COMMITTEE ON WAYS AND MEANS BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois E. CLAY SHAW, Jr., Florida NANCY L. JOHNSON, Connecticut AMO HOUGHTON, New York WALLY HERGER, California JIM MCCRERY, Louisiana DAVE CAMP, Michigan JIM RAMSTAD, Minnesota JIM NUSSLE, Iowa SAM JOHNSON, Texas JENNIFER DUNN, Washington MAC COLLINS, Georgia ROB PORTMAN, Ohio PHIL ENGLISH, Pennsylvania WES WATKINS, Oklahoma J. D. HAYWORTH, Arizona JERRY WELLER, Illinois KENNY C. HULSHOF, Missouri SCOTT MCINNIS, Colorado RON LEWIS, Kentucky MARK FOLEY, Florida KEVIN BRADY, Texas PAUL RYAN, Wisconsin	CHARLES B. RANGEL, New York FORTNEY PETE STARK, California ROBERT T. MATSUI, California WILLIAM J. COYNE, Pennsylvania SANDER M. LEVIN, Michigan BENJAMIN L. CARDIN, Maryland JIM MCDERMOTT, Washington GERALD D. KLECZKA, Wisconsin JOHN LEWIS, Georgia RICHARD E. NEAL, Massachusetts MICHAEL R. MCNULTY, New York WILLIAM J. JEFFERSON, Louisiana JOHN S. TANNER, Tennessee XAVIER BECERRA, California KAREN L. THURMAN, Florida LLOYD DOGGETT, Texas EARL POMEROY, North Dakota
Allison Giles, Chief of Staff Janice Mays, Minority Chief Counsel  SUBCOMMITTEE ON SOCIAL SECURITY E. CLAY SHAW, Florida, Chairman
SAM JOHNSON, Texas MAC COLLINS, Georgia J.D. HAYWORTH, Arizona KENNY C. HULSHOF, Missouri RON LEWIS, Kentucky KEVIN BRADY, Texas PAUL RYAN, Wisconsin	ROBERT T. MATSUI, California LLOYD DOGGETT, Texas BENJAMIN L. CARDIN, Maryland EARL POMEROY, North Dakota XAVIER BECERRA, California
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.

Advisory of July 24, 2001, announcing the hearing

Burtless, Gary, Brookings Institution

Cato Institute, L. Jacobo Rodriquez

Center for Strategic and International Studies, Paul S. Hewitt

Harris, David O., Watson Wyatt Worldwide

Orszag, Peter R., Sebago Associates, Inc.

Prudential plc, Keith Bedell-Pearce

Swedish National Social Insurance Board, Edward Palmer

SOCIAL SECURITY AND PENSION REFORM:
LESSONS FROM OTHER COUNTRIES

House of Representatives,
Committee on Ways and Means,
Subcommittee on Social Security,
Washington, DC.

The Subcommittee met, pursuant to notice, at 10:08 a.m., in room B-318 Rayburn House Office Building, Hon. E. Clay Shaw, Jr., (Chairman of the Subcommittee) presiding.

[The advisory announcing the hearing follows:]

Chairman SHAW. This hearing will come to order.

Good morning. Today we focus on the lessons that we can learn from other countries who have worked to strengthen their public retirement systems. The challenges presented by an aging society are not unique to the United States. Throughout the world, many nations are confronted with seniors collecting benefits for a longer period of time, as life expectancy increases, while there are fewer workers supporting each retiree as birth rates fall.

But before we get to how Social Security might be strengthened, given the statement of my Democrat colleagues in response to the President's Commission to Strengthen Social Security's interim report, I want to revisit the question of whether Social Security needs to be strengthened at all. Let me begin by drawing your attention to the placards at the front of the room, and I quote:

"After the next 15 years--not 37 years--after the next 15 years, increasingly larger amounts of annual interest income must be used to meet the benefit payments and other expenditures, and the general fund of the Treasury will be drawn upon to provide the necessary cash. The accumulation and subsequent redemption of substantial trust fund assets has important economic and public policy implications that go well beyond the operation of the Old Age Survivors and Disability Insurance, OASDI, program itself."

Moving on now to the second placard: "The redemption of a Treasury security held by a trust fund requires that the Treasury transfer cash obtained from another revenue source, such as income taxes or borrowing from the public through the trust fund."

