because one of the goals often claimed by proponents of privatization is increasing the rate of return on Social Security contributions. Insofar as the money is simply borrowed, as President Bush has proposed, 

then any increase in the rate of return due to privatization is simply coming at the 

expense of the rest of the population. This could be seen fairly directly in the case 

of Chile where accounts earned double-digit real rates of returns through the 

eighties. The main asset of Chile’s private accounts in the eighties was Chilean government bonds, which paid double-digit real interest rates. In effect, Chile’s workers 

received high returns on their accounts because Chile’s taxpayers paid high interest 

rates on the money their government borrowed to finance the accounts. It may have 

been desirable to transfer money from Chile taxpayers to Chile’s retirees, but this 

could have been done without going the route of privatization. 

66 

In short, it is important that policy makers recognize the distinction between 

using private accounts as a way to redistribute income—which they may be to some 

extent—and a mechanism to increase national wealth, which they surely are not. 

(There is a separate issue of whether private accounts in the United States will 

be able to earn the rate of return claimed by proponents of privatization. Stock returns come from either capital gains or dividend payouts. No analyst has yet passed 

the ‘‘No Economist Left Behind Test,’’ which asks for a set of dividend payouts and 

capital gains, consistent with the Social Security trustees profit growth projections, 

that add to the 6.5–7.0 percent returns assumed in analysis of Social Security privatization. Given current price to earnings ratios and low projected profit growth, 

there is no plausible set of dividend yields and capital gains that will produce 6.5– 

7.0 percent real stock returns.) 

Mr. Chairman, this concludes my testimony and I would be happy to answer any 

questions from you or other Members of the Subcommittee. 

f 

Chairman MCCRERY. Thank you, Dr. Baker. Mr. John. 

STATEMENT OF DAVID C. JOHN, RESEARCH FELLOW, THOMAS 

A. ROE INSTITUTE FOR ECONOMIC POLICY STUDIES, THE 

HERITAGE FOUNDATION 

Mr. JOHN. Thank you for having me, and also for looking at this 

rather important set of experiences around the world. I am going 

to concentrate on the UK’s experience. Let me start by just—I 

think it is obligatory for conservatives dealing with the UK to 

quote Winston Churchill, so, I have to do my Winston Churchill 

quotes, which is that he reminded us that the United States and 

UK are two people, separated by a common language. This is especially true in pensions. We have similar wordings of terms in areas 

of pension reform, and in the United States, we actually do deal 

with some specific issues that are very similar to what the UK has, 

but each of the countries’ systems has been shaped by very special 

national circumstances and by past experience. Eight years ago, 

many conservatives wrote that the UK would serve as a perfect 

model for a U.S. system of Social Security accounts. Frankly, we 

were wrong. More recently, a group of more liberal writers have 

been writing say that the United States, UK experience proves that 

any form of personal retirement accounts cannot work in the slightest, and that is wrong also. One of the key things to remember 

again is that the UK has special circumstances. There has been reference, for instance, to a mis-selling scandal in the UK pension 

plan. The mis-selling scandal did happen, and it was extremely serious. However, it actually resulted from a very specific example 

and circumstance in the UK marketplace; namely, that they did 

not have a retail market in mutual funds and similar investments. 

Therefore, these investments were sold by ill-trained insurance 

agents who did an exceedingly good job selling insurance but, not 

a good job selling investments. 

Most of the poor advice actually had to do with whether an individual would redirect a portion of their Social Security taxes into 

a personal account, thereby losing employer-matched contributions, 

or stay in an employer account where they would take advantage 

of these additional contributions. The net result was that the UK 

very sharply increased its retail regulation, and it also required 

these companies to make repayments. Now the UK system is also 

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67 

tem, which was predominantly a DB system similar to United Airlines, Bethlehem Steel, and so forth, at precisely the time that that 

type of pension system was essentially failing due to a variety of 

circumstances that actually have nothing to do with Social Security. This has affected the results in the UK market. Nevertheless, 

there are six lessons that the United States can learn from the 

UK—and the actual system itself is described in my written testimony. Number one, if you build it they will come, works for baseball, especially in Iowa, but it doesn’t necessarily work for a pension plan. In the UK, the government set up something called 

stakeholder pensions, which are relatively simple, low-cost pensions that were required to be offered by small businesses that had 

more than four employees. 

Unfortunately, the administrative costs were relatively low and 

probably too low, with the net result that 350,000 employers did 

set up this type of pension plan. Better than 80 percent of the pensions are empty without having any contributions in the slightest. 

About half of the money that went into the stakeholder pensions 

has actually been transferred from other existing accounts. The UK 

Trade Union Congress has charged that the stakeholder pension 

experience has actually been more of a boon for upper income 

workers seeking additional tax shelters than anything else. 

Second, simplicity is essential. Adair Turner, who heads up the 

UK Pension Commission, which we will be reporting this fall, recommending changes in their pension system, points out that the 

UK system is probably one of the most complex in the world. The 

net result of that is that a recent poll showed that precisely 6 percent of the UK population feels that they understand the pension 

system that is out there very well. It is a matter of great concern, 

however, to the average worker. A poll in October, in advance of 

the election that was held in May, showed that the question of pensions was number one on workers’ minds at that point. Second, 

they have a pension credit, which is means tested, which must be 

applied for. It is not a simple delivery system. The net result is 

that only 60 percent of those people who are eligible actually receive this pension credit. For the most part, the 40 percent who do 

not are the ones who need it the most, the most elderly, and the 

most poor. 

Number three, programs can have unintended motivational consequences. The pension credit is means tested, and it requires a 40- 

percent penalty on existing savings, with a net result that 20 million workers in the UK who have incomes between 16,000 and 

65,000 have stopped saving. This is 15 percent, roughly 20 percent 

of the overall problem in the UK. Fourth, index pricing requires a 

minimum benefit. The basic State pension was price indexed 25 

years ago. The net result is that most people who only receive that, 

about 12 percent of the work force, are actually living in poverty. 

There are two very positive mentions to this. Number one, accounts 

do work. Even with the serious problems that the UK experience, 

the UK has pension savings equal to 70 percent of their GDP, 

which is the most in Europe. The overall cost of their public pension system is one of the lowest in the world. Second, this is key, 

the UK governments, both Labor and Conservative, when they 

have found programs that promised more than they could deliver, 

68 

1Statement by Keith Bedell-Pearce, Executive Director of Prudential, plc to the Subcommittee 

on Social Security, Committee on Ways and Means, July 31, 2001. 2 ‘‘Crisis looms for ‘private’ pensioners,’’ Scotland on Sunday, June 12, 2005. Available at: 

http://news.scotsman.com/index.cfm?id=645242005 (June 13, 2005). 

changed the benefits. They actually went through and reduced benefits. There have been a number of instances in the last 25 years 

where the State benefits have been altered. 

Now, in October 2005, just to conclude here, the Pension Commission is going to report. The expectation is that they are going 

to require more savings, perhaps in the form of an Australian mandatory system, rather than less. The expectation also is that they 

are going to come up with a comprehensive approach rather than 

a continued bit by bit by bit, which has proved to have rather serious problems. The key lesson is that the UK is fixing their system 

while the United States is still working on it. The UK is likely to 

have a consensus by the end of this year or early next year. The 

question is whether we are strong enough to do the same. Thank 

you. 

[The prepared statement of Mr. John follows:] 

Statement of David C. John, Research Fellow, Thomas A. Roe Institute for 

Economic Policy Studies, The Heritage Foundation 

I appreciate the opportunity to appear before you today to discuss what we in the 

United States can learn from the United Kingdom’s experience with public pension 

reform. This is an extremely important subject, and I would like to thank both 

Chairman McCrery and Representative Levin for scheduling this hearing. Let me 

begin by noting that while I am a Research Fellow at the Heritage Foundation, the 

views that I express in this testimony are my own, and should not be construed as 

representing any official position of the Heritage Foundation. In addition, the Heritage Foundation does not endorse or oppose any legislation. 

The crisis faced by the UK public pension system 

In 1997, just eight years ago, reforms made to the United Kingdom’s pension system under both Conservative Party and Labour Party governments were regarded 

as a model for avoiding the fiscal problems caused by the imminent retirement of 

millions of baby boomers. Studies by international organizations and a variety of 

think tanks showed that rather than the huge increase in retirement-related costs 

that threaten to engulf most Social Security systems, the UK faced a future where 

these costs would be relatively stable in terms of the percent of GDP that would 

be devoted to paying for retirement benefits. The combination of reductions in government paid benefits and generous incentives for workers to finance their own benefits through personal or work-related pension plans looked like a complete success. 

This impression did not fade quickly. As recently as four years ago, testimony 

about the UK system by a leading British insurance executive to this subcommittee 

was entitled: ‘‘Pensions: A British Success Story.’’ 1 However, the last few years have 

been hard on the UK pension system. Due to poor planning, constant government 

tinkering, the closure of many corporate pension plans and other factors, all political 

parties recognize the need for a comprehensive pensions overhaul. A UK government pensions survey to be issued this week is expected to reveal that only one out 

of every six private sector employees can expect to have a ‘‘decent’’ pension when 

they retire 2

The British pensions system has become a national issue. As a result, a late October 2004 poll showed that UK voters regarded their pension system as the number 

one issue that needed to be addressed in the May 2005 general election. A total of 

54 percent of those polled listed pensions as one of the top four issues, above such 

usual political concerns as health care, crime and immigration. While in fact, pensions played a small role in the election, public concern remains high, and pension 

reform is expected to be a major issue in the coming year. 

As a partial response, the government of Prime Minister Tony Blair established 

a blue ribbon Pensions Commission under former Confederation of British Industry 

head Adair Turner that is charged with issuing two reports. The first, issued in October 2004, paints a gloomy picture of the current system, while the second, scheduled for fall 2005 elections, will propose solutions. 

69 

Two nations separated by a common language: the relevance of the UK experience to the U.S. Social Security debate 

The British pension experience does have significant lessons for the American Social Security debate. However, those lessons are different from recent claims made 

by opponents of President Bush’s proposed changes to the American Social Security 

system. Although there are superficial similarities between personal accounts in the 

UK system and those proposed for the American Social Security system, a closer examination shows major differences. 

First, the accounts in the UK mainly invested in either employer-sponsored defined benefits pension plans or to individual investment plans similar to the American IRA. The American proposal, on the other hand, is completely separate from 

any employer-sponsored pension plans, and would be limited to investment through 

a centralized, government-managed investment platform similar to the Thrift Savings Plan (TSP), which is only open to U.S. government employees and to military 

personnel. 

Further, the accounts did not cause most of the problems faced by British pension 

system. Instead, the overall UK situation closely parallels the problems faced by 

U.S. defined benefit pension plans such as those recently turned over to the Pension 

Benefit Guarantee Corporation by United Airlines and Bethlehem Steel. 

Finally, to the extent that personal accounts are a significant problem in the UK, 

this is mainly due to design flaws and poor planning that were present from the 

beginning, misguided short-term fixes that had unforeseen consequences, and the 

bursting of the late 1990’s stock market bubble. While the British experience shows 

mistakes for Americans to avoid, it does not prove that adding personal retirement 

accounts (PRAs) to the American Social Security system will be a failure. 

The structure of the UK public pension system 

The UK pension system is extremely complicated. There are two levels of state 

pensions, which are supplemented in some cases by two additional programs aimed 

at increasing the state pensions of lower income retirees. In addition, there are a 

variety of employer-related and personal pension plans. To make matters more confusing, workers have the ability to shift a portion of the taxes that fund the second 

state pension into either their employer-provided pension plan or a personal account. Finally, different governments over the past twenty years have revised and 

re-named various parts of the state pension system, changing benefit levels, tax 

treatment of pension contributions, and even account structures seemingly at random. The result is a constantly changing array of programs that are confusing to 

the British and can bewilder foreign observers. 

The Basic State Pension: The most basic level of public pension benefits in the 

UK is the Basic State Pension, which pays a flat-rate pension to all workers who 

have both worked and paid taxes for at least a minimum period. Currently, women 

are allowed to retire at age 60, while men are only allowed to retire at age 65. The 

retirement age for women will increase to 65 between 2010 and 2020 starting with 

women born in April 1950. Approximately one in eight retirees receives only the 

Basic State Pension. 

Currently, the Basic State Pension pays single people GBP 82.05 ($148.50) per 

week and couples GBP 131.20 ($237.50) per week. This equals $7,722.50 per year 

for single people and $12,348.50 annually for couples. As a comparison, the U.S. Social Security system paid individual retirees an average of $11,460 annually as of 

December 2004. Benefits are indexed to the change in prices, and are adjusted every 

April. 

In order to qualify for the Basic State Pension, men must work and pay taxes for 

at least 44 years, and women must work and pay taxes for at least 39 years. However, workers who are unemployed, unable to work due to illness, or who stay home 

to care for a family member may receive credits that can replace some of the required earnings years. U.S. Social Security benefits are based on the worker’s highest 35 years of employment, and do not give any form of credit for these situations. 

The State Second Pension (formerly SERPS): Since 1978, the UK has also had 

a second level of public pension that is based—at least in part—on past earnings. 

Starting in 2007, this pension level will also pay a flat rate benefit. Prior to 2002, 

the State Second Pension (S2P) was known as the State Earnings-Related Pension 

Scheme (SERPS), and paid benefits that are much more directly linked to earnings 

than the new S2P is to be. 

Workers receive credit towards their S2P benefits for income earned between 15 

percent and 110 percent of national average earnings. Overall, they pay National 

Insurance Contributions (NIC) (which help to fund several different benefits including the Basic State Pension) equal to 11 percent on income between about GBP95 

per week ($172 per week or about $8,941 annually) and GBP 625 per week ($1,131 

70 

per week or $58,825 annually) and 1 percent on incomes above that level. In addition, employers pay 12.8 percent on all income above GBP 95 per week. Both the 

income levels and tax rate are subject to change annually, and if the employee has 

contracted out of the S2P, taxes rates are different. 

Workers have the ability to ‘‘contract out’’ of this pension level and re-direct a portion of their taxes into either their employers’ pension plan or a personal plan. In 

the case of an employer pension, the tax level is reduced, while for an individual 

pension plan, the government pays a portion of taxes directly into the plan. If a 

worker contracts out, he or she receives credit for those benefits only on a prospective basis; benefits already earned are not affected. 

Since 1978, the UK has changed benefits payable under both SERPS and S2P several times. These changes are more fully reviewed below, but the mixture of changes 

combined with the ability of workers to jump in and out of this pension level have 

resulted in some workers gaming the system, and make it very hard to determine 

benefits. The S2P is intended to improve benefits to low and moderate income workers, and gives workers who earned under GBP 12,100 annually (about $21,900) 

credit for earning that level. 

Means tested benefits: In addition to these two public pension levels, low income 

workers can qualify for additional means tested benefits. The Pension Credit is intended to ensure a minimum retirement income of at least 30 percent above that 

paid by the Basic State Pension. These benefits are reduced by 40 pence for every 

pound that an individual receives above the Basic State Pension level, and must be 

applied for. In addition, low income retirees are eligible for non-cash benefits that 

mainly rebate some or all of the local (‘‘council’’) taxes they pay and a portion of 

their rent payments. 

Employer and personal pension plans: As mentioned above, UK workers have 

the ability to re-direct a portion of their NIC into either their employers’ pension 

plan or a personal pension plan. The UK had a highly developed defined benefit 

(DB) pension system, but it has been hit with a series of reverses similar to those 

that have hit DB plans in the U.S. As a result, the majority of these private sector 

plans have been closed to new entrants and replaced with less favorable defined 

contribution plans. 

Stakeholder Pensions: Since October 2001, employers (including small businesses with more than 4 employees) that do not offer workers another pension plan 

have been required to offer their employees a ‘‘Stakeholder Pension’’ plan. Designed 

by the government, and intended to be a simple and low cost pension system that 

would especially appeal to moderate income workers. Fees for these plans were initially capped at one percent of assets under management, and plans were required 

to accept an opening deposit as low as GBP 20 ($36). After initial enthusiasm, this 

plan has widely been regarded as a failure, and in an effort to revive it, the UK 

Department of Work and Pensions increased the allowable fee to 1.5 percent of assets under management for the first ten years an account is open in December 2004. 

At the same time, it also reduced the regulatory burden (in the form of a required 

level of investment counseling) for certain types of simple investment products. 

What Americans should learn from the UK public pension system 

Simplicity in program design and administration is essential: The UK system is overly complex both in its design and in its administration. To some extent, 

this is the unintentional consequence of program changes intended to correct specific problems, but the end result is a system that is extremely difficult for even professionals to understand. 

As a result, a December 2004 survey found that only 6 percent of felt that they 

understood the pension system very well, while 29 percent did not know about key 

tax benefits. Not surprisingly, only 5 percent of those polled felt that they were 

‘‘very confident that they would have enough to live on in retirement, and only 3 

percent thought that state benefits would provide a comfortable income. 

