Social Insecurity

Opponents of liberal, market-oriented economic reform are fond of declaring that theirs is the cause of “social cohesion.” First among globalization’s many sins, they claim, is that it frays the bonds that hold communities together. Globalization destroys the connections that lift us above our narrower interests and embrace us all, rich and poor alike, in a greater whole. The frenzy of unchecked competition, the argument goes, has set one group against another while leaving the neediest and most vulnerable to fend for themselves.

There is nothing new about such attitudes. The belief that market competition alienates and atomizes was never expressed with more passionate ferocity than in Karl Marx and Friedrich Engels’ The Communist Manifesto. Only two years after England repealed its protectionist Corn Laws and embraced full-fledged free trade, Marx was already proclaiming the socially corrosive effects of nascent globalization:

“The bourgeoisie…has left remaining no other nexus between man and man than naked self-interest, than callous ‘cash payment.’ It has drowned the most heavenly ecstasies of religious fervour, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egoistical calculation. It has resolved personal worth into exchange value, and in place of the numberless indefeasible chartered freedoms, has set up that single, unconscionable freedom — Free Trade.”

How does such thinking fit into today’s historical context, now that Marx’s dreamed-of future has come and gone? For a century, the collectivist, centralizing impulse worked to shape the goals and instruments of social policy. Now much of that work is coming into question. For partisans of social cohesion, the shoe is now on the other foot: Where once they fought in the name of alluring, untested possibilities, today they must defend existing and increasingly dilapidated structures from criticism and reform. They have transformed themselves from reformers and revolutionaries into conservatives and reactionaries.

The rearguard defense can be seen vividly in the fight over the centerpiece of the 20th century welfare state’s attempts to centrally manage in the name of social cohesion: traditional social insurance programs. It is increasingly apparent that such policies are doomed to collapse and need fundamental rethinking. Blind resistance to that rethinking will only further rend the social fabric.

Behind the appealing rhetoric of unity, the contemporary anti-liberal agenda is deeply divisive: It pits the privileged beneficiaries of current policies against their more numerous but less visible victims. It sets current pensioners against the young and middle-aged whose hopes for retirement security are imperiled by the defects of current pension systems.

Critics of globalization argue that the spread of markets is undermining social cohesion by compromising national governments’ ability to tax (and thereby fund) the social safety net. “The increasing mobility of capital has rendered an important segment of the tax base footloose, leaving governments with the unappetizing option of increasing tax rates disproportionately on labor income,” according to Harvard University economist Dani Rodrik in Has Globalization Gone Too Far? (1997). “Yet the need for social insurance for the vast majority of the population that remains internationally immobile has not diminished. If anything, this need has become greater as a consequence of increased integration.”

It is difficult even to take seriously the proposition that, whether because of globalization or otherwise, the governments of industrialized countries are hurting for tax revenue. Between 1965 and 1998, while globalization was supposedly eroding rich countries’ tax bases, average total tax revenues as a percentage of GDP rose for Organization for Economic Co-operation and Development (OECD) member countries from just over 25 percent to well over 35 percent. There is, in short, no evidence whatsoever that national governments lack the resources to fund appropriate social policies.

Meanwhile, the notion that globalization has increased the need for social insurance does not square with the facts. The theory behind the notion is that international integration increases the risk of dislocation (and thus the need for the safety net) in those sectors of the economy exposed to international competition. But the majority of social spending goes to senior citizens who are retired from the work force; their exposure to the slings and arrows of foreign competition is nil.

It is undeniably the case that the welfare states of the advanced countries are now under severe fiscal strain. But if market forces are not the culprit, what is? The social safety net has been badly frayed, not by any pressures of globalization, but by the collectivized, top-down nature of traditional social insurance. At the heart of the problem are enormous, monolithic public pension systems that violate the most basic precepts of actuarial soundness. Those systems are primarily responsible for the welfare state’s mounting financial woes.

Roots of Dependence

The founding father of collectivized social insurance, German Chancellor Otto von Bismarck, was brutally candid about the political benefits of centralization. As ambassador to Paris in 1861, he had seen how Napoleon III used state pensions to buy support for the regime. “I have lived in France long enough to know that the faithfulness of most of the French to their government…is largely connected with the fact that most of the French receive a state pension,” he recalled later. For Bismarck, the appeal of social insurance was that it bred dependency on, and consequently allegiance to, the state.