These quotes are from the 2000 annual report of the Board of Trustees, made up of the top economic and pension officials from the President Clinton administration, namely Lawrence Summers, Secretary of the Treasury, managing trustee; Alexis Herman, Secretary of Labor; Kenneth Afpel, Commissioner of Social Security; and this is among others. Donna Shalala was one that also signed the report. I was just reading it the other day.

These trustees conclude precisely the same thing as the President's Commission, that in approximately 15 years the system will face cash imbalances that will grow rapidly, and it is very important that we keep this in mind. It will have cash imbalances. There will not be enough coming into the trust fund to pay the benefits, and the trust fund will have to go to the Treasury and cash in the Treasury bills, and the Treasury will have to go to the taxpayers or borrow money in order to get the funds in order to pay off these Treasury bills.

Not only were the conclusions the same, but so were the explanations. Like other social insurance programs of industrialized nations, the aging of the population in the United States will result in fewer workers supporting each retiree. Many nations examined all the available alternatives, as we are doing now, and chose to use personal accounts to help sustain and supplement the benefits that have lifted seniors out of poverty and kept them out of poverty in this modern era.

For Social Security and the people who depend upon it, inaction is the greatest enemy. Each time the debate on Social Security delays progress, the cost and risk to the system increases. Some Democrats consider any type of personal account is radical. However, ignoring the system's problems until it reaches a crisis and faces the prospect of a 38-percent tax increase on all workers, including working mothers or low-income families, is what is truly radical and truly reckless.

Other countries are struggling with how to make ends meet, and their pension systems are in more immediate danger, since their populations are aging more quickly. Several countries, including Japan and the United Kingdom, have raised retirement ages. In addition to increasing taxes or reducing benefits, more and more nations, such as the United Kingdom, Sweden, Australia, and Chile, are using personal accounts as an important part of their retirement program. Even South Africa is.

Today we will hear from experts, some of whom have traveled great distances, regarding the similar challenges other countries have faced and their diverse approaches to modernizing retirement income security programs and establishing individual accounts as part of their programs. Given our shared challenge, and the fact that more and more countries are using personal accounts as their strategy to reform their public retirement system, it makes good sense to learn from one another. Knowing more about their experiences will help us forge our plan for strengthening Social Security.

Now, if there are some other areas and other ways to meet the challenge of the cash shortfall that we are going to start experiencing in 2016, I would like to know about it, because I do know that personal accounts have become controversial. They have been attacked by many of my colleagues, perhaps well-intended. But I think anyone who comes in and attacks these programs has the obligation to come forward with a plan on how we are going to take up the cash shortfall that is going to begin in 2016.

We are obviously going to have Treasury bills, that is the full faith and credit of the Federal Government, that are going to extend well into the '30s, but how are we going to pay them off beginning in 2016? That is the dilemma that I see as the challenge before this Subcommittee.

I would now yield to the gentleman from California, Mr. Matsui, for his opening statement.

[The opening statement of Chairman Shaw follows:]

Mr. MATSUI. Thank you very much, Mr. Chairman. I appreciate your remarks, and I want to apologize. My Democratic colleagues, I think many of them are on the floor at this particular time. We have the Jordanian trade bill up now, and I know that Mr. Doggett, Mr. Cardin, and a number of others wanted to speak on that issue, but I believe that they will be here shortly.

And I want to also welcome the seven panelists, one of the first times we have had so many on one particular panel. I might just mention to the Chairman, because you did suggest that if anybody has any other ideas about how to fix Social Security, they ought to come up with them, at this very moment Mr. Stenholm and Mr. Kolbe in the triangle are having a press conference on support of their privatization proposal.

As we know, Speaker Hastert, Minority Leader Gephardt, and Ari Fleischer on behalf of the President yesterday all came out against Mr. Stenholm and Mr. Kolbe's proposal. And so it is my hope that the commission comes up with something that might be a little different, although I don't see how, but perhaps they will. And anybody who is interested probably should endorse Mr. Kolbe and Mr. Stenholm's proposal. That might be one way to get this debate joined, and we can then obviously begin to debate the real issues, rather than hear from the Chileans and a few others that have no relevance to the U.S. economy.