Unfortunately, this complexity also applies to the administration of certain benefits. The Pension Credit, a means tested benefit intended to improve the retirement 

incomes of lower income retirees, must be applied for, and is not automatic. Retirees 

are required to answer a complex survey in order to qualify, and despite the fact 

that individuals could answer the questions over the phone, many have not bothered 

to apply for the benefits. As of September 2004, 40 percent of those eligible had not 

claimed their benefits. Experts believe that most of those who have not claimed the 

credit are those who need it the most—the lowest income retirees. Interestingly, the 

government had assumed that 30 percent would not claim benefits in its planning. 

Programs can have unintended motivational consequences: A side effect of 

the Pension Credit has been to reduce pension savings by low and moderate income 

workers. While the 40 pence per pound of income above Basic State Pension levels 

71 

reduction in this benefit is actually significantly lower than the program that it replaced, the net result has been a sharp drop in pension savings. A June 2005 study 

found that almost 20 million workers earning between GBP 9,000 and GBP 25,000 

annually ($16,200 to $45,000) are not saving for retirement because they fear that 

a means tested system would penalize them for their savings. In the aggregate, the 

means tested program is estimated to reduce annual pension savings by about GBP 

3.7 billion a year ($6.7 billion). 

Constant change increases confusion: Change has been a constant feature of 

the UK public pension system since the 1980’s. Programs and new benefit levels 

have been created, revised, and re-named many times. A side effect of this has been 

to increase confusion among UK workers. 

Looking at SERPS alone, the program was created in 1978 and promised to pay 

benefits based on the 20 best years of a worker’s earnings. In 1986, SERPS benefits 

were changed to being based on all earnings between the age of 16 and retirement, 

and in 1995, changes to the pension formula further reduced benefits. In 2001, 

SERPS was replaced with the S2P, while the benefit formula was made more generous to lower income workers, and after 2007, the S2P will become another flatrate pension. In 2002, thousands of workers who had contracted out of SERPS and 

its successor received letters from their financial services companies advising them 

to contract back in, as the amount they were savings was unlikely to be enough to 

equal what the government was likely to pay. Even though most benefit credits 

earned prior to these various changes were grandfathered in, workers can be excused if they feel completely confused and unsure what their benefits will be. 

The availability of individual accounts does not alone solve problems: Despite massive publicity and fanfare when they were first offered in April 2001, 

Stakeholder pensions have largely been a failure. Even though about 305,000 employers started these pension plans for their employees, and that number grew to 

about 350,000 by the end of 2003, 82 per cent of those remained as ‘‘empty boxes’’ 

with no members, while only 13 per cent of employer-based pensions have contributions from employers. To make matters worse, only about 1.5 million plans were 

sold by the end of 2003, and sales have steadily dropped annually since then. Even 

these poor numbers do not indicate new savings, for about half of all Stakeholder 

plans were funded with money transferred from another existing plan. In addition, 

a significant number were estimated to be set up by wealthier individuals in order 

to claim the tax benefits of opening such an account. 

Merely designing an ‘‘ideal’’ account structure and making it available does not 

guarantee that industry will aggressively sell it—especially if there is an unrealistic 

cap on fees. In the UK case, one key error seems to have been including marketing 

charges in the fee cap rather that limiting it to fees directly associated with the individual’s account. Faced with such a limited profit potential, companies were unwilling to spend the amount necessary to continue to promote Stakeholder accounts. 

While the December 2004 fee increase may help, these plans have been labeled a 

failure, and are unlikely to revive as a significant retirement investment vehicle. 

Price indexing can reduce benefits below poverty: Since 1980, the Basic State 

Pension has been calculated using price indexing rather than growth in wages. As 

a result, the flat rate pension amount has dropped to only about 17 percent of average wages (GBP 82.05 ($148.50) per week and couples GBP 131.20 ($237.50) per 

week or $7,722.50 per year for single people and $12,348.50 annually for couples). 

The roughly 12 percent of retirees who only receive this pension have incomes that 

are below poverty level. If the wage indexing had been retained, the benefit levels 

would equal GBP 109 a week ($197.29 week—$10,259 year) for individuals and GBP 

174 a week ($314.94 week—$16,377 year) for couples. 

This is not to say that changing the method of indexing is a mistake, but that 

policy makers must be aware that doing so could result in unacceptably low benefit 

levels. As a result, such a move should be accompanied with a benefit floor that 

guarantees an adequate minimum retirement income level. 

Poor planning increases costs: When SERPS was created 1978, the UK government failed to conduct accurate longer-term studies of the cost that these benefits 

would impose on their government. Its failure to estimate benefit payments after 

2007, despite the fact that most younger 1978 workers would only be retiring then 

was a key reason why benefits had to be revised in both 1986 and 1995. 

This was also seen after the 1998 SERPS changes that were intended to encourage workers to contract out of SERPS and into either an occupational or personal 

pension plan. The government estimated that only between 500,000 and 1.75 million 

workers would take advantage of this option, while by 1993, almost 5 million workers (about 85 percent of those most likely to benefit from contracting out) actually 

did. 

72 

A 1990 government study showed that while about GBP 9.3 billion (about $17 billion) would be paid by the government in the form of rebates and special bonuses 

into accounts, the cost of paying SERPS benefits in the future would only decline 

by about GBP 3.4 billion (about $6.2 billion). Pensions expert Edward Whitehouse 

has an even higher estimate of GBP 12 billion (about $22 billion) revenue lost in 

return for the same level of reduction in future benefit payments. 

A retail-based account system requires close monitoring: The most famous 

problem with the UK system, the so-called ‘‘mis-selling’’ scandal, is widely misunderstood in the U.S. When individuals were allowed to move out of SERPS into 

personal accounts in 1988, many were poorly advised by ill-trained insurance 

agents, and either moved out of employer-based plans that included an employer 

contribution and into personal plans that did not include that employer contribution, or failed to make an appropriate level of additional voluntary contributions 

that would be necessary to reach their retirement goals. 

The mis-selling scandal resulted more from a sales force that was used to selling 

conventional insurance products and did not themselves understand the products 

they were selling than from other reasons. The fact that the agents’ compensation 

was also tied to commissions exacerbated the situation. 

As a result, however, a thorough investigation was conducted, and companies 

where mis-selling had occurred were required to compensate their customers. In addition, a new financial regulator, the Financial Services Authority, was created from 

several smaller and weaker regulators, and it has, if anything, overly compensated 

by requiring levels of disclosures to individual customers far in excess of those required in the U.S. 

For Americans, this problem is interesting, but does not apply to Social Security 

reform proposals. For one thing, the SEC and other financial regulators have long 

monitored sales to individuals and require significant consumer disclosures. More 

importantly, the proposed U.S. Social Security reforms are based on a governmentmanaged centralized investment system, and neither individual companies nor 

agents and brokers will not be allowed to participate. 

Conclusion 

It would be a mistake to assume that the UK pensions experience has only been 

one of failure. The opposite is actually true. The country still has a higher level of 

pension investments, about 70 percent of GDP, than any other country in Europe, 

and the cost of public pension benefits is substantially lower than most countries 

in the world. In addition, roughly 50 percent of the workforce is covered by some 

level of private pension. 

While the current UK government is responsible for some of the problems in their 

current system, most notably the Pension Credit that has destroyed the incentive 

to save for many of their workers, others have resulted from the collapse of the defined benefit pension system and problems caused by mistakes by earlier governments. The current government is also responsible for the Pensions Commission, 

whose recommendations are expected to result in an overall reform of their system. 

However, their experience teaches Americans that even well intentioned individual changes can only make matters worse. In addition, it is important to consider 

the overall structure of the complete pension system. The UK has well learned this 

lesson, and the expected October 2005 final report of the Pension Commission is expected to give a full picture of proposed changes in light of the complete pension 

system. 

It is important for Americans to remember that much of the UK experience results from special circumstances unique to that country, and that they do not apply 

to the United States. In addition, it would be a serious error for Americans to assume that the lesson of the UK experience is to discourage individual accounts, 

whether as part of Social Security or as part of 401k or other retirement savings 

options. The opposite is rather the case. 

Personal accounts are a source of strength, both in the UK pension system and 

in their economy, and the current government has been actively seeking ways to increase the number of workers who have them. It would be both ironic and sad for 

Americans to draw the opposite conclusion from their experience at the same time 

that the UK is working to build individual pension savings. 

The Heritage Foundation is a public policy, research, and educational organization operating under Section 501(C) (3). It is privately supported, and receives no 

funds from any government at any level, nor does it perform any government or 

other contract work. 

73 

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States. During 2004, it had more than 200,000 individual, foundation, and corporate 

supporters representing every state in the U.S. Its 2004 income came from the following sources: 

Individuals 56% 

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Corporations 4% 

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The top five corporate givers provided The Heritage Foundation with 2% of its 

2004 income. The Heritage Foundation’s books are audited annually by the national 

accounting firm of Deloitte & Touche. A list of major donors is available from The 

Heritage Foundation upon request. 

Members of The Heritage Foundation staff testify as individuals discussing their 

own independent research. The views expressed are their own, and do not reflect 

an institutional position for The Heritage Foundation or its board of trustees. 

f 

Chairman MCCRERY. Thank you, Mr. John. I thank all of you 

for your excellent testimony. Dr. James, in her testimony, talked 

about a mandatory add-on. By that, I took her to mean that the 

government would mandate that everybody have an account. It 

wouldn’t be voluntary, it would be a mandatory account, and she 

talked about the government’s financing that mandatory add-on account through a tax increase, basically, funding those accounts 

with general revenues from the government. So, you are saying— 

well, that is the question I want to get into. Let us assume, rather 

than the President’s voluntary account proposal, we talked about 

a mandatory account that the government would fund. We wouldn’t 

mandate that the taxpayer take another, say, 4 percent of his income out of his pocket to fund his account, but it would be funded 

by the government. Obviously, there are three ways to do that. The 

government could issue more debt, general debt, the government 

could cut spending elsewhere, or the government could find a new 

revenue source or increase an existing revenue source, increasing 

the tax take sufficient to fund those accounts. If we were to cut 

spending to fund the accounts or increase taxes to fund the accounts, we would automatically increase national savings, would 

we not? Does anybody disagree with that? 

Dr. JAMES. As long as there is no offsetting effect going on. 

Ms. CORONADO. By household. 

Dr. JAMES. Government impact would be positive. 

Chairman MCCRERY. Well, it is the same. The people who are 

investing, you are saying there would be a decrease in private investment? 

Dr. BAKER. Right. As long as there was no offsetting decrease 

somewhere else. 

Chairman MCCRERY. As long as there is no decrease in private 

investment, there would be a net increase in national savings; correct? 

Dr. BAKER. If you assumed that is the definition. 

Chairman MCCRERY. Well, I am trying to get to some basics 

here. Mr. Whitehouse in his testimony said that given the size of 

the U.S. economy and the maturity of our financial markets, capital markets, a change such as those that took place in South 

America wouldn’t have as big an effect on the economy. So, I guess 

74 

one thing I would like for you to comment on, would it be wise for 

the United States, or would it not make much difference, if we 

were to mandate personal accounts, not take the money from the 

payroll tax, but have the government fund those accounts from 

some other source. Would it be wiser to fund it with an increase 

in general revenues, or an increase in debt, or an increase or a decrease in other spending? Any comments on that? Let us assume 

we could do any of those. 

Dr. BAKER. I can give you a typical economist answer. It depends on what you are trying to do. Is the point to increase national saving, in which case that would have the same effect as any 

other sort of cut and spending or increase in taxes. So, if that is 

how to fund it, yes, that is one point to increase national savings. 

Chairman MCCRERY. Is that a good thing to increase national 

savings? 

Dr. BAKER. I do think we need to increase national savings. We 

do have a deficit that is too large. I don’t know if that is the only 

way to increase national savings, but that is one way to do it. The 

second idea is, do we have to increase retirement security, and 

then you have to ask if that is the best way to do it. The question 

is, what are the goals here? Then the question is—you could advance both of those goods, but the question is, is this the best way 

to advance them? 

Chairman MCCRERY. Any other? Mr. Whitehouse. 

Mr. WHITEHOUSE. As I said in my testimony, the target benefit level under Social Security on this level is quite low by international standards. I don’t see that as a particular problem, but it 

is for most Americans who have to make a voluntary provision either on their own, through an Individual Retirement Account 

(IRA), or through their employer. The issue for me is people who 

are not saving enough for retirement. Now, the average contribution rate to 401(k)s is 9.5 percent. That is, if people maintain that 

for a full year, going to be enough to give them a pretty comfortable retirement. It is the people who are not covered by private 

pensions who concern me and the people who are not saving 

enough in those private pensions. If one were to save—to add on 

to Social Security a mandatory 4-percent contribution to some form 

of account—and clearly the people who are in 401(k)s already, they 

are not going to change their behavior, but you are going to pick 

up the people who are currently going to be relying solely on Social 

Security in their retirement, and they are not going to have a very 

comfortable retirement. 

Chairman MCCRERY. Well, I didn’t understand that last comment. If we keep the current system and then add on a 4 percent 

account? 

Mr. WHITEHOUSE. The people who are saving already in that 

401(k) are in the company plans. They don’t need to change. They 

are doing that already, but there are some people who are not saving enough. 

Chairman MCCRERY. Right, but why wouldn’t the 4 percent 

add-on account not help those who are not saving enough? 

Mr. WHITEHOUSE. It would make them save. They are not saving at the moment. 

Chairman MCCRERY. It would help them. 

75 

Mr. WHITEHOUSE. Yes, it would help them. Those are the people who concern me. They are not saving enough. We are having 

this debate in the UK at the moment about how—the importance 

of compulsion in this. I think the United States performs very well. 

Most people are saving enough for retirement. People who are currently retired, most of them, are in a good position. There is a 

missing sort of 25 percent of the work force who are not saving 

enough now, and 25 percent of pensioners who are on very low incomes. 

Chairman MCCRERY. Dr. James? 

Dr. JAMES. Yes. Just following up, and so I can explain what 

I meant by my comment, if we want to maintain the currently 

scheduled benefit level from the total—from what I see as the total 

mandatory plan—that will require additional funding. That is why 

I thought of a mandatory add-on. The question is where should the 

funding go? Better off going into an individual account, in my opinion, than into the Social Security Trust Fund. There is a danger 

if it goes into the Social Security Trust Fund that it will be borrowed by the Treasury and actually increase Treasury borrowing 

more than we would have otherwise. In that case, the extra money 

would not be increasing national saving, it would leave us with a 

bigger debt at the end. So, that is a rationale for putting the money 

into individual accounts where the money is actually invested in 

productive assets, and does not—is less likely to—increase Treasury borrowing. In addition, as Ed Whitehouse said, what this really 

does is to make sure that everyone saves some minimal amount. 

I think the proportion that is not saving enough through 401(k)s 

is probably greater than 25 percent when you take into account the 

amount that they save, the consistency of saving through a lifetime, and the likelihood that they will keep it in the 401(k) until 

retirement. I believe the proportion with insufficient voluntary saving is greater than 25 percent. That is basically the reason for the 

mandate. The people who are already saving through 401(k)s might 

actually reduce that saving if they had to put the money into an 

add-on, which would be a little bit of an offsetting factor. 

Chairman MCCRERY. If you took it out of their pockets, yes. 

Dr. JAMES. Yes, if you took it out of their pockets. 

Chairman MCCRERY. There may be an offset, yes. 

Dr. JAMES. Now, your method might have a somewhat different 

effect. 

Chairman MCCRERY. Ms. Coronado? 

Ms. CORONADO. If I could make one general comment about 

the general revenue financing of this. You are sort of weakening— 

through that method of financing, you are weakening the link between the taxes paid and the benefits received. If one of the goals 

of addressing the aging problem is to strengthen the incentives to 

keep working, and if your work results in higher benefits in the future, then that is a good thing for the stability of the system. General revenue financing weakens that link because it is not if I work 

more, or if I work harder, or if I work a year longer I am going 

to have more benefits, it is just going to come from the government. 

That sort of financing actually creates more of the dependency 

mentality rather than the right incentives for retirement, delaying 

retirement. 

76 

Chairman MCCRERY. I understand that link, but I also understand the current fiscal situation of the United States, which is we 

are taking in more than we need to pay benefits right now. The 

surplus that we are taking in is really general revenue. Don’t kid 

yourself. We are spending every penny of it for defense, for other 

things. To me, it doesn’t make a whole lot of difference whether it 

is general revenues or payroll tax revenues. We are using that 

money as if it were general revenues and have been for quite some 

time, and will be for the next 11, 12, 13 years, depending on whose 

numbers you believe. I am not really hung up on that. I am worried about Mr. Whitehouse’s concern about providing for a minimum level of retirement security for everybody in this country. I 

don’t really care how we do it, except I want to do it in a fiscally 

sound way. The Social Security system, as it is currently built, is 

a ticking time bomb. As Dr. James alluded to, if we just increase 

payroll taxes we are just going to add more debt, in effect. That is 

what I want to avoid. That is why, to me, this concept of pre-funding through personal accounts is a no brainer, as evidenced by the 

rest of the world that is doing this. 