Social insurance was thus born of contemptuous disregard for liberal principles: What mattered was not the well-being of the workers but the well-being of the state. With that animating principle, social insurance necessarily assumed a collectivist character. In particular, it would clearly not do simply to compel workers to provide for their own retirement; funded pensions that actually belonged to the workers would not inspire the proper feelings of dependency and subservience. Far better was the “pay as you go” system in which the government would transfer funds directly from current taxpayers to current retirees.

When such ventures are attempted in the private sector, they go by the name of pyramid or Ponzi schemes and constitute criminal fraud. The essence of a pyramid scheme is that investors’ money is never put to productive use; it is simply diverted to pay off earlier investors. As long as new victims can be found, everything seems to work fine. Eventually, though, the promoters of the scheme run out of new investors, and the whole house of cards collapses.

Pay-as-you-go public pension systems operate in precisely the same way. As long as the contributions of active workers are sufficient to cover payments to current retirees, the system is fiscally healthy.

Indeed, in the early decades of such programs, it appeared that the market had been outfoxed. Consider Nobel Prize-winning economist Paul Samuelson’s smug optimism back in 1967: “The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in….How is this possible? It stems from the fact that the national product is growing at compound interest….Always there are more youths than old folks in a growing population….A growing nation is the greatest Ponzi game ever contrived.”

Sooner or later, though, such hubris must receive its grim comeuppance. Shifting demographics impose the ultimate constraint. As populations age, the number of retirees begins to grow faster than the number of new workers, until at last the burden is unsustainable.

Meanwhile, the perverse incentive structure of collectivized social insurance works to accelerate the system’s ultimate breakdown. In particular, workers have strong incentives to minimize or evade their contributions to the system, while retirees have an obvious stake in campaigning for higher benefits. Such dynamics steadily worsen the relationship between revenues and obligations and thereby hasten the eventual day of reckoning.

Today, with a global pension crisis that affects rich, developing, and postcommunist nations alike, the reckoning is at hand. Around the world, the ratio of active workers to retirees is shrinking. Promised benefits have spiraled out of control, while demographic changes and widespread evasion reduce the relative size of the contribution base. Consequently, the hopes for retirement security of hundreds of millions of workers are now in serious jeopardy.

The inevitable Ponzi endgame is now obvious in the rich countries of the industrialized world. In the United States, for example, average life expectancy at birth was only 61.7 years in 1935 when Social Security was established — lower than the original minimum retirement age. Today, U.S. life expectancy stands at 76.5 years, and is expected to climb to around 80 over the next 20 years. For most other industrialized countries, current and projected life expectancies are even higher. Meanwhile, fertility has dropped sharply. With the single exception of Ireland, birth rates in all the advanced countries are now below the replacement rate of 2.1 children per woman. In Japan, the fertility rate is only 1.68; in Austria, 1.45; in Italy, a mere 1.33. Continued declines in fertility are expected.

The upshot of these demographic trends is a steady erosion in the funding base for social insurance benefits. In 1950, there were 16 workers in the United States for every retiree; today the ratio is only 3 to 1, and in 20 years it will have fallen to 2 to 1. Elsewhere the outlook is even bleaker: By 2020, worker-to-retiree ratios are expected to fall to 1.8 in France and Germany, and 1.4 in Italy and Japan.

Social insurance in the advanced countries is caught in a squeeze between rising life expectancy on one flank and falling fertility on the other. In that tightening vise, what once seemed so clever is now a catastrophe in the making. “When population growth slows down, so that we no longer have the comfortable Ponzi rate of growth or we even begin to register a decline in total numbers,” a chastened Paul Samuelson wrote in 1985, “then the thorns along the primrose path reveal themselves with a vengeance.”

The Crushing Burden of “Security”

Already today, public pension spending in the rich member countries of the OECD averages 24 percent of the total government budget, or 8 percent of GDP. To fund these enormous outlays, the tax burden imposed on current employees has reached punishing levels: In Italy, Germany, and Sweden, for example, the combination of employer and employee contributions and personal income taxes now averages around 50 percent of gross labor costs. And while workers put more and more into the system, they can expect to receive less and less. In Sweden, the average rate of return for the generation retiring 25 years after the establishment of the public pension system approached 10 percent per year; for the generation retiring 20 years later, the rate of return had dropped to 3 percent. In the United States, real rates of return for two-earner couples now range from -0.45 percent to 2.13 percent, depending on income.