I might just point out a few things. In terms of the 2016 date, as I said earlier last week, there is no question that the commission was attempting to frighten the American people, and pit young people, those in the work force, against senior citizens at this particular time. And it is somewhat unfortunate because on the year 2016 we are going to have $5 trillion worth of payroll taxes that will be sitting in the Social Security trust fund, undoubtedly will be used, hopefully to pay down the debt, not spent on other expenditures.

In the meantime we will be accumulating interest on that $5 trillion at the rate of 6.9 percent per annum, and we won't really draw down on the surplus, the $5 trillion corpus of that trust fund, until the year 2025. And as we all know, it is not until the year 2038 that we actually do have a problem where there will be a benefit shortfall.

The benefit shortfall for the next 75 years is 12 percent, a fundamental problem and one that we need to address immediately. And with President Bush in the White House, and with the Republicans in control of the House, it would be my hope that they would come up with a proposal, or sit down with Democrats and Republican Members so that we can work out a bipartisan compromise.

In fact, I will make that request at this very moment, Mr. Chairman. Perhaps you and Mr. Thomas and the Republican leadership can sit down with Mr. Rangel, myself and Mr. Gephardt, and maybe even bring in the Democratic and Republican leadership, and see if we can come up with a proposal. I would welcome that opportunity, because we cannot leave the uncertainty that we currently have in the market today.

Now, let me just mention a few other things, if I may, and I will be very brief but I don't want this to go undiscussed. And I have the greatest respect for Mr. Hewitt. Mr. Hewitt, I might say that your report is not finalized yet, and I know Mr. Mondale, the co-chair who you will be mentioning in your opening statement, has significant reservations about privatization just as I do. And so I would hope that these are your opinions and not necessarily the organization upon which are you are talking, because certainly there will be a lot more discussion about the report when it does become final.

And I might just point out, just by way of discussion here, in terms of my opening statement, that you mention in your statement on page 2 that Japan's health and welfare industry recently estimated that at current birth rates, there will only be 500 Japanese left in the year 3000. That is a rather startling statistic. I don't know the relevance of it, but 999 years from now I would be more worried, rather than 500 Japanese being in existence, that the human species would be in existence, given the fact that no one seems to be concerned about global warming in the administration, and a few other significant issues.

But the fact of the matter is that numbers don't really mean a lot when you talk about 1,000 years from now, maybe even 75 years from now. Seventy-five years ago I think Lindbergh was flying over the Atlantic, and if he would have been thinking about supersonic transportation and the kind of internet operations we have now, he would probably think he was crazy. So we don't really know what the birth rate, population, will be in 75 years.

And let me just conclude by making a couple other observations. I mentioned Chile, and I didn't mean to pick on Chile, Mr. Rodriguez, but you know Sweden and Denmark and Australia, these other countries that we are talking about, Chile has a population of 20 million and a work force of 10 million. California has a larger population and work force than that, and I just might say that we wouldn't adopt the Chilean example.

But I don't know what relevance the population of that has and the others have when you have 270 million people, 200 million people in the work force. And I just might point out, I guess London, England is probably the closest thing that we have today in terms of financial relevance to this hearing and what our problems are.

But I might just point out there that in terms of the industrialized countries of the world, this is a shocking statistic but people ought to know it, the pension, public pension rate to our senior citizens is the lowest. Canada has 5.2 percent of gross domestic product (GDP) going to their senior citizens; France, 10.6; Germany, 11.1; Italy, 13.3; Japan, 6.6. We only give 4.1 percent of GDP to our senior citizens, the lowest of all these countries except for the U.K. In the year 2050 it is going to get worse in terms of the U.S.

And I might just point out also that in terms of the industrialized countries of the world, the United States has three times the rate of poverty in senior citizens than these other countries. And so I don't think that we are spending too much money on our senior citizens. I think, on the contrary, that perhaps we have a ways to go.

And maybe these other countries have to do something because they are spending a generous sum on their senior citizens, but we are not. In fact, if we cut Social Security, we would put 60 percent of the American senior citizen population into poverty.

In conclusion, Mr. Chairman, and I really appreciate this hearing, but I know we are going to have somebody from Prudential here today, Mr. Bedell-Pearce, and I would like him to explain some of the issues that perhaps I won't have an opportunity to ask him, but he should explain this. He calls it, I guess, mis-selling that occurred in England in the late '90s. And I just read here a statement that--if I can find it--I have it right here. Here it is. This is from the Guardian of August 10, 1998. I quote:

"Britain's biggest life insurer, the Prudential, was the center of a new controversy last night after a Guardian investigation revealed it is continuing to attempt to mis-sell petitions. When approached by Guardian investigators, Prudential agents (1) attempted to sell policies that maximized their earnings for their salespersons and the company; (2) recommended poorer value pensions; (3) quoted future growth figures banned by the Financial Services Act; and (4) showed potential customers deliberately misleading competitors' statistics."