Why is the concept so hard for some to grasp that we are going 

to have to pay the bill now or pay later? The way we are financing 

this thing now, we are costing ourselves money. We are paying ourselves interest. We are promising ourselves to pay ourselves interest over time. That is swell if you are prepared to raise taxes 

enough to cover the bill. The rest of the world has seen that if we 

take advantage of capital markets, if we take advantage of the private sector to pay us interest over time, that is going to help us 

pay our bills for this minimum security that we want to provide for 

the people in the United States. What is wrong with that analysis? 

Dr. Baker, I am sure you have some comment. 

Dr. BAKER. Glad you asked. 

Chairman MCCRERY. Frankly, I am anxious to hear you because it is unassailable. The rest of the world has reached that conclusion, so, what is wrong with it? 

Dr. BAKER. Well, the rest of the world hasn’t reached that conclusion. 

Chairman MCCRERY. Well, they seem to be headed that way. 

Dr. BAKER. That is not clear. Actually the World Bank study of 

Latin American reform programs suggested that they should view 

these privatized systems as transitions to it moving to a system 

like the United States where you have a well-defined benefit system and a well-working voluntary system like our 401(k) employerbased system. I won’t assume that the rest of the world is moving 

toward that at all. The second point you asked me what is wrong 

with the logic. The logic is unassailable. The point here is the national savings rate. Now, if you are concerned—it strikes me as 

very peculiar. I don’t spend that much time on this at all, but the 

Social Security system is a system that is currently running a surplus. It is the rest of the budget that is $600 billion in deficit. If 

the Congress is concerned that we have inadequate national savings, it could address that tomorrow by doing something about the 

rest of that deficit. That affects how rich we will be 10, 20, 30 years 

in the future. It is national savings, it is not Social Security, per 

se. So, you say, okay, we are going to give you this add-on, and you 

77 

say, we are going to finance it either—well, if we do it by borrowing, debt is not going to affect anything at all. If we are going 

to do it by raising taxes, we could have done it anyhow. We can 

do it by cuts in other programs. That is fine. If you have the programs you want on the chopping block. 

Chairman MCCRERY. If we raise taxes now, Dr. Baker, to fund 

something that is going to pay us interest, to me that makes more 

sense than waiting to raise taxes even more to cover the interest 

that we promised ourselves. I see everybody else on the panel nodding. I just want the record to reflect that. 

Dr. BAKER. I would go back to the point that Dr. Coronado 

made, however. If you are thinking about raising taxes, I think it 

is better to raise them and put that into the individual accounts, 

so that the individual doesn’t think of it as a tax. It is actually 

something that is actually revenue. 

Chairman MCCRERY. Actually, revenue neutral. If we put it all 

back into private accounts for individuals, then it is basically a revenue neutral approach. We have given back in the form of personal 

account money, in a personal account, every penny that we have 

raised in taxes. So, it is not really a tax increase. It is something 

that is revenue neutral. 

Dr. BAKER. You do have the administrative taxes though. 

Chairman MCCRERY. We have raised taxes, Mr. Pomeroy, on 

the one hand—don’t laugh—and we have given it all back on the 

other hand. 

Mr. POMEROY. Mr. Chairman, I did not mean to snicker. 

Dr. JAMES. Could I just make a point on the administrative 

costs? The administrative costs of this plan would actually be lower 

than the average individual pays today when they save in 401(k)s 

or in mutual funds. The plan could be set up to provide an opportunity for people to save and invest their savings at lower administrative costs than they face now in the voluntary market. That is 

a plus of the system, not a minus. 

Chairman MCCRERY. Thank you. I have taken far too much 

time, but I appreciate the responses of the panel, and I appreciate 

the patience of my colleagues. Mr. Levin. 

Mr. LEVIN. Well, I was going to ask some questions, but I think 

I need to—— 

Chairman MCCRERY. You may. You may also take up some 

more time. 

Mr. LEVIN. I would like to say a few things about what you said. 

It is really strange that those who favor replacing the Social Security system because of the present budget situation are those who 

have voted for policies that have helped create—— 

Chairman MCCRERY. Mr. Levin, let me just interrupt here because I am not here to defend the President’s plan. You keep referring to the President’s plan. 

Mr. LEVIN. Let me finish. 

Chairman MCCRERY. Well, I just want to make it clear that I 

am prepared to talk with you about not replacing the current Social Security system but adding to it, making it better. I would love 

to have that discussion, rather than you continue to characterize 

us as wanting to do away with the current Social Security system. 

Mr. LEVIN. That is what the President has proposed. 

78 

Chairman MCCRERY. It is up to the Congress to dispose. The 

President may propose what he wants. It is our job to dispose. We 

can only do that through a dialog. 

Mr. LEVIN. I am all in favor of a dialog, but the President set 

a path in the State of the Union, on a strictly partisan basis, to 

say, ‘‘I want privatization.’’ It would diminish dramatically the replacement rate that you already say is relatively low compared to 

other plans, and also would create massive debt. Now—let me just 

finish. 

Chairman MCCRERY. Okay. 

Mr. LEVIN. We have made clear that that is unacceptable. We 

will not agree to replace the Social Security system. We will not 

agree to the diminution of the replacement rate. We will not agree 

to this massive borrowing. The President is the chief legislator in 

this country whether he is a Democrat Republican. He has the 

power to propose, and he also has the power to dispose. He can 

veto anything that we pass. It is totally misguided to say, all right, 

the President is out there, let’s go on, but we have said yes. Once 

the President of this country says that he is willing to set aside the 

privatization proposals, we have always said we are willing to sit 

down and talk about how we shore up the Social Security system. 

There is a shortfall. We want to address it without replacing the 

system. 

The President continues to say that privatization is a condition 

for his acceptance of any plan. He is out campaigning saying that 

today while the American people are telling him that is not acceptable. The American people are not willing to have privatization of 

our Social Security system or whatever you want to call it. So, it 

is up to the President to remove the barrier to our sitting down and 

having a discussion as to this shortfall. Now, it is interesting you 

say the Social Security moneys are general revenue moneys. When 

it is your policies—I agree there was 9/11. That is part of it. There 

was a recession. We don’t have to argue about who caused it at this 

point. There have been a lot of policies, including tax cut policies, 

that have not benefited savings in this country, and I think, have 

undermined this country. 

So, you use these huge deficits as an excuse to replace Social Security. They aren’t general revenue moneys unless this Congress 

acts as if they were. In the nineties we took steps to make sure 

that we were not going to use Social Security moneys for general 

revenue purposes. We had a projected $5.6 trillion surplus not 

using Social Security moneys. So, you are saying because your policies have led us to use Social Security moneys, we therefore need 

to change the system, and that is simply not acceptable. It is not 

acceptable to us. You say—I want to say a word about the increasing of savings. Look, you can do it through various devices, but 

there are some program cuts that will not increase savings. If you 

cut education programs, or if you cut some other programs and 

force people to use their moneys without any government help, you 

are not going to increase the savings rate. You are essentially displacing private savings. If you will have the President say the same 

thing that you will, take them—go beyond the barrier of privatization, we will sit down. He created that barrier, not the Democrats, 

he did. You shake your head no. He is the one who proposed it. He 

79 

is the one who continues to insist that they must be part of any 

plan. I was going to ask some questions. 

Chairman MCCRERY. Go ahead. 

Mr. LEVIN. Let me just ask one or two, if I might. It really reinforces what I have said. We each used this, the issue of other countries, I think, to support our own positions. Mr. McCrery, you have 

been very fair in creating panels. I think this is kind of an exception to the rule you have followed. 

Chairman MCCRERY. Thank you, Mr. Levin. 

Mr. LEVIN. It is kind of a McCrery exception. I kind of chuckle 

when the Heritage Foundation says it doesn’t take a position on 

plans. No, I take my hat off to you. You have been—as Cato has 

been—very clear for decades. You want to replace Social Security 

with a private system, or whatever you call it. Well, I will quote 

back what you said and what Cato has said. Let me just emphasize 

this issue of borrowing, because you said in your testimony—I will 

just ask one question of Ms. James, Dr. James, excuse me. If we 

in the United States want to use—this is on page four. If we want 

to use pension reform as a way to increase national savings, we either must use an add-on or we must come up with a plan for transition finance that does not depend heavily on enlarging the public 

debt. The President’s proposal, in addition to all of its other ramifications, involves massive debt, which it said in some cases, including Mr. Shaw’s comments, over decades would be offset. We 

just are not willing, and most Members have not been willing to 

accept more massive debt on top of the trillions we already have, 

with the belief that 40, 50 years from now that that massive debt 

will be counteracted. So, I think this hearing is serving a useful 

purpose, and to the Chairman, as soon as we have an acknowledgment that private savings are not a condition for a discussion of 

the shortfall, we will sit down, that you say we will take it off the 

table. 

Chairman MCCRERY. Say that again? 

Mr. LEVIN. That we will take it off the table? 

Chairman MCCRERY. Before that. 

Mr. LEVIN. We will sit down. 

Chairman MCCRERY. Before that. 

Mr. LEVIN. What we are saying is the President has made it a 

condition that there be privatization, a diversion of Social Security 

moneys. We are not willing to accept that as a basis for negotiation. 

Chairman MCCRERY. Okay. Once again, that is the President’s 

proposal to divert money from the trust fund and to finance it with 

debt. Once again, the President may propose all he likes. It is up 

to the Congress to dispose of those recommendations. If you would 

like to sit down, along with some of your colleagues, and discuss 

alternative ways to finance personal accounts so that we may prefund some of these obligations we know we have in the Social Security system, I am perfectly willing to do that, as, I believe, are 

other Republicans in Congress. 

Mr. LEVIN. Is it your understanding that either diversion of Social Security moneys or borrowing would be part of your proposal? 

80 

Chairman MCCRERY. We wouldn’t go in with that understanding, but we could go in certainly putting that on the table, 

and discussing it and seeing what we can come up with. 

Mr. LEVIN. That is the status quo, that the—it is that that has 

been the barrier, Mr. Chairman, and that the President take the 

barrier away. 

Chairman MCCRERY. Well, let us take the barrier away. 

Mr. LEVIN. Well, you take it away. 

Chairman MCCRERY. I have—— 

Mr. LEVIN. Well, you haven’t taken it away. 

Chairman MCCRERY. We will try. 

Mr. LEVIN. Take it away and we will go. 

Chairman MCCRERY. In plain words, it is gone. You and I can 

sit down and start from scratch and try to construct something 

that makes enough sense to enough of us so that we can pass 

something to do something very good for future generations of 

Americans as well as current generations. 

Mr. LEVIN. Well, I think the Democratic Party—and I will finish—we have always favored strengthening Social Security. 

Chairman MCCRERY. You have. 

Mr. LEVIN. As long as the premise is—as it was in 1983— 

strengthening it, not replacing it, if that is the clear understanding, 

we can sit down. That has not been the proposal either of the 

President or from your party. 

Chairman MCCRERY. Well, I appreciate very much your offer to 

sit down, and I will look forward to taking you up on that. Mr. 

Shaw. 

Mr. SHAW. Thank you, Mr. Chairman. I can’t help but wonder 

what some of these folks from across the pond must be thinking 

about, some of the things we are hearing here today. 

Mr. LEVIN. They hear more in the House of Commons. 

Mr. SHAW. We see it sometimes on C-SPAN, so, we are doing 

this to sort of make you feel at home, I guess. I would like to— 

I have to use some of my time to set the record straight. I do not 

know of one single time the President of the United States has put 

as a condition to sitting down with Democrats that they have to 

agree with his plan or they have to agree with individual accounts. 

I do know—and you heard it here today—that the Democratic leader on the Subcommittee on Social Security said that it is—that the 

President put his plan aside as a condition to sit down and negotiate, yet he has no plan to bring to the table. How can you negotiate with somebody who has no plan? That doesn’t make any sense 

to me. I think the President—and the President has made it very, 

very clear to this Congress—that he is welcoming all ideas to save 

Social Security. He has one idea. Quite frankly, my idea is different 

than his. I put mine on the table, and I made him very much 

aware of it. The reason that I support individual accounts, I don’t 

know any other way out of this box. Mr. Whitehouse, you said that 

401(k)s were bringing in an average of 9.5 percent; is that correct? 

Mr. WHITEHOUSE. That is the Employee Benefits Research Institute—Investment Company Institute surveys of 401(k)s, the 

largest survey, they have average contribution, both employee and 

employer, comes to 9.5 percent. 

81 

Mr. SHAW. Do you think it is reasonable then to assume that 

individual accounts might well throw off the same percentage? 

Mr. WHITEHOUSE. You mean that people would voluntarily 

contribute more than the amount diverted into them. 

Mr. SHAW. I am sorry? 

Mr. WHITEHOUSE. That people would make additional voluntary contributions to the account. 

Mr. SHAW. Is the rate of return 9.5 percent? 

Mr. WHITEHOUSE. No, no, no, that is the contribution rate. 

Mr. SHAW. Oh, I am sorry. 

Mr. WHITEHOUSE. That is the amount of earnings that people 

put in. 

Mr. SHAW. What is the rate of return? That is the important figure that we are talking about. 

Mr. WHITEHOUSE. I would say that over time that the real 

rate of return on pension funds in the United States is probably 

about 4 or 5 percent, real, over a very long period. I don’t have the 

exact numbers, but that would be my guess. 

Mr. SHAW. So, we should probably assume that would be the return we will get on the individual accounts? 

Dr. BAKER. Actually not—— 

Mr. SHAW. I didn’t ask you. If I could—listen I have already 

heard you talk. I know you are an economist, but your assumptions 

are really over the top. Mr. Whitehouse. 

Mr. LEVIN. He is in trouble with the panel. 

Mr. WHITEHOUSE. I wouldn’t like to make an over-the-top assumption and forecast the future. I am not very comfortable with 

that. In our work at the OECD we tend to assume a 3.5 percent 

real rate of return on private funded pensions, which I think is a 

reasonable, conservative sum. 

Mr. SHAW. What is the mix on that? I know that the actuaries 

at Social Security are—I believe that they have come in with over 

5 percent assumed return, and I think that is with about 25 points 

being paid out. 

Mr. WHITEHOUSE. I think Dr. James here, who was on the 

Commission—— 

Dr. JAMES. We used, with a 50/50 portfolio, we used a 4.6 percent net return. I am assuming that the administrative costs would 

be 30 basis points, that was 4.9 percent minus 0.3, so, it came to 

4.6. That is for 50/50 portfolio. Of course, it depends on what portfolio you assume, as you know, and what you assume about the future. 

Mr. SHAW. All right. Mr. Vasquez, you testified on the Chile 

plan. As part of your testimony, you were talking about some 30 

to 40 percent of the workers are self-employed and do not have to 

pay into any type of an account. What percentage of the workers 

who have employers and are not self-employed, what percentage of 

them opt to go into the personal account? 

Mr. VASQUEZ. Most of the workers are in the personal accounts. 

The issue is the level of contributions, and though self-employed 

have the option of affiliating with the private pension system, most 

of them do. They are not obligated to contribute, and that is why 

you see within the labor force—why 30 percent of the labor force, 

which is self-employed, is not regularly contributing. They are putVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00085 Fmt 6633 Sfmt 6602 E:\HR\OC\23925.XXX 23925
82 

ting their money into other types of investments, like their own 

businesses and that kind of thing. So, you see an increase in the 

rate of coverage of the work force from the time that the reform 

began, and it is now higher than it was before the reform happened 

under the old system. The World Bank just published a study this 

year that found since the reform was introduced, the contribution 

rates of people who were entering the work force after 1981 have 

increased significantly compared to prior to the reform. 

Mr. SHAW. So, what Dr. Baker said, that people are voting with 

their feet and leaving these plans is simply not true? 

Mr. VASQUEZ. No, I totally disagree with that. He used the 

measure of minimum pensions as some sort of an example—today 

there are about 65,000 minimum pensions that are being paid by 

the government. Let us remember that when you talk about a minimum pension, the government is not paying the entire minimum 

pension. It is topping up what the people who have accumulated 

money can’t make up. So, it ends up paying maybe 20 or 30 percent 

of that. That represents about 12 percent of the actual pensions 

that the system is paying. The vast majority of people who are in 

the system getting pensions are, if you want to talk about it as voting with their feet, voting in favor of the private sector. 

Chairman MCCRERY. Thank you. 

Mr. SHAW. Thank you. 

Chairman MCCRERY. Thank you, Mr. Shaw. Mr. Neal. 

Mr. NEAL. Thank you very much, Mr. Chairman. I also want to 

thank Chairman McCrery for not only the talent and caliber of the 

witnesses, but for the opportunity to address the witnesses. I wish 

that happened more often in the full Committee, but I think you 

have really done a good job with the Subcommittee. I am also 

pleased that he acknowledged a certain reality today when he said 

that the Social Security surplus is being used to fund a lot of surplus government expenditures. He mentioned defense and he mentioned a number of other things, but there is also another reality. 