Even with rising tax rates and declining returns, pay-as-you-go systems throughout the advanced nations are heading toward financial collapse. In the United States, Social Security revenues currently exceed expenses, but the system is expected to begin running deficits in 2016. The annual shortfall is projected to be $1.3 trillion by 2030, a figure that represents more than two-thirds of the entire federal budget for 2001. Over the next 75 years, Social Security’s total unfunded liabilities have an estimated present value of $9 trillion — as compared to the current national debt of $5.7 trillion. In Germany and Japan, the current unfunded liabilities of the public pension system are well over 100 percent of GDP; in France and Italy, they exceed 200 percent.

Since developing countries still have relatively young populations, one might expect that the problems with their pension systems remain in the distant future. One would be wrong. First of all, developing countries are making the transition from high birth and death rates to low fertility and mortality much faster than did the advanced nations. It took France 140 years to double the share of the population over 60 years of age (from 9 to 18 percent), while Belgium needed nearly 120 years; China, on the other hand, will repeat the feat in 34 years, and Venezuela will do it in 22. Between 1990 and 2030, the percentage of the world’s population over 60 years of age is expected to increase from 9 percent to 16 percent, and most of that growth will occur in poorer countries.

In addition, administering public pension systems in poor countries is severely complicated by the large informal sectors endemic to those societies. A vicious circle is often triggered. Because many people work in the informal sector, payroll taxes (collected only in the formal sector) have to be higher than would otherwise be necessary. High payroll taxes, though, create incentives for even more people to retreat into the informal sector, thus necessitating even higher rates, which push more people into tax evasion, and so forth. Rising payroll tax rates in Uruguay, for example, caused the proportion of workers contributing to the system to fall from 81 percent in 1975 to 67 percent in 1989. In Brazil, evasion cut contribution revenues by more than a third during the 1980s.

The transitional economies of the former Soviet empire have inherited no end of problems from the Communist era, including tottering public pension systems. During Soviet rule, dependence on state pensions was nearly total, since occupational pensions and private saving were virtually nonexistent. With communism’s collapse, the folly of that dependence has become abundantly clear. To begin with, the countries in question have populations that are nearly as old as those in the advanced nations: As of 1990, over 15 percent of people in former Communist bloc countries were over 60, as compared to 18 percent in the OECD. Like developing nations, though, they also have large informal sectors that erode the contribution base.

By the mid-1990s the pension systems of the transitional economies were saddled with cripplingly high dependency ratios. In Poland, pensioners totaled 61 percent of active workers by 1996; in Ukraine, the figure was 68 percent; in Bulgaria, 79 percent. To cope with this crushing burden, contribution rates were forced to remain at the punitive levels that had been set during Communist rule: 26 percent in the Czech Republic, 30.5 percent in Hungary, and 42 percent in Bulgaria. With the demise of the command economy, though, such high rates only accelerated workers’ flight into the informal sector, aggravating dependency ratios even further.

Government-provided social insurance is defended on the ground that it shields retirees from the market risks that attend private pension plans. Indeed it does, but only at the cost of subjecting current and future retirees to a far greater risk — the risk of living until the Ponzi scheme of pay-as-you-go pensions begins to break down. Over the past couple of decades retirees around the world have discovered, much to their chagrin, that substituting political risk for market risk has been a poor bargain indeed, as governments have been forced to renege on promises and slash benefits in order to stave off financial collapse.

Broken Promises, Spectacular Reform

The breach of faith has been especially severe in developing and transitional countries. Failure to adjust benefits for inflation was a favorite strategy in Latin America. The average real pension dropped 80 percent in Venezuela between 1974 and 1992 because of inflation; benefits fell 30 percent in Argentina between 1985 and 1992 for the same reason. In the transitional economies, a combination of inflation, explicit benefit cuts, and accumulation of arrears kept pension expenditures as a percentage of GDP more or less constant despite rapid growth in the number of pensioners. Consequently, in Romania, retirees’ real per-capita income fell 23 percent between 1987 and 1994; in Hungary, the fall was 26 percent; in Latvia, 42 percent. In 1999, some four million elderly Russians were expected to survive on the minimum pension of 234 rubles (less than $10 dollars) a month. Millions more received nothing as the government simply failed to honor its obligations to its most vulnerable citizens.