And I conclude by making this. Just two weeks ago the statement in a British newspaper stated:

"Ministers are concerned"--that is, the finance ministers are concerned--"that the financial problems of Equitable Life Pensioners could deliver a blow to the government stakeholder pensions." That is the second tier pension system. "About 1 million Equitable policyholders saw the value of their pension funds cut by 16 percent this week." That is the private sector pension program. "It certainly will not help us convince people to save if a big household name is cutting the value of its funds, but we believe it is an isolated case," one official said.

And perhaps you can comment on that. It is kind of interesting that we have somebody who benefits from private pension programs or privatization testifying on behalf of it, but there is nothing wrong with it, I suppose.

But in any event, I look forward to this hearing, Mr. Chairman, and look forward to the witnesses, and certainly the continuing debate on the issue of whether we should carve out 16 percent of Social Security payroll taxes and divert them to other sources to reduce the senior citizens' pension benefits and Social Security benefits.

[The following was subsequently received:]

Prudential plc
London, England

On the first point, the congressman referred to pensions mis-selling that took place in the "late 1990s" and cited an article appearing in the UK newspaper "The Guardian" in 1998 where it was alleged that a Prudential representative had offered bad advice in relation to a pension product and where it was alleged that the salesman was motivated by potential commission earnings.

The oversight mechanisms introduced by Prudential and the rest of the industry after 1994 mean that there should not be a reoccurrence of product mis-selling but the conclusion reached by both the industry and the Government was that the more satisfactory approach is the regulate the product itself. With the new Stakeholder pension introduced in April of this year, the maximum management charge has been restricted to not more than 1% per annum and there are further rules on the shape and nature of the product.

As for the Guardian article in question, I am happy to clarify that Prudential expressed concern about the contents and met the Guardian to discuss the background. Despite Prudential and the regulator (The Financial Services Authority) requesting transcripts, the Guardian was unable to produce any supporting evidence to substantiate the allegation. Equally importantly, the alleged incident refers, not to a sale, but to a "fact finding" meeting the first stage of the early process, a process which, since 1995, had been subject to "second pair of eyes" independent oversight. We are confident that no sale would have been completed in this particular case.

On Equitable Life, the problems of this, the UK's oldest mutual life company, were truly unique to that company and resulted primarily from a combination of the issue of guarantees on certain policies which required reducing payments on non-guaranteed policies because the financial reserves of the mutual were inadequate. The Equitable case underlines the dangers of open-ended guarantees and provides an important warning to both commercial and State providers alike. Far from diminishing confidence in pensions or the life industry in general, sales of life products by other life companies have increased substantially since Equitable's problems emerged.

In short, neither pensions mis-selling nor the problems of Equitable can be cited as legitimate reasons to avoid the creation of individual accounts for retirement if the lessons of product regulation and the inadvisability of guarantees are taken on board. The UK Government has had no hesitation in launching the new generation of Stakeholder pensions in partnership with the UK insurance industry, a partnership which is supported by both the public and the trade unions. Indeed, the Trades Union Congress (the representative body for unions in the UK) has appointed Prudential as its exclusive provider of stakeholder pensions for arrangements set-up by its member unions.

Yours sincerely,

Keith Bedell-Pearce
Executive Director

Chairman SHAW. I would like to just briefly reply, and I don't want this to be a battle of opening statements, and any other members that--

Mr. MATSUI. Mr. Chairman, can we go by regular order. I don't mind that, but then I wish to have an opportunity to reply. That is fine.

Chairman SHAW. Oh, yes, but I just want to make one point very clear. Last year Mr. Archer and I did meet with Mr. Gephardt and Mr. Hastert. We did meet with Mr. Rangel. I don't recall whether you were in those specific meetings. I think you were, but maybe I am wrong about that. And I would certainly accept your challenge to meet again. I think that is a very good suggestion, and I will be glad to repeat that and meet again.