It was used to fund the tax cuts, $2 trillion worth of tax cuts, over 

the next 10 years, and then to say there is a problem in the Social 

Security Trust Fund? After we ripped $2 trillion out? 

One of the problems of the modern Congress here is this is the 

Stepford Congress. This Congress has abrogated its authority. We 

don’t ask questions about Iraq, we don’t ask questions about 

changed policy numbers in terms of the Medicare debate and prescription drugs. We don’t ask questions about people who edit reports on global warning. Nobody is dragged before this Congress to 

ask a question. Even in the European system or the British system 

members get up—Prime Minister Blair’s own party, they resign, 

they go at it with him. Pretty good. That never happens in this 

Congress. 

To argue that the President doesn’t dictate what the majority 

party in Congress does is disingenuous. Whatever he says with this 

Congress, majority, it goes, and everybody knows it. They speak 

with one voice on everything, and you can see the disarray in Iraq 

and across the world now because of it. The job of Congress is to 

ask occasionally, just occasionally, maybe a few questions about 

policy. Let me ask and make a couple of points. The witnesses 

today have extolled the virtues of privatization. You have advoVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00086 Fmt 6633 Sfmt 6602 E:\HR\OC\23925.XXX 23925
83 

cated that the U.S. adopt this approach. At the same time we have 

heard some pretty glaring facts. There have been, quote, mis-selling scandals in the UK. Administrative costs have skyrocketed, eating away at people’s benefits in many of these countries. When 

given the option—I want to come back to you, Mr. John, because 

you raised a good point about the mis-selling issue. For those of us 

like Mr. McCrery, Mr. Levin, and Mr. Shaw who were here during 

the Savings and Loan debacle, we know that part of the problem 

was that people who weren’t qualified to get into that business got 

into that business, and that is something we should be mindful of. 

We have also heard that when given the option large numbers 

of workers don’t participate in the savings programs in the UK, 

and in Chile. We have also heard that price indexes eroded the 

value of benefits quite significantly. I think that as we focus on the 

benefits of the proposals that have been offered today, it is also fair 

to focus on some of the weaknesses. The idea is not necessarily to 

strengthen capital markets, the idea is to provide security in retirement. We have not heard either of the witnesses speak to the notion of disability. We haven’t heard the witnesses speak to the 

question of survivors’ benefits, what happens to widows, what happens to children. Maybe we could hear from the witnesses—Dr. 

James you are nodding your head, would you speak to that, please? 

Dr. JAMES. Yes, I was actually just in Chile to study disability 

and survivors’ benefits. I was there for two weeks. In fact, that is 

been an under-studied topic. If you like, I can tell you what their 

system is. It is a novel system. I don’t know if you would like to 

hear the details about that. Basically, they use the individual accounts and turn it into a DB. They guarantee that a disabled person will get 70 percent of his last 5 years average earning. From 

the point of view of the recipient, it is actually a DB, but it is a 

DB that uses the money in the accounts. The pension fund is required to buy a group insurance policy that will top up the account 

enough to purchase an annuity of that value, and, because it uses 

the money in the accounts, it costs quite a bit less than most other 

countries. It costs about 1 percent of earnings per year. 

Mr. NEAL. What about survivors’ benefit? 

Dr. JAMES. Same for survivors, it is part of the same program. 

I haven’t completely analyzed it yet, but that is the basic system. 

Mr. NEAL. I know that—— 

Dr. JAMES. It is something we need to talk about. 

Mr. NEAL. My time is running out. If I could go back to Dr. 

Baker here. Many of the witnesses have focused on lessons we 

could draw from countries that have had some problems with private accounts. They have also extolled those virtues, as I indicated 

a moment ago. What are the best lessons for us to learn, you think, 

as we get down the road in the Social Security debate. I meant 

what I said about Mr. McCrery in terms of the witnesses. He really 

has done a good job with these panels. 

Dr. BAKER. Well, just to repeat a couple of points. First off, 

there is no way to escape the risk that we are replacing a system 

of guaranteed benefit with risk. I know it is actually the intention 

of many people to cut benefits, and use the privatization as a way 

to cut benefits. So, you have had the problem in England where 

you are facing a situation where future generations of retirees will 

84 

have much lower benefits, at least relative to their wage income, 

than current generations. Thirdly, there is a lot of illusion here 

about rates of return. In Chile you had very high rates of return 

in the eighties primarily because their main asset, Chilean government bonds, paid very high interest. That is in one pocket, and out 

the other pocket. 

At the risk of disagreeing with Representative Shaw, I raised 

this issue of stock returns to all the economists in the debate, and 

I have asked a very simple question. If you think you will get very 

high return on stocks, give two numbers—we call it the No Economist Left Behind Test—the return on dividends and capital gains. 

That is the only way we get money from stocks that add to your 

assumption on returns, 6.5, 7 percent. Steve Goss, Chief Actuary 

at the Social Security Administration (SSA), said yes, you could get 

that if price/earnings ratios first fell by one-fifth. The fact is, no 

economist can support those numbers. I might be wacky here, but 

I stand by my arithmetic. 

Mr. NEAL. Finally I would say, Mr. Chairman, that President 

Bush did indicate that his proposal for Social Security—and he 

spent a lot of time traveling this country for a guy who doesn’t 

have a proposal—would include lower benefits. Thank you, Mr. 

Chairman. 

Chairman MCCRERY. Thank you, Mr. Neal. Mr. Lewis. 

Mr. LEWIS. Thank you, Mr. Chairman. Ms. Bovbjerg, I just 

want to get some respect here on the problem. Just recently, David 

Walker testified before our Committee. I am going back to this. I 

think I brought this up the last time you were here, that in about 

the year 2020, the revenue coming into the Treasury will only 

cover entitlements and interest on the Federal debt. There will be 

nothing left in discretionary spending. By 2040, the revenue line 

just comes in a little bit above interest on the debt. There is nothing for the entitlements, nothing for Medicare, Medicaid, Social Security. We keep hearing that Social Security will—the benefits will 

have to be cut by 23 percent, but looking at that revenue line by 

2040, there will be no Social Security, there will be no Medicare, 

there will be no Medicaid. There will only be revenue enough for 

interest on the debt. Is that chart accurate that you provided for 

us? 

Ms. BOVBJERG. It is our simulation, and it is based on presuming that everything pretty much stays the same in the outyears. We use the SSA and Congressional Budget Office (CBO) assumptions. We also assume that discretionary spending would grow 

with the economy. We assume that the tax provisions would not expire in that particular scenario. It presumes essentially that you 

are going to make up the difference with debt, and I know that Mr. 

Walker has spoken a number of times before the full Committee 

about the economic dangers of continuing on that course. 

Mr. LEWIS. When the fact is that the average family is paying 

basically 40 percent of their income in local, State, and Federal 

taxes, how much higher would the taxes have to be to cover all of 

our unfunded liabilities and debt? 

Ms. BOVBJERG. Oh, it would have to really be tremendous. I 

think that one of the things I remember the last time I was here 

is you asked me about a $45 trillion number. 

85 

Mr. LEWIS. Yes. 

Ms. BOVBJERG. I decided, since I wasn’t completely sure what 

was in that, I wouldn’t comment on that. I looked at that number, 

and that is really kind of mashing together all the obligations, the 

things that we think are going to be coming up with in the future. 

It is arguable whether that is—that is not a budget number, that 

is not a CBO number. 

Mr. LEWIS. Right. 

Ms. BOVBJERG. It would really represent a significant draw on 

our economy. One of the things I was thinking about in terms of 

how you finance certain things is that we don’t have a lot of slack. 

Mr. LEWIS. Right. 

Ms. BOVBJERG. To finance more things with debt. Just remember, we haven’t decided yet how we are going to deal with the 

health care problem. 

Mr. LEWIS. Exactly. If we were just dealing with Social Security, maybe we could increase taxes to deal with that, but when 

you are dealing with the other entitlements. This is a lot bigger 

problem that just saying, well, we can increase taxes. That burden 

would—when you are looking at a number that is four times the 

size of the American economy, my goodness, 50 years ago or more 

the government started on a path of a charge account to pay for 

retirement and health care in this country. If you look at Social Security and then the Great Society and all of the programs, it is basically a charge account on coming generations, and you don’t have 

the assets to back it up with. It is going to be a crushing situation 

if we do don’t do something, and I think Social Security is the easiest problem to fix. That is all. Thank you. 

Chairman MCCRERY. Thank you, Mr. Lewis. Mr. Pomeroy. 

Mr. POMEROY. Thank you, Mr. Chairman. I do want to sincerely indicate my appreciation to this panel like the other ones 

that you have had. I think that you have displayed constructive 

leadership in your discussion of issues. I meant no disrespect. Let 

me just—first of all, let me set the stage. Ms. Bovbjerg, if I get the 

essence of your testimony, it is that we can learn from one another 

across the community of nations, but in the end we each have our 

own idiosyncratic issues, and we need to tailor our plans to reflect 

individual circumstances ranging from national values to state of 

the economy. Would that be correct? 

Ms. BOVBJERG. Absolutely. 

Mr. POMEROY. Let me move to a line that strikes me from your 

testimony, Ms. Coronado. I found the discussion of the Swedish 

plan to be interesting, but on pages four and five, you discuss the 

way adaptations have been made relative to the increasing life 

expectancies of populations, bottom of page four, top of page 5: 

‘‘Upon retirement, the annuity rate will depend on expected survival probabilities for each cohort so that the beneficiaries bear the 

risk of future improvements in life expectancy through lower replacement rates, although the government continues to bear the 

risk for changes in immortality after retirement or you retire. If 

your group is living longer, your rate, your pension, is going to go 

down relative to the income replacement rate.’’ 

Then you say that the reform transfers much of the economic 

and demographic uncertainties directly into benefit levels, leaving 

86 

the financing of the system generally quite robust to changing economic circumstances. This is a case to me of us fixing the macro 

problem and ignoring the micro problem, the micro problem being 

the circumstances of an individual’s finances. Let me just reflect 

upon changing the—transferring the economic and demographic 

uncertainties directly into benefit levels. We have talked a bit 

about longevity risk and longevity indexing. I think we will talk 

about it some more. It is a very interesting concept that I have 

some very serious concerns about, depending on how you address 

it. One way I wouldn’t want to address it is one that reduces benefits because people are living longer, because as people are living 

longer you are going to have more years in retirement to have to 

deal with elevating costs. I think you made an honest statement 

there, but I don’t think we want that to be a guiding principle of 

ours. I think we want to, in the end, come up with a reform proposal that holds micro right at the forefront of what we are trying 

to do, because we don’t want to have people—— 

Ms. CORONADO. Keep in mind—— 

Mr. POMEROY. We don’t want to have a healthy system on the 

one hand, and people that are old and broke on the other. So, we 

have to figure that out. In the next paragraph you talk about how 

they have structured this in a way that also encourages work while 

people can work, and moves them into interesting notions of 

phased retirement that we could probably learn from. 

Ms. CORONADO. Right. 

Mr. POMEROY. The core is how do we protect an adequate benefit over the long-term. Frankly, I have some concerns about this. 

Chilean statistics that have concerned me, Mr. Vasquez, are that 

women, especially older women, are disproportionately falling on 

the minimum guaranteed rate. Their earning power is less for accumulated and private accounts. Then, their years of receiving payment are longer. So, if you are—something like 65 percent of 

women, depending on the minimum State pension—I am raising a 

concern of where that replacement rate is. What is the replacement 

rate? What is the minimum rate in terms of a dollar and a cent 

per month? 

Mr. VASQUEZ. Currently it is about $120 or so. 

Mr. POMEROY. It is $120 a month. Sixty-five percent of women 

are depending on that minimum rate? 

Mr. VASQUEZ. This is an improvement. 

Mr. POMEROY. It may be an improvement, but it is no guiding 

light for the United States to aspire to for this kind of $120 minimum payment for elderly women. 

Mr. VASQUEZ. Chile is much poorer—— 

Mr. POMEROY. Let me just ask you something across the panel. 

I will start with Dr. Baker. My time is so short. I don’t mean to 

unfairly cut you off. I got what I was asking for with that question. 

It seems to me that longevity risk—the heart of providing a pension program that works over the long haul—entails keeping people 

in a pool so that we have a mix of life expectancies, and so that 

those that are dying earlier, in the end, are not drawing upon the 

system nearly to the extent of someone who lives long, so, you have 

a cross subsidy. You operate a risk pool, a longevity risk pool. 

87 

Now, I do not understand how you run a private account for everybody. We are not in a pool any more. I got mine, you got yours, 

we are all individual, and you have that kind of risk sharing on 

longevity risk. So, I think one of the reasons we are so opposed to 

the private account going in is it is antithetical, in my opinion, to 

making sure that people have adequate benefits in their old age. 

Especially in times of increased life expectancy. That is terribly 

problematic. Mr. Chairman, I don’t know if you want to allow me 

time to go across the panel, but I am done talking and I would like 

a response to that question. 

Chairman MCCRERY. Sure. If anyone would like to respond. 

Dr. JAMES. If I could answer your question about the Chilean 

minimum benefit. It is 25 percent of the average wage. You have 

to take into account the average wage in the country. For someone 

over the age of 75, it is actually 28 percent of the average wage. 

We don’t have a minimum benefit like that in our own country currently. 

Mr. WHITEHOUSE. This is around 19 percent worth of average 

earnings. So, the minimum safety net level for all people in the 

United States is below—— 

Mr. POMEROY. I would hope we could do better than 25 percent 

replacement rate in terms of longevity risk protection. Let us get 

to that question. Dr. Baker. 

Chairman MCCRERY. Wait. 

Mr. POMEROY. Okay. Across the panel. 

Chairman MCCRERY. Across the panel. 

Mr. POMEROY. Longevity risk protection. 

Ms. CORONADO. May I say something? 

Mr. POMEROY. Longevity risk protection in private accounts. 

How do these two interact? 

Dr. JAMES. People buy annuities. At the point they buy the annuities the longevity risk is pooled, and the vast majority of people 

in Chile buy annuities. 

Mr. POMEROY. Private insurance, not social insurance. 

Dr. JAMES. It is through the private annuity market. They get 

back—studies of what they get back indicate they get back their 

full premium when you discount at the risk-free rate. It is privately 

provided, but it is a pretty good deal. It is price indexed. 

Mr. WHITEHOUSE. Sweden is not alone in having these longevity adjustments. Germany just introduced one. You have the 

same sorts of things in Italy and Poland. The idea is that the benefit will fall as life expectancy increases. I think the designers of 

the system hope that people will, as a result work longer, and so, 

they will retire later in these programs. As life expectancy increases they will work longer, and get the same benefit. 

Mr. POMEROY. To offset the falling benefit by working longer. 

Mr. WHITEHOUSE. Absolutely, that is the incentive. 

Ms. CORONADO. That is the incentive of the system. In Sweden, it is still the government that is sole provider of the annuities. 

It isn’t even going to the market to deal with load factors. The government is providing the annuity. It is very low cost, therefore, and 

you are pooling risk across the entire population, it is just that you 

are doing it on a cohort-by-cohort basis. So that as trends continue, 

and we don’t know whether people are living longer and longer or 

88 

whether that will sort of ameliorate a bit. Somebody has to pay for 

that. 

Mr. POMEROY. We are all victims of the notch baby issue. I 

think that cohort-by-cohort would raise some interesting political 

issues here. 

Mr. VASQUEZ. I would just emphasize that the minimum pension in Chile is greater as a share of the average wage than it is 

here, in the United States. Also, that studies have shown that 

women are doing much better now under the new system than they 

were under the previous system. 

Mr. POMEROY. Chile, old Chile to new Chile. 

Chairman MCCRERY. Any other members of the panel want to 

make a brief comment? 

Mr. HARRIS. I would just make a comment with regard to Australia, Congressman. There is a bedrock that all Australians will 

get, that is 26 percent of male total average weekly earnings, if 

they need it. Now I probably won’t need it when I retire, hopefully 

I have saved enough through thrift so that that safety net will not 

come into operation due to the income and assets test. I think it 

is important to share with you that it was the trade unionists and 

social Democrats in Australia who said you have to give the individual the ability to save, and that is important in an IRA-oriented 

system. 

Chairman MCCRERY. Final word, Dr. Baker. 

Dr. BAKER. On the question of annuities. If you allow people to 

opt out, as President Bush proposed, invariably, adverse selection 

occurs, which reduces benefit by 10 percent. Also, in the Chilean 

system, many workers don’t work enough to get the benefits. So, 

to compare apples to apples, that would be conservatively less than 

25 percent for those who don’t get the minimum benefit. 

Chairman MCCRERY. Mr. John, very briefly. 

Mr. JOHN. Very brief. I would just like to point out that my 19- 

year-old daughter is guaranteed to lose about 28 percent of her Social Security benefits due to the fact that she will retire 10 years 

after the U.S. trust fund expires, and that is not exactly risk free. 

Chairman MCCRERY. Mr. Ryan. 