On a less dramatic scale, chiseling has been occurring in rich countries as well. In the United States, a 1983 patch-job for Social Security included making benefits taxable for high-income recipients, skipping inflation indexation for one year, and gradually raising the retirement age from 65 to 67. Germany has scheduled an increase in the retirement age and reduced benefit levels by basing them on post-tax rather than pre-tax wages. Japan cut benefits back in 1986. Iceland shifted to a means-tested benefit in 1992, thereby eliminating payments altogether for thousands of retirees. While such moves and others like them may have been necessary under the circumstances, the fact remains that promises have been broken, repeatedly, and more infidelity is in store.

As the gap between promise and reality grows ever wider, countries around the world have begun to experiment with alternatives to the collectivized status quo. Leading the way was Chile, which in 1981 moved to phase out its pay-as-you-go system and replace it with privately owned individual retirement accounts. Instead of the old 26 percent payroll tax, workers are now required to deposit 10 percent of their wages into special savings accounts. Private companies, known as “administradoras de fondos de pensiones” (AFPs), manage the accounts. Workers are free to choose their AFP and switch their savings from one to another. Upon retirement, workers can either use their accumulated savings to purchase a lifetime annuity from an insurance company, or else leave the money in the account and make programmed withdrawals. Any money remaining in the account when the retiree dies can be passed on to heirs.

Workers who entered the labor force after the new system was in place were required to participate in the new system, while those who had already retired had their benefits under the old system guaranteed. Transitional workers were given the choice between sticking with the old system or switching to the new; if they switched, they were given a “recognition bond” to credit them for their prior contributions. The bond was placed in the worker’s account and its amount was set so that, at retirement, it would be equal to the worker’s accrued benefits under the old system.

Finally, the Chilean pension reform maintains a safety net in the form of a minimum pension guarantee. If for any reason a retiree’s private benefits do not meet a minimum threshold, the government will supplement those benefits to bring them up to that threshold. Such supplemental payments are funded from general tax revenues, not a payroll tax.

Chile’s pension reforms have been a spectacular success. Some 5.9 million workers owned private savings accounts by the end of 1998 — up from 1.4 million at the end of 1981. More than 95 percent of the transitional workers who were given a choice have decided to join the new system. Assets in that system have grown to over 40 percent of GDP and are projected to reach 134 percent of GDP by 2020. The real rate of return on those assets averaged a gaudy 11.3 percent a year through 1999. A 1995 study found that pension benefits averaged 78 percent of a retiree’s average salary over the last 10 years of his working life.

Meanwhile, the reforms have generated an impressive array of ancillary benefits. In conjunction with other market-oriented reforms, pension privatization has helped to raise Chile’s national savings rate from around 10 percent in the late 1970s to over 25 percent at the beginning of the 21st century. Capital markets have deepened dramatically thanks to the accumulation of large private pension funds. Financial markets have grown in sophistication as well as size: Stock market liquidity has increased; new financial instruments like indexed annuities and mortgage-backed bonds have been developed; and transparency has improved with better disclosure and the emergence of credit-rating institutions. One econometric analysis credits the development of financial markets promoted by pension reform and related factors with increasing total factor productivity in Chile by 1 percentage point per year, or half the overall rate of increase.

Perhaps most important, pension reform has helped to end the class conflict that so convulsed Chile during the 1970s. “We recognized that when workers do not have property, they are vulnerable to demagogues,” recalls José Piñera, who as minister of labor was the architect of Chile’s pension privatization. (Full disclosure: Piñera and I are colleagues at the Cato Institute.) “The key insight of our pension reform was that, by allowing workers to acquire property in the form of financial capital, we could strengthen their commitment to the free market by aligning their interests with the health of the economy.”

Piñera and his fellow reformers turned the tables on Marx: Workers became owners of the means of production, but through the expansion of the market system rather than its overthrow. In the process, Marxist-style collectivism lost much of its appeal. “Since our reforms we have had three center-left governments,” observes Piñera, “and none of them has touched the core of our major free-market policies. And one reason for this is that nobody dares to threaten the value of the workers’ retirement accounts.”

Recovering from Dysfunction

A host of other countries have followed Chile’s example in recent years. Argentina, Australia, Bolivia, Colombia, El Salvador, Hungary, Kazakhstan, Mexico, Peru, Poland, Sweden, Switzerland, the United Kingdom, and Uruguay have all instituted mandatory private savings plans that, to a greater or lesser extent, supplant the old pay-as-you-go approach. In most of these countries the new private system only partially replaces the pay-as-you-go system. In Hungary, for example, workers contribute 6 percent to private accounts while a 24 percent payroll tax continues to support the old system. In Sweden, a 16 percent payroll tax goes to maintain the old system, while 2.5 percent of a worker’s salary now goes into a private account. The Bush administration is now considering a similar partial privatization for the United States.