Now, if you want to reply--

Mr. MATSUI. The only thing I would reply, I was in one of the meetings, Mr. Chairman, and at that meeting the Archer-Shaw bill was presented to us as the approach we needed to take. I recall Mr. Archer saying that this is the way we have to go. It wasn't really a discussion of negotiations. It was the discussion of whether we could support that bill.

My problem with your bill was the fact that by 2033 we would have had to borrow from the general fund, if there was a general fund surplus, $11.7 trillion, and I didn't think that that was something that was supportable by your own party. In fact, Mr. Hastert kind of backed away from it at that time and the meeting was terminated.

Chairman SHAW. Well, I would say that is totally incorrect. But in any event, your recollection is totally flawed, and I will supply you with the numbers of what the Archer-Shaw bill would have done.

I would like at this time to yield to Mr. Camp for purposes of introducing one of our panelists this morning.

Mr. CAMP. I thank the Chairman for yielding, as I am not a member of this Subcommittee. And as the gentleman from California and I have discussed, I am sure that the person I would like to introduce will certainly attempt to answer your concerns later on.

But I just want to say that I attended a seminar with Keith Bedell-Pearce, who is chairman of Prudential and also affiliated with Jackson National Life, which brings income security to many Americans as well as people of the State of Michigan. And his knowledge of the public-private partnership in place in the United Kingdom to address retirement security I think will be of some help to this Subcommittee, and I look forward to hearing his testimony and to hear his insights on the pension system in the United Kingdom, so that as we go forward on this very important debate, that we have at least the knowledge of experts from around the world on this subject.

And I certainly welcome the entire panel, as well. We have got a number of distinguished visitors, as well as David Harris, who I have met before and attended seminars with, as well. So I look forward to hearing the testimony this morning, and thank the Chairman for his indulgence.

Chairman SHAW. Thank you, Mr. Camp.

And to introduce the other witnesses, some of whom have already been partially introduced: Paul Hewitt, who is the director of Global Aging Initiative, the Center for Strategic and international Studies, welcome; Gary Burtless, who is a senior fellow at the Brookings Institute; Edward Palmer, who is the chief, Research and Evaluation, National Social Insurance Board in Stockholm, Sweden; Peter Orszag, Dr. Peter Orszag--and if I am mispronouncing your name, you can correct me when it is your turn--who is the president of the Sebago Associates in Belmont, California; Mr. Rodriguez, who is assistant director, Project on Global Economic Liberty at the Cato Institute, and I might add here at this particular point, I believe Chile had a social security system over 10 years before the United States did, so they have been very progressive in that area; and Mr. David Harris, who is a consultant, Watson Wyatt Worldwide, at Reigate--am I pronouncing that correctly?

Mr. HARRIS. Reigate.

Chairman SHAW. Reigate, Surrey, United Kingdom.

Welcome, all of you. We have all of your full statements that will be made a part of the record. You may proceed and summarize as you see fit. Mr. Hewitt?

Mr. HEWITT. Mr. Chairman, in 1999 CSIS undertook a multiyear research program to assess the economic and financial consequences of population aging throughout the developed world. Our work began with the recognition that America is not the only nation that faces a sharp rise in old-age dependency over the coming decade.

The whole industrial world is aging, most of it a lot more rapidly than we are. The transition economies of the former Soviet bloc are aging faster than we are, and even such key emerging market countries as China, Korea, Taiwan, Thailand, Brazil, and Chile can all expect to have older age structures than we will by mid-century.

Given these trends, it is not surprising to find ourselves in the midst of a global revolution in pension reform. This common challenge holds great dangers for the global economy, not least because financial catastrophe in any one nation could tip others into crisis. But one advantage it gives us is that there is a rich record of reform from which we can draw.

Franklin Roosevelt liked to call State governments the laboratories of democracy, and the same could be said today of national governments the world over. Our own research effort, the Global Aging Initiative, is evidence of this cross-national trend. Overseeing our work is a panel of 86 leading voices from three continents, reflecting an extraordinary diversity of political perspectives.

I am proud to note that both you, Mr. Chairman, and Congressman Matsui serve on the Global Aging Commission, together with five other Members of Congress from both sides of the aisle and seven current or former cabinet ministers from the EU and Japan. Another member of the commission is also present on the dias today, Mr. Pomeroy. Thank you for participating in our project.