Mr. RYAN. All right. Thank you. Two questions, but first I just 

want to make an observation based upon what we have been talking about here. There is one area where I think all of us have 

reached consensus, both sides of the aisle. It is a statement I hear 

politicians from left and the right making. That is, whatever we do, 

we are not going to change benefits for people over the age of 55. 

I think that is the number we use these days, those who are in or 

near retirement. We have all come up with the notion that we are 

going to figure out a way to make sure that those benefits are 

locked in, guaranteed, dependable for people aged 55 and above. 

That leads us to the rest of us, the rest of the country. Mr. Harris, 

you called yourself a Gen-Xer, what is a Gen-Xer? I don’t know 

where that age break is. 

Ms. CORONADO. It is 1964. 

Mr. HARRIS. Those born between 1964 and1972. 

Mr. RYAN. Thank you. I didn’t even know that. So, I am a GenXer then. 

Mr. HARRIS. You’re welcome. 

89 

Mr. RYAN. My generation is expected, at best, to get a 1-percent 

rate of return on our payroll taxes when we retire. Now, when I 

retire, we may or may not have the money to pay our benefits. My 

three children are expected at best to get a negative 1-percent rate 

of return on their payroll taxes. When 80 percent of the American 

people pay more in payroll taxes than they pay in income taxes, 

this is a big deal. We should be asking ourselves, can’t we do better 

for our money? When we hear from the other side, take off the 

table any idea of pre-funding your retirement, of utilizing capital 

markets to get ahead, and then we will talk, that just sounds ridiculous to me, especially when we are not even bringing another alternative to the table. It is basically saying we will either raise 

taxes or cut benefits to fix this problem. 

That means that negative 1 percent rate of return that my kids are getting, and we are $4 trillion short of paying them their benefits, is going to go less than negative 1 percent rate of return. You 

are telling my generation that the 1 percent rate of return I hope 

to get, future generations will get less than that. To me that is not 

fair. We should talk about how to make this system not just fair 

today, but fair for all generations. That is a point I want to make 

that is lost in this room every time we have these hearings. Now, 

Dr. Baker, I had a couple of questions I want to ask you. First, I 

went through your testimony here. You make some interesting 

points. You argue that Social Security’s financing shortfalls are exaggerated and the system is in far better shape than most perceive, 

it is not a crisis. Am I paraphrasing fairly accurately? 

Dr. BAKER. I don’t think that is my testimony, but I will stand 

by the statement. 

Mr. RYAN. I read it in one of your papers here. Then you argue 

that the slower economic growth projected by the Social Security 

trustees implies lower returns in market investments like stocks 

and bonds. In your paper, which I have here in your binder, you 

argue that a 4.6 rate of real return on stocks is consistent with the 

trustees’ economic growth projections, which is a lot lower than 

their 6.5-percent growth projections by the SSA actuaries; therefore, you argue that personal accounts wouldn’t be a very good 

deal. 

That is a very interesting point, but I am not sure they are consistent with one another, because you also argue in your paper that 

as stock returns fall, so do bond returns. I think you say that bond 

returns would go from 3 percent to about 2.1 percent. If bond returns are low, then a couple of things have to happen. First, personal accounts invested in stocks wouldn’t be such a bad deal after 

all, because what matters most is premiums paid to stocks over 

bonds. Second, any debt incurred in transition financing would 

have a lower interest rate and, therefore, bear a lower cost. Third, 

a lower bond rate in this country would mean that the current system’s deficits would be much bigger than we are currently projecting. The 75 year actuarial deficit would grow about 30 percent, 

and the infinite rise in deficit we had calculated would about double if you go to a 2.1 percent bond rate. 

It seems to me if we accept your argument regarding economic 

growth and investment returns, then personal accounts are still a 

good deal; relatively speaking, transitional costs are more affordVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00093 Fmt 6633 Sfmt 6602 E:\HR\OC\23925.XXX 23925
90 

able and the current system’s problems become much, much larger 

than we are now calculating them to be. 

Dr. BAKER. Well, let me point out a couple of things. First, in 

terms of calculating the current system’s problems, people like to 

put this in a way to make it very dramatic and scare people. Very 

frankly, I don’t think there is anybody in this room, probably anybody in the country, that really has a very good sense of numbers 

like a $4 trillion deficit or $11 trillion over an infinite horizon, or 

the $44 trillion number we heard here. I like to express things as 

a share of GDP. Now, if you use a lower discount rate, GDP rises 

as well, so that $44 trillion we expect as the share of future income 

would be about 6 percent. You would still end up with about 6 percent, as a share of future income. Now, you get a more dramatic 

number in terms of trillions if you use a lower discount rate, but 

that doesn’t change the nature of the economic problem. 

In terms of how individual accounts stack up if you have a lower 

return on stocks and also a lower return to bonds, I am very skeptical of what sort of return you will have on bonds and what sort 

of return you will have on stocks, but again, given the gross assumption of the trustees—those are not my assumptions, they are 

their assumptions—the return we could expect on stocks is about 

4.5 percent. I am more agnostic on bonds. I coauthored that paper; 

I will just say that. I am, for the moment, willing to say 3 percent, 

but if you want 2.1 percent, fair enough. The point is, that gaps 

about 2.4 percentage points. The gap that is currently assumed by 

the CBO and by the actuaries in analyzing individual accounts, is 

on the order of 3.5 to 4 percentage points. If your gap is just 2.5 

percentage points, 2.4 percentage points, you assume that 50-50 

mix, whatever mix you want, and then you would assume administrative costs. Therefore, you are ending up with a very small premium. 

Mr. RYAN. It sounds like a self-defeating argument if you are 

saying the trend is that bonds will be lower, then transition costs 

are lower, returns are better for stocks relative to bonds, but more 

importantly, our projected problems get higher. Let’s just say it 

is—2.1 percent from 3 percent. It doesn’t seem like a big difference, 

but that doubles the infinite-horizon forecast and adds 30 percent 

to the 75-year window. 

Mr. BAKER. It also doubles our income, those horizons do. So, 

it is proportional. The share of our income doesn’t change. That 

would be the relevant measure. 

Mr. RYAN. You are saying the notion that we should measure 

Social Security’s finances in and of itself is a notion we shouldn’t 

use? 

Mr. BAKER. Well, it is not terribly meaningful. Again, it is relative to our income. If Botswana had a debt of a trillion dollars, 

it is devastating. Us having a debt of—— 

Mr. RYAN. Do you think it is meaningful that DB plans are 

measured, in and of themselves, as to their health and financial 

safety and security? 

Mr. BAKER. They aren’t measured in and of themselves. They 

are measured relative to their future contributions. 

91 

Mr. RYAN. So, with reference to Bethlehem Steel’s DB plan, it 

is irrelevant whether we measure that one on its own or in the context of the broader economy? 

Mr. BAKER. No. I am saying it is measured relative to its contributions. If you expected more money coming in, then whatever 

liabilities it had today would be of less consequence. 

Mr. RYAN. Anyone else wish to comment on that? I think I still 

have a second. I can’t see from here, but administrative costs— 

again, I am using that excuse. 

Mr. LEVIN. One advantage of being a senior Member. 

Mr. RYAN. That is why Mr. Rangel chooses to sit down here, because he can’t see the light. 

Chairman MCCRERY. You are two and a half minutes over, Mr. 

Ryan. 

Mr. RYAN. I am hopeful we will have a second run. I want to 

ask you about administrative costs. Literally, I want to understand 

how you come up with $75 million per year administrative costs. 

Chairman MCCRERY. You can be thinking about that as we go 

to the next Member. Ms. Tubbs Jones. 

Ms. TUBBS JONES. Thank you, Mr. Chairman, and thank you, 

ladies and gentlemen, for coming this morning, now this afternoon. 

Mr. Ryan and I are in the same class. Fortunately, I am 55, and 

so, supposedly I am guaranteed a benefit. I am not confident that 

I am guaranteed a benefit if, in fact, we decide to go to individual 

accounts. I couldn’t sit here—Mr. Ryan, you are my good friend and 

colleague. What was ridiculous in my mind was the tax cut for the 

top 1 percent, which put us in a situation where we could not fund 

many of the programs that the people in the country are relying 

on, like education. 

Mr. RYAN. Would my friend from Ohio yield for a second, 

ma’am? 

Ms. TUBBS JONES. Absolutely not. So, seeing how you thought 

it was ridiculous, I just wanted to put something that I thought 

was ridiculous on the record. Let me, first of all, ask each one of 

you, what is happening with health care for seniors in the countries? I am going to leave you out, since you have been with us so 

many times already, Ms. Bovbjerg. 

Ms. BOVBJERG. I am not much offended. 

Ms. TUBBS JONES. Dr. James, what is happening with health 

care in the country that you looked at? 

Dr. JAMES. Well, I looked at the world. 

Ms. TUBBS JONES. You testified today—I don’t have but 5 minutes, so, you can’t tell me about the world. 

Dr. JAMES. Every country—if you are asking about health care 

costs, every country faces the problem of high and rising health 

care costs. There is a wide variety of solutions and—— 

Ms. TUBBS JONES. For example, our seniors right now are 

faced with a significant problem of having to pay a lot of money 

for prescription drugs. Many of our seniors are using more, or 

most, of their Social Security benefit to pay for their prescription 

drug benefit. I am just curious about what is happening around the 

world, because as we talk about retirement security, the lack of 

health care for the seniors that are in retirement is a significant 

92 

issue. If we will just go down the line—again, I don’t have but 5 

minutes and can see the light, so, I have to be guided by the light. 

Dr. JAMES. Let me just say that health care is much more complicated than Social Security, as I am sure you know. 

Ms. TUBBS JONES. Mr. Whitehouse. 

Mr. WHITEHOUSE. I will answer about the UK, as that is 

where I am from, even though I do live in France now. 

Ms. TUBBS JONES. I should say, Bon jour, comment allez-vous? 

Mr. WHITEHOUSE. Merci, tres bien. We are very wedded— 

great political consensus on that—to our system of the National 

Health Service, which many Americans describe as socialized medicine. We are very happy with that because it is a system which delivers a pretty reasonable level of health care. It is not that wonderful, but it gives a pretty reasonable level of health care, and it 

is extraordinarily cheap. We are probably spending, possibly half of 

the percentage of GDP on health care. 

Ms. TUBBS JONES. Do you buy prescription drugs in bulk? 

Mr. WHITEHOUSE. We have a very complicated pharmaceutical 

pricing regulation system. For seniors, prescription drugs are free, 

as they are in France, as well. 

Ms. TUBBS JONES. Ms. Coronado, before I go to your answer 

on health care, I read with interest a paragraph on page three of 

your statement. It says, ‘‘The first of these problems associated 

with the fact that benefits in Sweden were indexed to prices rather 

than wages. The result of price indexing was volatility of replacement rates through economic cycles when wages grew either more 

slowly or more rapidly than prices.’’ You go on to say, ‘‘It is worth 

noting that current proposals for price indexing benefits in the 

United States would also likely result in volatility in replacement 

rates and lead the system toward a flat benefit structure.’’ Expand 

on that for me for a moment, if you would. 

Ms. CORONADO. The pressures that these systems face require 

either raising taxes or cutting benefits, and price indexing is proposed as a way of phasing in basically a reduction in replacement 

rates over time. It is associated because, ultimately what we are 

worried about in retirement is replacing a certain fraction of preretirement income and maintaining a standard of living. Price indexing has some problematic characteristics when you are trying to 

achieve that. 

Ms. TUBBS JONES. Do you suppose that is why now the administration has created this new term called progressive. 

Ms. CORONADO. Progressive price indexing just basically puts 

a floor on that, but you are still going to have the same problems 

in the middle and upper tiers when the real value of benefits is basically going to be declining over time as a way of achieving balance. 

Ms. TUBBS JONES. Let me ask Mr. Vasquez about health care. 

Mr. VASQUEZ. Well, I don’t pretend to be an expert on health 

care. In Chile, I can only say that, to the extent that people who 

are retiring today in Chile are better off, they are going to be able 

to deal with their health care needs in a better way. The whole discussion about health care is something much more—— 

93 

Ms. TUBBS JONES. Do you know whether or not people pay for 

their own health care? Is there a Medicare kind of program? Prescription drugs? 

Mr. VASQUEZ. Yes, but I don’t pretend to be an expert on that. 

There was some limited reform, where people contribute their own 

money to a private account. Again, that was a reform that was far 

more limited than the pension reform. 

Ms. TUBBS JONES. Mr. Harris, I would love to ask you and Dr. 

Baker and Mr. John, but I am out of time. Maybe somebody else 

will ask the same questions. I thank you all of you for your responses and your presentations today. Thank you, Mr. Chairman. 

Chairman MCCRERY. Thank you, Ms. Tubbs Jones. I would advise all Members that assuming we don’t have—we are not interrupted by votes—I will allow a second round of questioning if anybody has any other questions and our panelists are agreeable to 

staying. Mr. Brady. 

Mr. BRADY. Thank you, Mr. Chairman. I think this hearing has 

been really helpful from the standpoint of your goals to try to build 

an educational base. As we tackle this problem, learning from other 

countries, the consequences of ignoring a growing retirement mass 

and some of the impacts of the decisions that are made to address 

the retirement, I think is very helpful. I am going to spare the 

panel a question, from the standpoint of, we are fortunate, as we 

look at solvency and sustainability, and can we grow the money in 

the United States—we are fortunate that we can also look at some 

proven models right in our own communities and neighborhoods. 

The Galveston plan, for example, has been in existence a quarter 

of a century. They invest only in interest-bearing accounts, and 

throughout that quarter of a century had an average return of 

about 6.5 percent. The TSP that many of us are putting our precious payroll dollars into over the years has averaged a 7.5 percent 

return. Our Texas teachers, which is a very large group—that plan 

has operated now over half a century, and the average return here 

is, in the last decade, about 10 percent—even through Enron, even 

through the recession in the dot-com bust a good, solid return. 

When I talk to average people in those plans, and I tell them, you 

are in a risky scheme, you are in a guaranteed gamble and you 

really need to come under Social Security instead, they look at me 

like I am crazy, because they have real accounts with real assets 

that have grown gradually and steadily, never in a direct linear 

way, there is risk in everything, but in a very good, solid way—and 

as a result, their retirement checks are much, much, much larger 

than Social Security. I think Mr. Chairman, it is really helpful 

from a global perspective, to see the experiences that this panel has 

outlined and then to be able to translate that, meld that with some 

proven models that are right around us in this room. The combination of the two, I think are very helpful, so, I will yield back my 

time. 

Chairman MCCRERY. Thank you, Mr. Brady. Mr. Becerra. 

Mr. BECERRA. Thank you, Mr. Chairman, and thank you for 

also indicating that we could have a second round. I think that is 

generous and also lends itself to meaningful discussion. I would 

also point out, as some of my colleagues have, that while this has 

been a phenomenal panel and we appreciate your testimony, it is 

94 

undeniably an unbalanced panel because of the private witnesses, 

not including the government witness; six of the seven have either 

written or spoken in support of privatization. While I think it is 

important to have a full discussion, it would also be helpful to be 

able to air all perspectives, to be able to come up with meaningful 

policies. So, I do thank you for your testimony. 

Chairman MCCRERY. Mr. Becerra, I won’t count this against 

your time. That is the second time we have had that comment, and 

I appreciate it because you are right, you are accurate. We did offer 

your staff the opportunity for more witnesses to express your point 

of view. Dr. Baker, and he is a mighty force, but he is the only one 

that they chose. I appreciate your observation. It is not my—by our 

that it turned out that way. 

Mr. BECERRA. I see our staff chattering in the back, so, I won’t 

try to dispute what the Chairman has said, only to say that I think 

it is important to try to have as ample a discussion as possible. I 

do appreciate, Mr. Chairman, that I think you have been, and you 

have made every effort to try to be, fair and have good discussion, 

so, that is not a concern. I do believe that when we finally have 

a chance to sit down—and I think we will get there, especially if 

someone like the Chairman is helping conduct those opportunities—we will want to have heard from as many people as possible, 

from every perspective. 

Chairman MCCRERY. Absolutely. 

Mr. BECERRA. As we sit here and look at this panel, while it 

is great to have six perspectives and only one to counter, at least 

to provide a different perspective, it does make it difficult to get a 

full sense of what is out there. Again, be that as it may, you have 

been very generous in doing these hearings. I thank you for that, 

and I thank you for not counting that against my time. Just a 

quick point on budget perspective because we are seeing this discussion about how we don’t have the money to deal with Social Security, therefore we have to replace it with privatization. Ms. 

Bovbjerg, you responded to some degree about that. I don’t know 

if you know the numbers, but if you take the tax cuts that the 

President has proposed and, as you indicated in your assumptions, 

you project them out as if they were permanent. If you were to take 

those tax cuts that went mostly to wealthy folks and extended 

them out, the cost of those tax cuts, isn’t it correct, are far more 

than the cost of making sure Social Security is solvent for that 

same period of time? 