Partial reforms are still only a partial solution. Private accounts will help to generate higher returns for future generations of retirees, but those generations will still be saddled with a dysfunctional, if somewhat shrunken, pay-as-you-go Ponzi scheme. The longer that thorough reform is delayed, the more unfavorable the demographic situation becomes and the more onerous the burdens of maintaining the old system are.

It must be acknowledged, though, that the path toward full-scale privatization — with government-provided benefits limited to ensuring some guaranteed minimum — is arduous and lined with hazards. The most obvious hurdle to overcome is financing the transition from the old to the new system. Phasing out the traditional system does not create any new costs; on the contrary, by preventing future unfunded liabilities from accruing, reform contains and ultimately cuts off the flow of red ink. But there is a temporary cash-flow problem: Benefits under the old system must be paid out to current retirees, but the contributions that formerly funded those benefits are now being directed into private accounts. Other sources of funds must be tapped to pay off the remaining liabilities — which can be staggeringly large.

The Chilean experience shows that this obstacle, though daunting, is not insuperable. The implicit debt of its pay-as-you-go system had grown in excess of 100 percent of GDP. But shifting most current workers out of the old system quickly slashed that figure. To deal with what remained, Chile used a variety of methods. It continued a portion of the payroll tax for a number of years, sold off state-owned enterprises to raise revenue, cut other government expenditures, issued new government bonds, and painlessly reaped the benefits of the additional tax revenues that came from a faster-growing economy. Together, these measures have sufficed to cover the transition’s financing requirements, which have ranged from 1.4 to 4.4 percent of GDP per year.

Other risks lurk in designing a new system. While some measure of prudential regulation may be necessary, especially in countries with underdeveloped financial markets, excessive government meddling in how private accounts are to be invested can reduce returns for savers — possibly catastrophically. Chile, for example, still requires AFPs to guarantee a minimum return relative to other AFPs. Consequently there is little difference in the portfolios of the various AFPs, therefore denying savers the opportunity to choose different mixes of risk and return. Also, Chile has rigid restrictions on the commissions charged by AFPs that prevent discounts based on maintaining a specific balance or keeping an account for some specified amount of time. Thus prevented from competing effectively on product or price, the AFPs attempt to lure customers through marketing ploys — just as American banks in the days of interest rate controls offered toasters for new accounts. Such empty competition drives up administrative costs.

In Mexico, meanwhile, fund managers are required to invest a minimum of 65 percent of assets in government securities — a grievously wrongheaded mandate that risks turning the system into a dumping ground for government debt. A fiscal crisis, not a remote contingency in Mexico by any means, could wipe out the retirement savings of a generation. The Mexican system also prohibits investments in equities or any foreign assets. Such restrictions stifle the new sophistication in financial markets that is an enormous side benefit of privatization, as well as preventing prudent portfolio diversification. In poorer countries with underdeveloped financial markets, it is especially important that savers be allowed to invest in high-quality foreign assets.

Whether in the form of regulation or market participation, overweening government control over investments in a “privatized” system merely substitutes one form of hyper-centralization for another. Indeed, for decades many developing countries have pursued this variation on top-down control in a pure and explicit form. Rather than adopting pay-as-you-go systems, these countries, including India, Malaysia, Singapore, and a number of African nations, created retirement plans in which there is a single retirement fund or “provident fund” and the government manages all the investment assets.

These provident fund systems do avoid the perverse Ponzi-scheme dynamics of conventionally collectivized social insurance — but only to fall prey to other dysfunctions. Specifically, the government as investment-fund monopolist is immune from competitive pressure to earn a decent return; consequently, it is not constrained from investing in ways that are politically advantageous but economically dubious. Unsurprisingly, the performance of provident fund systems has ranged from lackluster to disastrous. In the latter category, Kenya’s system averaged a negative 3.8 percent rate of return during the 1980s, while returns in Zambia averaged negative 23.4 percent.

Social insurance is not menaced by excessive reliance on markets. On the contrary, it is the systematic suppression of market principles that has put the retirement security of millions in jeopardy. Undoing past mistakes will require formidable resolve, as will resisting the continuing temptation to attempt control from above. But if the resolve can be found, the proper direction is clear: For the sake of retirement security, for the sake of true social cohesion, the growing movement for market-based reform in social insurance is the one best hope there is.

Brink Lindsey is vice president for research at the Cato Institute.