Two overarching points can be made about the revolution in pension reform. First, it is not driven by ideology. In Italy, pension reform has been spearheaded by the New Democratic Party of the Left, formerly known as the Italian Communist Party. Germany's individual account law was recently pushed through the Bundestag by Gerhard Schroeder's center-left coalition of Socialists and Greens. These reforms have been nicknamed the "Riester reforms" after Labor Minister Walter Riester, the former deputy national chairman of Germany's largest industrial union, IG Metall.

Some of the other social security reforms to be examined in this panel today were also championed by parties of the left. In every case, reform has reflected a pragmatic, non-ideological response to developments that now threaten sustainability of retirement systems everywhere.

The second observation that can be made is that retirement insecurity in the industrial world today stems from social insurance itself. It doesn't matter whether you are in Austria, Belgium, Greece, or Japan, public opinion polls reflect the same overwhelming fear among the young and middle-aged that social security will not be there for them when they retire.

This is not some international fad that will go away if we ignore it. By 2030, old age dependency ratios in Japan, Canada, and the major continental European countries are projected to roughly double, while in the U.S. this ratio will rise by somewhere between two-thirds and three-quarters. In every case, serious funding problems lie ahead.

In order to insure against this new insecurity, governments are having to work with the private sector. Increased reliance on funding underlies all of the major social security reforms of the past decade. Funded pensions, essentially retirement savings plans, have two key advantages over pay-as-you-go intergenerational transfers.

First, they are not directly affected by changes in the old-age dependency ratio. Whereas a declining ratio of workers to retirees immediately signals the need for higher taxes or reduced benefits, funded systems are only indirectly affected by population aging through structural changes to the broader economy.

A second advantage to funded pensions is that cross-border investment can shield individual retirement security from adverse national economic trends. This is an important consideration in countries where labor forces are expected to decline for the foreseeable future.

America's working-age population is projected to grow by about 11 percent between now and 2030. Most of this will come before 2010. But decades of below-replacement birth rate has left much of Europe and Japan facing substantial declines in both labor forces and total populations. It was mentioned earlier that Japan's Health and Welfare Ministry recently estimated that at current birth rates, there will be just 500 Japanese left by the year 3000. I think that number is around 1,000 by the year 2500. It tails off. But in Italy, Spain, Bulgaria, a whole series of other countries, birth rates are even lower. They have been projected to come up for a long time, for decades now, and they have gone in the other direction.

Over the next 10 years these demographic trends will begin to adversely affect our economies. Surging numbers of workers have accounted for between one-half and two-thirds of the rise in the developed world's output over the past half century. In future, declining labor forces are forecast to subtract 1 percent a year or more from the economic growth rates in some countries.

Pension funding will allow citizens in Europe and Japan to invest in multinational companies whose operations inevitably will shift to faster-growing markets abroad. In this way, the global economy provides an important resource for the aging nations of this world, but it is only a resource to nations that fund their pensions.

There is a lot we can learn from the reforms adopted in other nations. The UK has a voluntary savings scheme that becomes compulsory once you select it. Australia, Chile, Sweden, have adopted compulsory savings schemes. Each has its own contribution levels and unique fiduciary rules, administrative structures, and contingent guarantees. The experiences of these and the many other countries that have moved toward pension funding in recent years should be closely examined as part of any Social Security reform effort.

Of course, as was mentioned, compared to most other industrial countries, America is aging less rapidly; our Social Security benefits are less generous; our private pension system is more robust; and we continue to be the most favored destination for capital and talent the world over. Our situation, though still serious, is less dire, and this gives America important competitive advantages in the global economy. But we will squander these advantages if we fail to learn from other nations whose situation is different from ours only in degree.

Thank you.

[The prepared statement of Mr. Hewitt follows:]

Chairman SHAW. Thank you, Mr. Hewitt. Mr. Burtless?

Mr. BURTLESS. Thank you very much. I am honored by the invitation to participate in this hearing. The goal of the hearing, as I understand it, is to learn what other countries can teach us about operating a national system of individual retirement accounts.

My written testimony concludes with an overview of these issues, and I describe some basic principles about designing such a system, principles that are based upon experiences overseas and here in the United States. I have done research in this area over the past 15 years. I am also guilty of co-authoring a book on U.S. Social Security reform and another one on the pension crisis in the five biggest industrial countries.