Ms. BOVBJERG. Mr. Becerra, I don’t know what those numbers 

are. I believe we might have provided something like that for the 

record, perhaps before the full Committee. I will check and—— 

Mr. BECERRA. You can check, but I can tell you right now that 

everybody that has done an estimate on this will tell you the cost 

of the tax cuts that went mostly to wealthy people were somewhere 

between three to five times greater than the cost of providing solvency for Social Security for that same period. If we want to talk 

about being fiscally responsible—in fact, if you want to talk about 

being fiscally responsible, you can avoid extending tax cuts that are 

going mostly to wealthy folks at a time when people are saying 

‘‘the sky is falling’’ for Social Security. Indeed you could probably 

take only the tax cuts that went to the wealthiest 1 percent of 

95 

Americans, and with that, just with that, you have almost enough 

to take care of any solvency problems that Social Security has in 

the long term. Going back to the whole issue of Social Security and 

privatization that we have seen throughout the world, please tell 

me if I am wrong, but in every case where we talk about the mistakes in some of these privatization systems, the losers have either 

been the retirees or the taxpayers. When a mistake—the euphemism ‘‘mistake’’ is used whether it is because somebody got 

charged a lot in fees or because bad investment advice was given, 

the mistakes have cost either the retiree, because he or she will 

have less money in his account, or the taxpayers, who have to bail 

out the system to correct that. 

Dr. JAMES. Not exactly correct, no. In the UK, I believe there 

is a lawsuit which has resulted in about an $11 or $12 billion settlement. 

Ms. BOVBJERG. It is $20 billion. 

Dr. JAMES. That will come from the companies. 

Mr. BECERRA. Well, Dr. James, you made my point: $11 billion 

is going to go back to the retirees, because the companies took the 

money from the retirees. 

Mr. WHITEHOUSE. They are not retired yet. They are the workers. 

Mr. BECERRA. You made the point that I was trying to express, 

and that is that the ones that are contributing the money when socalled ‘‘mistakes’’ are made, are the ones most likely to lose, unless 

they, of course, happened to be successful in some litigation. I guarantee you that if you tell the American seniors that that is what 

they have to rely on, going to court so they can get their retirement 

benefits, I suspect, Dr. James, you are going to have a hard time 

passing this in Congress. Dr. Whitehouse, you mentioned rate of 

returns in private pensions average somewhere around 3.5 percent, 

real rate of return, about 3 percent. Have you examined the rate 

of return for the thousands of Enron employees in this country who 

saw Enron go bankrupt? 

Mr. WHITEHOUSE. Minus 100 percent would be my guess of 

that. 

Mr. BECERRA. What about the United Airlines employees who 

today are relying on a bankruptcy court to determine how much 

they are going to get out of their retirement? 

Mr. WHITEHOUSE. That is a DB plan. The 401(k)s do have 

some of those problems, and I believe this House is addressing 

these issues of large quantities of money in employer stock. The optimal employer stock in your pension plan is zero because your future welfare already depends on the success of that company, your 

earnings in that company. So, the way 401(k)s have been structured have not been regulated perhaps as they should have been 

in the past. 

Mr. BECERRA. Let me ask you one last question, as I see the 

light is red, and I know the Chairman has said we will have a second chance for questions. Mr. Vasquez, in the case of the Chile privatization model in 1981, when the military dictatorship decided to 

scrap the old DB system that was in place, that had a lot of problems because of abuse and underfunding and so forth that had ocVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00099 Fmt 6633 Sfmt 6602 E:\HR\OC\23925.XXX 23925
96 

curred, and replaced it with a privatization system, they didn’t include themselves in that privatization plan, did they? 

Mr. VASQUEZ. The military was not included and that was a big 

mistake. Today, they are having financial difficulties and they are 

facing the same sorts of problems as public pension systems. 

Mr. BECERRA. They still haven’t included themselves in that? 

Mr. VASQUEZ. The architect of that program, Jose Pinera, always said it is a mistake for the military to be left out and they 

have a deficit in their public pension. 

Mr. BECERRA. Having recognized that mistake—24 years later, 

having recognized that mistake, have they now included themselves in the privatization plan? 

Mr. VASQUEZ. No, and that is a political problem. 

Mr. BECERRA. That is—the test of any plan that you propose 

is, are you willing to be part of it, and in this case, it seems that 

some of the leaders aren’t. 

Mr. VASQUEZ. The Chilean Minister of Labor is part of it, and 

he was advocating the military to take part in it. 

Mr. BECERRA. Mr. Chairman, why don’t I stop there, and if you 

have a second round, if we have any further questions, I will ask 

it. 

Chairman MCCRERY. Thank you, Mr. Becerra. Mr. Rangel, distinguished Ranking Member of the full Committee, do you have 

any questions you would like to ask the panel? 

Mr. RANGEL. No, but I do want to compliment you, as other 

Members have, for the selection of such qualified panelists to assist 

us to see how this has worked in other countries; and just once 

again, say publicly that I don’t doubt that we all want to reach the 

same end and make certain that we provide the President with a 

bipartisan bill. So, therefore, Mr. Chairman, at some point we are 

going to have to make a political judgment in terms of what we can 

do with this information that we are getting, so that in the parts 

of the bill that we are agreed on, we will be able to have the pros 

and cons of the different approaches to this serious problem. I really think that you have made a great first effort as the Committee 

moves toward trying to reach a solution. I hope we can enjoy that 

same activity in terms of the political questions that we will have 

to face when we seriously face the problem. Thank you so much. 

Chairman MCCRERY. Thank you, Mr. Rangel. Now, are there 

any Members that would like to have a second round of questioning? Mr. Ryan, you may proceed. 

Mr. RYAN. Mr. Baker, I just wanted to ask you, you mentioned 

$75 billion. Where did that number come from? How did you come 

up with that? What you said at the end of the testimony sort of 

caught me off guard. 

Dr. BAKER. Sorry. Very, very simple calculation. What I was 

saying was, suppose the United States were like Chile, where our 

entire system was funded through individual accounts. 

Mr. RYAN. You said whole 12.4 percent payroll tax. 

Dr. BAKER.If you just look at the benefits that we are taking, 

roughly $500 billion a year in benefits. In Chile, the administrative 

costs are roughly 15 percent of what goes into the system; 15 percent of $500 billion is $75 billion a year. 

97 

Mr. RYAN. That is an interesting computation. What if you 

added the rate of return that you would get by going to—did you 

add the rate of return, say that 4.6 percent the actuaries use, or 

the 5.2 percent on a different blended stock? Did you change that, 

or did you adjust for an increased rate return that would be attributed to bonds and stocks versus the current system? 

Dr. BAKER.I was just saying, given that amount of payout, given 

that you had 500 billion a year in payout, given administrative expenses that are roughly equal to 15 percent of what gets paid in, 

paid out each year that gets you $75 billion in administrative fees. 

Mr. RYAN. Are you saying 15 basis points or 15 percent? 

Dr. BAKER. Fifteen percent. Again, there is a confusion here. A 

lot of people have exploited, I think, and misled a lot of people on 

this. This President’s commission expressed their cost as 30 basis 

points of the stocks. If I have a dollar in that account for 40 years, 

I am paying three-tenths of a cent for 40 years. Over that 40-year 

span, I have paid a cost of 12 cents, 12 percent. Now, these systems 

actually have much higher costs. In Chile, it is around 1 percent 

which—you take that over 40 years, that would be 40 percent. 

Now, most money isn’t in there for 40 years, but if you just take 

an average—say it is in there 15 years—that gets you the 15 percent. 

Mr. RYAN. I have a lot of questions. I see everybody shaking 

their heads as well. I will let Mr. Vasquez and Mr. John and anybody else who wants to comment on that. 

Mr. VASQUEZ. I will quickly say that the proper way to measure administrative costs is costs, fees, as a percentage of assets 

managed. In Chile that is 0.66 percent, and that is better than the 

mutual fund industry here in the United States. So, if you are 

going to be worried about administrative costs, we should also be 

worried about all the mutual funds here in the United States. We 

might as well propose nationalizing and monopolizing that. The 

issue in Chile is that Chileans have control over their Social Security, control over their retirement, and that is something that gets 

lost in technical analysis about administrative costs, even though 

the administrative costs are very, very low in Chile. 

Mr. RYAN. Mr. John? 

Mr. JOHN. Twelve percent over 40 years, that assumes there is 

$1 in the account and there is only that $1 in that account for the 

entire 40 years. The one advantage of any account, whether it is 

TSP or 401(k), or just a plain old Christmas account, is that it is 

joined by lots and lots of friends that come along as the account 

grows. Therefore, you especially have more friends joining those 

dollars toward the end of the period, and they are only in there for 

a very brief period of time. 

Dr. BAKER. It is less than 5 percent. 

Mr. JOHN. Three-tenths of 1 percent is actually an incredibly 

low amount. You are talking in terms of 30 cents per $100, and 

that is just an astonishingly good deal. 

Dr. BAKER. Ten times the cost of the current system. 

Ms. BOVBJERG. May I jump in on administrative costs for a 

minute? We did a report for this Committee several years ago on 

the range of administrative costs and how those compounded over 

a working lifetime. The range that we developed came from talking 

98 

to a lot of people with different proposals and looking at a lot of 

different ways to think about individual’s accounts, and it ranged 

from one-tenth of a percent to 3 percent. Now, admittedly, the 3 

percent maximum assumed that the accounts were in a very decentralized system. When we looked at the difference between onetenth of a percent and even 1 percent over a long, working lifetime, 

a 45-year working lifetime, it was a 22 percent difference in the administrative costs that came out of an individual’s account. My 

point here is that account administration matters a lot. This is 

something that has not always been done well in other countries, 

and something I did want to say in my testimony. 

Mr. RYAN. It has been very beneficial to hear from everybody on 

how to do this and how not to do it. Mr. Harris. 

Mr. HARRIS. There has been a lot of talk, probably too much 

talk, on that. There is a correlation between high administrative 

costs in individual accounts. I have been flying 7,200 miles in last 

the 24 hours. By the time I get back to the UK, I think it is important to clear up this inaccuracy. I think it is important to note that 

in Australia an average member of a plan pays 97 cents per member, per week. Expressed in another way, the cost as a percentage 

of assets in June 2000 were calculated as 1.29 percent of assets in 

the management, and that has fallen to 1.03 percent. In the UK, 

there is a stakeholder pension account which has a maximum administrative cost for everything—originally at 1 percent, now set at 

1.5 percent. The correlation between high administrative fees and 

charges or costs in individual accounts is a fallacy. 

Dr. JAMES. Could we just put the administrative cost issue in 

context, that this money is being saved, it is being invested, it is 

earning a rate of return? So, some of the benefits that are paid at 

the end come not directly from the dollar of contribution that was 

paid at the beginning, but from the rate of return that was earned 

all along the way, which far exceeds the 30 basis points that we 

are talking about; and therefore, as compared with the PAYGO system, you should be able to get the same benefit at the end for a 

lower initial contribution. I think—— 

Mr. RYAN. That is the point I was hoping to make, Dr. James. 

I will just conclude. 

Chairman MCCRERY. Mr. Whitehouse. 

Mr. WHITEHOUSE. We had this implicit comparison of the administrative expenses of running funded systems and on the old 

PAYGO systems. I just did a check on the laptop, earlier, on the 

data I have on administrative expenses in Latin America. The 

PAYGO schemes were costing something like 30 percent of the benefit expenditure in administration. So, the old systems that were 

in place before that were probably more inefficient than the new 

systems are now. So, as Dr. James says, there are extra services 

you are getting for those contributions, but it is not true to say that 

they are necessarily, vastly administratively more inefficient. 

Mr. RYAN. Thank you, Mr. Whitehouse. Let me conclude with 

this. We heard mentioned three times that if we just repealed the 

tax cuts for the top 1 percent we could fix all these problems. I am 

not exactly sure what tax cuts are being referred to, but I am assuming that marginal income tax rate cuts—and one thing that occurred in the tax cut, we brought the marginal income tax rate— 

99 

remember, over two-thirds of those who pay that are small businesses, Subchapter S corporations, Limited Liability Companies, 

we brought their tax rate down to the level that large corporations 

pay, the corporate tax rate. 

What is more important is, contrary to the projections that we 

were giving in Congress as to what those would, quote, unquote, 

‘‘cost,’’ we have actually exploded those projections. Last year, receipts coming from those individual tax rates grew at double-digit 

rates. This year, just this quarter, receipts from individual income 

tax rates are up 16 percent. The corporate tax rates are up 47 percent this year from these lower tax rates. So, it is a matter of fact 

that the projections that estimated that, quote, unquote, ‘‘cost’’ to 

revenue lost to the tax cuts did not materialize and, more importantly, we are receiving higher revenues from those lower tax 

rates. So, to try and extrapolate the, quote, unquote, ‘‘cost’’ to revenue lost from tax cuts based on old projections, which have already been disproved as a means to try and pay for Social Security, 

is just a comparison that now current history, current facts, have 

disproved. With that, I would like to yield. 

Chairman MCCRERY. Thank you, Mr. Ryan. Mr. Becerra. 

Mr. BECERRA. Thank you, Mr. Chairman. Thanks again for the 

second round. Just to comment on my friend from Wisconsin’s comments, if indeed that is the case, that we have seen such great returns from the corporate tax, income taxes that are being paid, I 

would hate to see what condition we would have been in if, we are 

suffering from an over $600 billion deficit, as it is. If that is what 

we are getting, and this is as good as it gets with a $600 billion 

deficit, woe is the day we get into another recession with corporations having helped us with—— 

Mr. RYAN. If the gentleman will yield, it helped reduce the def- icit since the tax cuts passed by $150 billion. So, our deficit would 

have been higher. 

Mr. BECERRA. That is a number that can be used, but when 

you take into account the trillions of dollars the tax cuts have cost, 

it is going to be a matter of balancing things out. I think many of 

us believe that had we not gone the route of cutting taxes so heavily and so skewing it toward the wealthy, that we could have still 

got some of these returns done, some things that would have 

helped the business community without having cost the Treasury 

so much money, which now we will be paying for quite some time 

in deficit interest payments. 

Chairman MCCRERY. We would urge both Members to confine 

your questions to the subject at hand because these panelists have 

spent an awful lot of time here. 

Mr. BECERRA. Let me do that then. Going back to Chile, Mr. 

Pomeroy pointed out that 65 percent of women who are retiring fall 

within this minimum benefit for retirement under this privatized 

plan in Chile; and in many cases, they are receiving this minimum 

amount not because they have earned it necessarily, but because 

their actual private account would have paid them less, but because there is a minimum account amount that the government 

says you are entitled to, the government then has to make up the 

difference. Here we would call that welfare. So, we are making sure 

that—or, Chile is making sure that its retirees, regardless of their 

100 

condition and regardless of the wisdom of their investment or the 

production of their investment, they will receive a minimum benefit, as minimal as that might be $140, $145. 

In many cases those individuals who are receiving that minimum 

benefit would be receiving even less were they to rely solely on 

their private account return; and only because the government is 

guaranteeing them the $140 to $145 a month pension are they able 

to receive even that. I am not sure if those calculations are made 

to determine the costs through a welfare system for retirees, that 

taxpayers have to pay for now that they are retired, that didn’t 

earn enough out of these private accounts. I would be interested 

in—perhaps in writing, if you could supply figures—because we are 

short on time, if you could provide some remarks on what has been 

done to deal with the fact that in some cases the governments have 

had to, in essence, put seniors on welfare in order to get them a 

minimum payment. 

The other point I wanted to make—and you can comment if you 

wish on this—we put in the abstract all the time, a number of stories have been written about the Chile privatization model. An example was provided for in, I believe, the New York Times. A gentleman by the name of Dagoberto Sain, who is a 66-year-old laboratory technician who was planning to retire because of a recent 

heart attack, he earns about $950 a month and he had been told 

by his pension plan that after nearly 24 years of contributions, that 

he will be able to receive a 20-year annuity. It will pay him, until 

he is 88, a total of $315 a month. 

His comment was—I am quoting from the article—‘‘Colleagues 

and friends with the same pay grade, who stayed in the old system, 

meaning the Social Security tax system, people who work right 

alongside me, are retiring with pensions of almost $700 a month, 

good not until they are 86, but until they die. I have a salary that 

allows me to live with dignity,’’ and all of a sudden when he prepares to retire, ‘‘I am going to be plunged into poverty all because 

I made the mistake of believing the promises they made to us back 

in 1981’’—and 1981, of course, is the date that they started their 

privatization system. 

I know there are a number of concerns that are being raised by 

people in many of these countries, and I know there are aspects 

that need to be explored, as well, where some people have done 

very well. I think the difficulty for us is, how do we make sure that 

we don’t have the hills and valleys for seniors after 40 years of 

work in this country, and make sure that everyone knows that they 

will be able to retire in dignity. So, with that, I will allow anyone 

who wishes to comment, but understanding my time is quickly expiring. 

Mr. VASQUEZ. First of all, on the minimum pension—yes, that 

is a minimal welfare type of program in Chile; and that costs about 

0.1 percent of GDP, and it is minimal. That is a superior and far 

more efficient way of providing welfare than the previous system. 

As far as the anecdote that you provided from the New York Times, 

in my view it is—— 

Mr. BECERRA. It is not an anecdote. It is a real-life case of an 

individual. 

101 

Mr. VASQUEZ. It is an anecdote of a person that is very difficult 

to analyze because there is not enough information in the article 

as to how many years prior to it he was working. Was he working 

for the government before and then he switched? There are many 

people in Chile who were working for the government, and when 

they switched into the private system, the government didn’t pay 

them the full recognition bond that other people in the private sector got because the government had been under-reporting their 

wages. Those people have suffered from the move to the private 

system precisely because the government didn’t pay them the full 

amount, and the way to fix that is, get the government to pay them 

the full amount that they were owed. I suspect he may have been 

one of those people, but there is no way of telling from the article. 

Dr. JAMES. The article also contains obvious factual errors. For 

example, he could not have gotten a 20-year annuity; that is not 

one of the allowable payouts in Chile. He would have to have gotten a lifetime annuity, so, he may have colloquially said, It is a 20- 

year annuity, but in fact it could not have been. Perhaps it was a 

life annuity that promised to pay his estate for 20 years if he died 

early, but it would continue to pay him for as long as he lived. If 

you look at the replacement rate—that is, the ratio between the 

benefit that he gets and his initial wage; I don’t remember the 

exact numbers there, but I think if you go back to it, you will find 

it is actually a pretty good replacement rate for 20 years of contributions, probably quite a bit higher than he would get for 20 

years of contributions in the United States as a replacement rate. 

Mr. BECERRA. Again, you could be right, but that goes contrary to what he said he would be receiving, a $358 pension instead of 

a $700 pension. 

Dr. JAMES. The article was factually incorrect. 

Dr. BAKER. Just on the point about the welfare program, obviously, systems of accounts are not redistributive; they are neutral. 

If on top of that you have some guaranteed minimum benefit, that 

is a form of redistribution, conceivably a form of welfare; and that 

will presumably enjoy the same political support as other welfare 

programs do in this country. 

Mr. BECERRA. Mr. Chairman, thank you. 

Chairman MCCRERY. Thank you, Mr. Becerra. I think one lesson we have learned from this hearing today is you can’t believe 

everything you read. Mr. Lewis. 

Mr. LEWIS. Thank you, Mr. Chairman. This is for the whole 

panel. Among the countries that have undertaken reform, primarily have solely by reducing benefits and raising taxes. What is 

the financial status of their Social Security system, right now? Will 

they have to go back and make more significant changes in benefits 

and taxes in the foreseeable future? 

Ms. BOVBJERG. It depends on how sustainable their changes 

have been. By the way, this country would be included as a country 

that has made changes to the PAYGO system, and of course, we 

are revisiting the changes. One of the things that I have been really struck by in looking at 31 countries is how normal it seems for 

governments to go back and revisit these changes. Pension reform 

is a work in progress in most places, depending on how sustainable 

the changes are. 

102 

Dr. BAKER. If I can make a quick comment on that, how we 

think about this. It is not clear it is desirable to put in a system 

and then never re-examine it, because it is basically a fundamental 

democratic issue. How much money do we want to put aside during 

our working lifetime to support us at what level of income during 

our retirement? At what age do we want to begin to collect those 

benefits? Whatever we might think is a good idea in 2005, people 

might think very differently about in 2025 or 2040. So, the fact 

that they might revisit that at some future point, to me at least, 

is not an obvious indictment of the system. 

Mr. LEWIS. Do you think this is the time we need to address 

this issue with Social Security? 

Dr. BAKER. Let me put it this way: There are a lot of other 

issues that present much more immediate problems. 

Mr. HARRIS. In Australia, Congressman, there is a fundamental 

need that an acknowledgement exists for consensus. This is a very 

important point to establish—that both major political parties realize that consensus is important to drive through pension reform, 

Social Security reform. They acknowledge that 9 percent compulsory contributions is simply not enough, and the Labor Party, if 

you like, still remains wed to the idea of 15 percent contributions 

by the individual in the second pillar. It is important also to note 

is that the old age pension increasingly is becoming less and less 

important for Australians as more and more people leave that program through the income and assets test. 

Mr. LEWIS. Let me add another question to that. Is there a way 

to—if you take personal accounts off the table, is there a way to 

fix our Social Security system for the long term? Any ideas on that? 

Mr. WHITEHOUSE. By contribution rates would be an obvious 

solution, which other the countries have adopted. If you look at the 

fiscal position of Social Security versus all the other OECD countries, the spending is already among the lowest among OECD countries, about 4.5 percent of GDP. The average for the OECD countries is about 8 percent of GDP. You have Italy there at the top 

already spending 14 percent of GDP on pensions, and that is forecasted to rise, even though they have had some fundamental reforms there. The answer, I am afraid, on the other side of the pond 

has been a mixture of tax writers, contribution writers, and benefit 

cuts. 

Dr. JAMES. In addition to that, one of the things that happens 

in the very long run is that conditions never turn out to be what 

you predicted initially. So, no matter what you do now to fix it, 10 

or 20 years down the road, there will be surprises. So, I think it 

would be useful to think about what kinds of built-in stabilizers 

you can put into the system so this Committee doesn’t have to hold 

hearings every 5 or 10 years to fix it again. One of the surprises 

always comes from longevity increases, which are often greater 

than predicted. So, we have talked about indexing benefits to longevity. Another way of looking at it is to index the retirement age 

to longevity. If longevity increases, it is not unreasonable to expect 

that people would spend some of those years working more, and 

you can put a built-in mechanism in there, which would make it 

politically easier for you Congressmen and women, down the road. 

103 

Mr. LEWIS. We are talking about similar demographic areas or 

concerns, too. We are coming up on two people working for one person on retirement, so—— 

Ms. CORONADO. The Swedish system was in a much more dire 

demographic situation than the United States, and they did follow 

the route of building in some of these macroeconomic stabilizers, although it will remain to be seen when those actually have to kick 

in, whether that will itself induce a revisitation of the system. That 

is how they chose to set the system on a fiscally sustainable course, 

and then it could be revisited. 

Mr. LEWIS. Thank you. 

Chairman MCCRERY. Mr. Levin. 

Mr. LEVIN. Briefly, thanks again. Last—almost the last thing 

that was said, I think struck a chord, at least with me, that in 

order to tackle these issues, there has to be consensus. This issue 

started off on the wrong foot in that regard. Instead of there being 

an effort to sit down across party lines across the Rotunda and 

with the White House, it was started very differently. I do think 

consensus is an absolute essential. You can’t tackle any of these 

long-term issues otherwise, including the tax issue, and that was 

done with the opposite of consensus. So, I think that is one bit of 

your experience, some of you, that I think should be taken seriously. Second, Mr. Chairman, is how often we have to do this. I do 

think there are other issues that may be more pressing in terms 

of fiscal impact. I think that is true. We acknowledge that. I would 

assume every 20, 30 years we will sit down. 

For example, the assumptions as to growth may turn out to be 

very wrong at 1.7 or 1.8. I realize that if that turns out to be 

wrong, it will have an impact not only on dollars that are coming 

in, but also on wage indexing. That is true, and I am not an economist, and I don’t know exactly what the relationship would be. Immigration issues, as we look at them today—and they are a very 

difficult issue here—we may find out 10 or15 years from now that 

work force estimates were wrong, and the ratio of workers to recipients may have turned out to be incorrect. Even a two-or threetenths of a percent change is a major change, I take it, in our calculation. That is why, for all those reasons, there has been a major 

resistance to upsetting the Social Security apple cart, a system that 

in this country has worked so well. 

Let me finish with one other point about administrative costs. I 

do think one of you said that this country is really different. I think 

the person—I think it was the person who ran the TSP who 

warned us that in terms of administrative costs, it was going to be 

very different with huge numbers of people paying in, employers 

paying into a system, than it is in other countries; you can’t equate 

them. I think it was he, or somebody else, who thought that the 

private account proposal was therefore unworkable. I just think we 

need to look at the entire administrative picture. 

Last, I just wanted to emphasize what has been said. I think you 

have tried to create an atmosphere of fairness here, of objectivity, 

even though we have some basic disagreements. I don’t always 

know what the staff says to each other. These staffs are talented 

people who work very, very hard, but they don’t always say to us 

what they say to each other. So, for example, as to the hearing next 

104 

Tuesday, I think it was said that we were allocated one witness, 

and I hope you might talk with the staff and see if we could be allocated more than one witness for next Tuesday. 

I didn’t mean to lump all of you together—and if I did that, I 

should not have, even though I think there is a disequilibrium 

here. I think it would be useful if these hearings proceed to do 

what you really intend to do, and that is to make sure that we 

have a full airing because, while I think we started on the wrong 

foot—I am sure of that, the way this has turned out—at some point 

we are going to have to get on the right foot. I don’t mean left or 

right. I mean the effective foot. 

Chairman MCCRERY. Thank you, Mr. Levin, and I agree with 

you that this panel has been excellent in their expertise certainly. 

I think it is something that we all took advantage of today and all 

appreciate. I appreciate your comments. I have one final question 

to take advantage of this expertise. One concern that has been expressed about personal accounts in the context of Social Security— 

and I think it is a legitimate concern that needs to be addressed— 

that low-wage workers and workers without continuous attachment 

to the workforce—women who have had to stay at home to raise 

children or those who have gone through times of unemployment— 

may have small personal account balances. In your studies of other 

countries’ systems, has this problem been addressed in their personal account systems? If so, how? 

Ms. CORONADO. I could start with the Swedish system. They 

actually give credits to one of the parents of small children up until 

they are school age, so, there is a fixed credit that get applied to 

your individual account and your notional account for child rearing. 

Likewise, your unemployment benefits count as income in the determination of your benefits. They have tried to address those 

issues through the individual account mechanism. 

Mr. LEVIN. Has it affected the birth rate? 

Ms. CORONADO. No. The birth rate is very low in Sweden. 

Dr. JAMES. This problem is a problem in every contributory 

scheme. It is not specific to individual accounts. Any time you base 

your payout on contributions, on amounts or years of contribution, 

you have to deal with this issue. Some countries simply have a flat 

benefit for every old person out of general revenues. Then they 

don’t have to deal with the issue. As long as it is contributory, you 

do have this problem. 

Chile has this issue certainly, because developing countries have 

it more so than Sweden. They deal with it partly through the minimum pension guaranty, which everyone gets who has contributed 

for at least 20 years; and that is a kind of insurance for low work 

participation, low contribution densities, as they call it. In fact, 

those are the main people who would end up getting the minimum 

pension guarantee, people who have not contributed for their entire 

working life. Once you have contributed for your entire working 

life, your own pension would far exceed the minimum pension 

guaranty. Chile also has a social assistance program which is 

means tested for people who have not contributed for 20 years. It 

pays approximately half to two-thirds of the minimum pension, and 

on a means tested basis, people can apply for that. 

105 

Mr. WHITEHOUSE. Could I add something? I do have a section 

in my written testimony on treatment of low earners, and one further example is the case of Mexico where the government pays a 

fixed amount. I think it is—when it was introduced, it was a peso 

a day into all the workers’ accounts regardless of their incomes. So, 

that is one way you can—by putting a flat rate amount into everyone’s account as well as, say, 4 percent of earnings, a way you can 

help the low earners out. That is another international example. 

Chairman MCCRERY. Anyone else? 

Mr. HARRIS. Congressman, in Australia, for low-income earners 

there is a rebate system where the government will assist them on 

a dollar-for-dollar basis up to a certain level in terms of making cocontributions, if you like, into their individual accounts. With regard to smaller accounts, they are rolled up into what is called eligible rollover funds. They are high-volume, low-margin individual 

managed funds where a number of accounts are pooled together 

and literally put out into the market; and the charges on those are 

very low, and there is also some regulatory capping of pricing or 

charges that can be applied to those small accounts. 

Chairman MCCRERY. Thank you. Mr. John. 

Mr. JOHN. In the UK they have a series of credits for things like 

unemployment, inability to work due to illness, or family situation. 

Also, under the new State second pension, if an individual earns— 

which is the individual related component, if an individual earns 

under 12,001 pounds a year, they are credited as though they had 

actually earned that much, so, there actually is a subsidy for lowincome workers in that case. 

Chairman MCCRERY. Thank you very much, once again, for 

your excellent testimony and your patience in answering our questions. We hope to report back to you in the not-to-distant future 

that we have changed our system to meet the fiscal obligations that 

we face and also meet the obligations of a society to its elderly. 

Thank you. 

[Whereupon, at 1:00 p.m., the hearing was adjourned.] 

[Submissions for the record follow:] 

Statement of Margaret Daniels, Hurst, Texas 

I am a retired elementary school secretary for the Hurst-Euless-Bedford School 

district in Bedford, Texas. I became a secretary for the school district while my children were in secondary school to have my working hours more in accord with theirs. 

I previously worked in banks under Social Security. I began drawing my own Social 

Security when I was 62 years old. I have been affected by the WEP offset for my 

own pension. However, that does not affect me as much as the GOP offset will 

should my husband pass away before I do. I would like to be able to draw the portion of his Social Security benefits that I would even if I had never worked during 

our marriage. I know this is a hard decision for you to make at this time. I believe 

Texas is one of the last sixteen states to not have repealed this. My daughter-inlaw is a teacher in Louisiana and I believe will also be affected. Your consideration 

of this matter in your committee will be greatly appreciated. 

f 

Statement of Marilyn Sprang Fransen, Rapid City, South Dakota 

I was a music teacher in Colorado from 1963 to 1975. When I quit teaching I went 

into business and took out in cash what had been put into the retirement association. I was married with two children and felt ‘‘burned out’’ by the demands of 

teaching. 

106 

In 1981 I returned to the school district but in the capacity of an elementary office 

manager or secretary. I felt that my work was every bit as important to the education of the children of this school as my teaching had been, perhaps more so, because I knew the demands upon teachers and I aided them in every way I could. 

I also became nurse: surrogate Mommy; liaison between teachers, administrators, 

parents, and other community; and believed that I accomplished much toward making the school run smoothly and efficiently. I stayed happily in that position for sixteen years and bought back some of the teaching years’ retirement benefits so that 

I could retire in 1998. 

Because I retired as a classified employee and not a certified employee my retirement is only adequate and just above poverty level. I was never informed about the 

GPO/WEP laws that came into effect in 1983. I had realized that no Social Security 

had been taken from my salary those years but I also knew that as a married 

spouse and later as a divorced spouse I would be eventually eligible for half of my 

ex-husband’s benefits as a supplement. I realize now that my divorce lawyer was 

not aware of the laws either. Also, because of the animosity of my ex-husband I was 

driven into bankruptcy, and I truthfully believe my lawyer for that process was not 

aware, also, of the laws. I finally learned about my predicament when I applied for 

my benefits after turning 62 in July 2002! 

It came as a complete shock. I contacted friends and co-workers in the school district where I was employed and learned that they, also, were in ignorance about the 

effects these laws would have on their lives. They didn’t and still don’t believe me. 

The laws are so complicated to understand. I’ve had three years to try to verbalize 

what I believe has happened to me and it is still hard to make sense of it. I am 

weary of this problem and worried about how I will be able to live out my senior 

years on such a limited budget. 

Because of the loss of much needed Social Security supplemental benefits I am 

forced to work again despite health issues. I try to make enough each year to put 

money into an IRA. How unfortunate for me that I wasn’t aware of this problem 

when I was working those years 1983 to1998 in the schools. I could have been investing money in other ways then for this time in my life. 

I have been actively trying to contact Senators, Congressmen, the White House, 

AARP, NEA, and anyone who will listen to my plight and, always it seems, it falls 

on deaf ears. I have given up hope that the GPO will ever be repealed but, to me, 

the most unfair law is the WEP. Now that I have been forced back to work I am 

contributing to Social Security with the knowledge that I will never get back the 

benefits in total that people in the other 35 states of the U.S. not affected by WEP 

will get. My retirement from the school district which I served is so little how could 

anyone believe it is ‘‘a protection against double dipping by highly paid State Employees’’ to deny me my full benefit? 

I am convinced that the WEP arm of the SS Pension Offset Law is unconstitutional. I am being denied, after the fact, the right to pursue happiness 

in being able to provide ably for myself in my declining years! 

It is too late for me to make up the loss of several hundreds of dollars a month 

for the rest of my life. What difference should it make upon my eligibility for complete benefits that I worked at very low pay for 20+ years as a school secretary? 

It is absurd that this badly written law should have not had a floor on it so that 

people in my salary range wouldn’t be victimized in this way. I am also convinced 

that this law discriminates against women who are in lower wage slots in 

the states that are affected. Most of my co-workers in classified positions— 

cooks, kitchen managers, office clerks, bus drivers, custodians, nurses, 

teacher instructional aides, and etc.—were women by a large percentage as 

they are in most every school. We all know very well that statistics bear 

out the fact that these women live longer than their spouses and will suffer 

either widow-hood or divorce in their later years when supplementary benefits will be critical to them! 

Classified personnel have no one to lobby for them, no national associations that 

I have been able to find; and, frankly, do not comprehend what is being done to 

them. As I stated before I am having great difficulty convincing them that this law 

even exists. It is not particularly humorous to me that one senator in one of the 

affected states admitted to an acquaintance that he didn’t even understand the law 

when he signed for it’s legislation in 1983! 

I am praying that the wrong will be made right. I am praying that my country’s 

governmental representatives will see the injustice I am seeing. And I am praying 

that when I reach my own 40 credits in a year or so I will be able to receive my 

full benefits and not something lowered by a complicated formula thought out erroneously in 1983! 

Please consider my situation and do the right thing. 

f 

107 

Statement of Dr. Ronald J. Gathro, Springfield, Massachusetts 

Teacher Recruitment & Retention Issues 

On the Springfield Public Schools website www.sps.springfield.ma.us under 

(Teacher Resources/Teachers Helping Teachers) the following quote can be read: 

‘‘It’s alarming but true: studies have shown that 35% of teachers leave the 

profession during the first year. By the end of the fifth year, 50% of teachers 

have left he field!’’ WOW! 

Before going further, what is the profile of new teachers in Springfield? This 

statement is based on observation of participants in Springfield’s Teacher Licensure 

Program over the past three years. This program assists new teachers in getting 

their Preliminary License (generally pass the Communication & Literacy Test and 

a subject matter test) and their Initial License. The rules on obtaining an Initial 

License vary according to what you bring to the table but for many it involves taking the equivalent of 18 credits (6 courses) of appropriate Educational Professional 

Development. 

What is the profile of a new teacher? Most people would say a new teacher just 

graduated from college with an appropriate education degree (major or minor) and 

is in their early 20’s and raring to go! My observations at the Professional Development Center where teachers take courses for Licensure or attend New Teacher Orientation, is that this profile fits probably less than 25% of the new teachers in 

Springfield. I think it would be worthwhile to research new teacher profiles for the 

past 3 to 5 years. Most of the new teachers are career changers, most over 30, many 

pushing 50 or more. These people like me have had their careers terminated for 

some reason and are faced with major career and life choices. One acceptable choice 

appears to go into teaching. 

Many of the new teachers I have met in the system have one or more master’s 

degrees and need only the educational component to become fully certified under the 

No Child Left Behind Act. 

Allow me to give my profile. I am 48 years old and entered the Springfield Public 

School system at the age of 46. I am a degreed engineer (Ph.D.). I worked in local 

industries for 23 years of my professional career. I taught part time at Western New 

England College in the School of Engineering part time for twenty of the past twenty-three years. When my last job terminated, given the state of manufacturing in 

western Massachusetts and northern Connecticut where good jobs are hard to come 

by, I decided to give teaching a try at the high school level. With strong family ties, 

a spouse with a good job (25+ years) and good benefits, it is extremely hard to leave 

the area. Therefore, teaching (math in my case) became an obvious option. Not 

being certified / licensed means that only Springfield would consider hiring me. I 

was hired in 2002 on a waiver from the state. I took the Mathematics test and the 

Literacy and Communications test to obtain my Preliminary License. I am currently 

enrolled in Springfield’s Licensure Program. This program takes between 3 and 5 

years (5 being the state limit) to obtain your initial license. 

In 2003, at the Professional Development Center, I took the first class in the program. Over 20 new teachers were participating in the class. This past August, I took 

the second class in the program. There were 14 teachers enrolled; 13 from last year 

and 1 new one. After discussing what happened to the other 7+ teachers, the group 

accounted for over half leaving the system because they didn’t like teaching or they 

got better job offers from other local cities and towns. More than 1⁄2 left teaching 

altogether! I think that if the economy turned around maybe another 4 to 5 would 

leave teaching because of the bureaucracy and return to industry or business. For 

many it is frustrating to deal with what is going on. 

In my case as many others, I took a pay cut from $72,000 per year to $42,000 

per year and with a Ph.D. I am at the top pay scale, new-teachers without masters 

degrees get closer to $30,000. For most of the people at my class, their pay cuts were 

in the range of 25% to 50%. The problem is they couldn’t find work in their chosen 

profession and are faced with the challenge of changing professions. In many cases, 

this career change involves obtaining another masters degree after completing these 

18 credits of education. Most of us have never taught at the high school, middle 

school or elementary level before. Based upon my college teaching experience, I was 

not prepared for the issues confronting me at my high school! Additional education 

is generally mandated by law (No Child Left Behind), however it is the teacher that 

has to pay for it, out of their own pocket. In any industry that I worked in prior 

to this, if the employer mandated additional education, it was the employer who 

paid for it not the employee. If the employee wanted additional (not mandatory) 

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education, the company typically paid a substantial portion of the cost ranging from 

70% to 100%. The level of reimbursement may be dependent upon the grades attained. 

HOW DOES THIS RELATE TO SOCIAL SECURITY? 

On top of all of this, after becoming a teacher most of us find out that when we 

retire we will be faced with the Windfall Provisions/Government Pension Offset act. 

This law reduces the amount of social security we can collect simply because we 

work as teachers in the state of Massachusetts for a period of time at the end of 

our careers. Once you work as a teacher for 10 years, this law will impact you and 

possibly your spouse depending on the retirement options you chose. Since I worked 

in Industry for 23 years and I will work as a teacher for between 17 and 20 years 

(retiring between 62 and 65) the WEP/GPO will cost me personally between $2,900 

and $3,800 per year. This represents about a 12% reduction of my retirement income. When I retire after 17 years at age 62, I will only receive about 69% of my 

highest 3 years average salary at retirement. This is less than the career teacher 

who gets 80% and typically leaves earlier. 

After all this, you might ask why did I enter into the teaching profession? Simply 

put, I discovered that I loved teaching when I taught at the college level and given 

the loss of my career, teaching was a natural progression. My mortgage holder prefers to be paid monthly and teaching pays substantially more than unemployment 

or welfare. I teach at Putnam Vocational Technical High School. It is an under-performing school as designated by the state of Massachusetts. Teaching at Putnam is 

a challenge but it is fun as I can relate real uses of what we are learning in math 

class to what the students are doing in shop and what they will do for a living after 

graduation. I can answer the proverbial student question: ‘‘When will I ever use this 

stuff, Mister?’’ Putnam is a good fit for me and I enjoy it there. 

The congress has been educated with respect to the national shortage of certain 

teaching specialties such as Mathematics, Science, etc. There are a vast number of 

professionals who when facing economic downturns (layoffs vs. relocation), would 

gladly change professions, as I have done, if the change was made to be less painful! 

What is needed to solve the Teacher Recruitment & Retention Issue? 

• Eliminate the WEP/GPO (Windfall Elimination Provision/Government Pension 

Offset) from Social Security. This costs individuals vast sums of retirement income when they have already taken an earnings reduction during their working 

career. 

• Money for training new teachers/career changers. Money to hire more teachers 

and reduce class sizes. 

• Money to hire or develop Special Education Teachers who are qualified in the 

appropriate subject matter i.e. math, science, history, etc. Currently, many special education teachers are in classrooms helping in subject areas where they 

have no academic clue regarding what is being taught. These are great people 

being wasted. 

• Money to be used for new classroom books and equipment. 

• Money to be used for curriculum development and improvement. 

• Money to provide more in service training time for new teachers (less than 5 

years of service). 

• Money to provide a reasonable number of course electives and offerings that 

make sense of each school. Many schools cut back on electives when resources 

are tight. 

• Money to pay for mandatory advanced degrees for teacher certification. 

SOCIAL SECURITY NEEDS TO DO ITS PART IN SOLVING THE TEACHER 

SHORTAGE ISSUE BY REPEALING THE WEP/GPO! 

f 

Statement of Bruce Hahn, American Homeowners Grassroots Alliance 

The American Homeowners Grassroots Alliance (AHGA) appreciates the opportunity to submit this testimony to the Ways and Means Subcommittee on Social Security on the subject of Protecting and Strengthening Social Security. Social Security is a critically important and widely supported tool that supports our nation’s 

retirees. For most it is not the only source of retirement income, and it was never 

intended to be the sole source of retirement income. As members of the Ways and 

Means Committee look at ways to strengthen Social Security we urge that you simultaneously consider other programs and incentives to expand retirement savings. 

109 

To the extent that other programs may be created or enhanced to increase broad 

based U.S. retirement savings, the pressure to assure higher future social security 

program payout rates will be mitigated. For that reason we recommend that the 

focus of the Subcommittee be broadened to include all elements of retirement savings reform. 

Retirement savings reform and other tax reform efforts are inextricably linked 

from both a policy and political standpoint. No matter what plans to strengthen Social Security and enhance other retirement savings are eventually adopted, there 

will be costs associated with them. Other pending tax reform proposals, including 

a variety of tax provisions that will expire in coming years unless extended will also 

be subject to the same budget pressures, so it makes sense to try to address these 

issues simultaneously. 

It also makes political sense to address these issues as part of a larger effort. The 

Social Security debate has become quite polarized, but other alternatives to increase 

retirement savings and other elements of the tax reform debate are at this point 

less partisan. A broader approach will no doubt be more complex but under the best 

circumstances may avoid gridlock and lead to a tax reform package that can be supported by a majority of the populace as well as Republicans and Democrats in Congress. 

We commend President Bush for his courage in addressing the issue of Social Security. You can debate the timetable, but the projections make it clear that this 

issue must be addressed. It is much better to begin work on social security reform 

today, while there are more options, than in the future, when Congress will have 

fewer options. We believe that the President’s proposal has much to recommend but 

that thoughtful supporters of a strong Social Security program have pointed out 

some real challenges as well. We urge the Committee to take the best of the Administration’s package and modify it so as to address the legitimate concerns of many 

thoughtful Social Security supporters who have made alternative suggestions. It is 

also important to keep in mind that Social Security is only one part of the puzzle 

in retirement savings, and that other unrelated retirement savings incentives may 

be key to expanding retirement saving in the U.S. To the extent that other programs are successful in increasing retirement savings the pressure for higher future 

social security payouts will be lessened. 

For most homeowners the single largest form of savings they can tap for retirement is their home equity. In many cases homeowners retiring today can use the 

equity in their pre-retirement homes to purchase for cash a very nice retirement 

home without having to draw upon any other retirement savings. Based on our informal discussions with many recent retirees this is extremely common, and may 

even be the dominant source of retirement home funding. For retirees, who often 

have more modest ongoing financial needs than their children or grandchildren, the 

economics of a reasonable retirement lifestyle that doesn’t involve a monthly mortgage payment is not nearly so daunting as it would be for a couple or individual 

with only social security and income from relatively modest savings and/or pension. 

In the last decade U.S. home ownership has expanded 10 million to nearly 75 million, thanks to economic circumstances, and home ownership programs enacted by 

Congress and promoted by the Bush and Clinton Administrations. To the degree 

that these programs have contributed to the expansion of home ownership, they are 

almost certainly very cost-effective contributors to retirement savings. Home financing has always been highly leveraged. A home that costs $100,000 and appreciates 

a modest 3% per year provides a substantially higher return relative to it’s fractional down payment, and a huge return on that down payment if the equity is allowed to accumulate over the life of its ownership (or is rolled into successor primary residences). 

As appreciating and marketable assets (in most cases) the downside risk to the 

government’s programs that stimulate home ownership is reduced by a home’s underlying utility and likely long term appreciation. For this reason we believe that 

expanded home ownership incentives, especially for those at the margin of home affordability and with good indicators of fiscal responsibility, should be a significant 

component of a comprehensive tax reform package that has, as one of its primary 

objectives, the growth of U.S. retirement savings. Such a package has to take into 

account existing negative incentives, such as the fact that some low income home 

buyers would be giving up subsidized rent if they became homeowners 

Home equity as a savings vehicle has several additional advantages. Serious observers of human behavior of savings patterns have noted that inertia plays a significant role. If someone participates in a company 401K program they are likely 

to stay in, and if they don’t now they are unlikely to participate in the future. To 

an even greater degree a mortgage is a forced savings plan relative to the growing 

home equity because your mortgage lender probably won’t let you opt out of future 

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payments. In addition because the amount of the equity can’t easily be precisely 

measured at any given time, and accessing that equity through refinancing requires 

time and effort, there is a good chance that home equity will be left in place and 

will continue to grow. 

There are many ways to increase home ownership and the attendant long term 

savings through home equity growth. They include the expansion of many existing 

programs and worthy new policy proposals such as home ownership tax credits and 

other tax incentives to encourage the use of existing equity for the purpose of home 

financing. They all deserve consideration. The criteria against which all proposals 

should be measured are cost effectiveness and the degree to which they create home 

ownership opportunities for those who otherwise would be unable to afford it. 

Of course home ownership is not the only way to increase retirement savings (albeit very likely one the most cost-effective under the right circumstances). President 

Bush’s personal account proposal is based on the correct historical observation that 

the stock market outperforms the formula that drives social security payments. 

Some substantial concerns have been raised about other aspects of the proposal, but 

many critics of the President’s proposal would not object to the personal account 

concept if it were funded as a separate program not tied to the existing Social Security program. Budget realities largely drive the need to integrate personal accounts 

into the existing Social Security system. If revenue could be found to fund incentives 

for personal accounts through other parts of the tax reform process, personal accounts could make significant contribution to peoples retirement savings, even if it 

were reduced from its current scope. 

President Bush has expressed his willingness to be flexible on his personal account proposal, and given that flexibility there is a basis for a bipartisan approach 

that could include other concepts to stimulate retirement savings as part of a broad 

tax reform package. Some other worthy proposals include: 

• Make permanent the 401k improvements enacted in 2001 and which sunset in 

2010. We suggest that the concepts in the Administration’s personal savings account proposal be blended with an enhanced, means tested version of proposal 

to expand 401k/IRA or other retirement saving incentives. • Make 401K participation automatic rather than opt in. Savings patterns suggest that once people participate in retirement savings programs they will stay 

in. The lowest participation rates (which are declining overall) are among low 

and moderate income workers. Consider additional incentives for employees 

(such as faster vesting) and employers (such as incentives to make it easier and 

cost effective for small businesses to use outside plan administrators). • Make the tax credit for IRAs and workplace retirement plans permanent (many 

of the benefits expire in 2006). Increase the contribution limits and make the 

incentives permanent. • Expand allowed contributions into health savings account IRAs, and allow annual surpluses to be rolled into retirement years when healthcare costs will 

typically rise. 

• Allow for tax deduction of private mortgage insurance (PMI) premiums and condominium fees as these are both also costs of home ownership. 

• Repeal the ‘‘new homes tax’’, a protectionist tariff which adds approximately 

$1,000 to the cost of a new home through the taxation of Canadian softwood 

lumber. 

• Create a first time home buyers tax credit of 10% of the home’s price, 

capped at $6,000 and a new home ownership tax credit to encourage development and rehabilitation of resident-owned housing for those of affordable to low 

and moderate income. 

• Provide tax credits to homeowners and builders to encourage higher standards 

of energy efficiency in new home construction and remodeling. 

• Tax the proceeds of annuities at the rate of dividends rather than ordinary income. 

The cumulative cost of all of these proposals would be substantial. Given federal 

budget realities some of these suggestions will have to be dropped and many of 

those that survive will have to be means-tested to focus their benefits on segments 

of the population that are currently unable to increase their savings and segments 

of the population that could be saving more but do not feel the incentive for savings 

that was instilled in our nation’s generations who experienced the Great Depression. 

Restrictions on existing tax incentives, including some that benefit homeowners, 

will have to be enacted to generate additional revenues to pay for new incentives. 

What benefits will have to be trimmed? To generate additional revenue the current $250,000/500,000 capital gains exemption on home sales might be limited to 

the application of the proceeds to worthy purposes (there are currently no restricVerDate Aug 31 2005 23:51 Mar 02, 2006 Jkt 023925 PO 00000 Frm 00114 Fmt 6633 Sfmt 6621 E:\HR\OC\23925.XXX 23925
111 

tions on the use of the proceeds). There are some indications that there is an unfortunate and growing trend towards tapping real estate equity for the purposes that 

do not either contribute to savings or other worthy uses. While there are many productive ways to reinvest real estate equity, we consider the use of tax-favored real 

estate equity withdrawals for such purposes as fancy vacations a questionable use 

of this favorable tax treatment. Worthy purposes might include income producing 

investments upon retirement, home remodeling (since it contributes to equity), the 

purchase of a second home or a more expensive primary residence (same rationale), 

education (a worthy investment in the minds of most), and other similarly meritorious investments. 

This same philosophy should be applied to all other tax incentives. To the extent 

that they contribute to individual wealth building, competitiveness, and productivity, they should be retained. Absent evidence that they are making a contribution 

to those goals, or that their contribution is limited, they should be more precisely 

targeted to achieve their intended objectives, cut back, or eliminated. 

The American Homeowners Grassroots Alliance is a national consumer advocacy 

organization serving the nation’s 75 million homeowners. AHGA engages in policy 

issues that significantly impact homeowners and home ownership. 

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