But my interest in this subject is not just academic. Over the past decade I have also advised a number of countries on how they can reform their pension programs to make them more solvent and protect the retirement incomes of their workers. Perhaps imprudently, a couple of these countries have even adopted some of this advice.

My oral statement, however, is not going to focus on the technical issues connected with how to design a safe and efficient individual account system. Instead, what I want to do is talk about a more basic question: Is the decision of other countries, like Chile or Sweden, Australia or Great Britain, to adopt an individual account system, really very informative about whether this would be a good idea for us?

The experiences with their new systems may be helpful in guiding the design of a similar system here in the United States, but do they really tell us whether such a system would be a good idea here? I don't think so. In the next couple of minutes, what I want to do is mention three key differences between the United States and countries that have made individual accounts part of their system. The differences make individual accounts less compelling for us than they are in these other countries.

First of all, compared with the situation in other industrial countries, the funding problem in Social Security is not particularly severe. One reason is that the American population is younger and is expected to remain younger than the populations of the other rich industrialized countries. This makes the traditional pay-as-you-go financing method more affordable for the United States than it is elsewhere.

Congress has also been much more cautious about liberalizing pensions than legislatures in other countries. Even if we faced the same aging problem as France, Germany, or Sweden, our financing problem would be smaller because our basic benefits are less generous and often start at a later age.

Incidentally, this also distinguishes us from Chile and other Latin American countries which have adopted individual accounts. The old pension systems in those countries often provided unaffordably generous benefits to favored groups in the population. Imprudent benefit expansions and widespread tax evasion made the old systems insolvent. The United States, fortunately, has never faced those problems.

Table 1 in my testimony gives you details about the demographic outlook and the public pension imbalances in the seven largest industrial countries. You will notice that the current U.S. pension system is in much better shape than the equivalent systems in most of the other G-7 countries, with the important exception of Great Britain.

A second factor distinguishing our situation from that in other countries is that we already have a well-developed system of individual and company pensions. To an extent that people often forget, the United States has a retirement system built in part on voluntary contributions by employers and their workers to company pension plans and to individual pension plans. More Americans are covered by employer and individual pension plans than is the case in most of the rest of the industrialized world.

There are some countries like the Netherlands and Switzerland where participation is even higher than in the United States, but we have a very high rate of participation already. Over half the U.S. work force is covered by an employer pension plan, and the percentage is higher still if you restrict your attention to people who are adults in full-time jobs and who have held their job for at least one year.

Thus, the case that our retirement system has a big hole because we lack a system of private funded pensions completely misses a big part of our existing system. Employers and Congress have been busy over the past half century in developing a private pension system, and then assuring that it is reasonably safe, that it is transparent, that it is well-regulated, and that it is nondiscriminatory.

I mentioned earlier that the U.S. has been more cautious than other countries with regard to liberalizing benefits. This holds down the cost of our basic system. An unwelcome side effect is that the United States has a much higher rate of old age poverty than the other rich countries. This brings up a third big difference between us and other industrial countries. The sorry facts are presented in Chart 1 of my testimony.

Among the 15 rich industrial countries where comparable evidence can be assembled, only Australia has a poverty rate among the elderly as high as ours. If you take out the United States and look at the rest of the countries, our rate is more than three times higher than that of the rest of the industrialized world.

Now, to me this is relevant to thinking about how we should fix our Social Security system. I don't think you want to take out funds from the system that does more than any other program to hold down the poverty rate among the elderly in the United States, and put those funds in a system of voluntary pensions. Anything that diverts funding from the basic pension program is something that I think in the long term is going to threaten the well-being of workers who have low or erratic earnings.

Thank you.

[The prepared statement of Mr. Burtless follows:]

Chairman SHAW. Thank you. Mr. Bedell-Pearce?

Mr. BEDELL-PEARCE. Mr. Chairman, just by way of introduction, the Prudential is one of the largest U.K. financial institutions. We have in the region of $70 billion of pensions assets under management, which I suspect pales into insignificance compared with, say, CALPERS, but it is about twice the total assets under management in Chile under their private arrangement. About 20 percent of the working population of the United Kingdom in defined contribution schemes are members of Prudential's pensions arrangements, and about one in four of the personal pensions in existence in the U.K. are with the Prudential.

I should also explain that we are no relation of Prudential Insurance Company of America. That company was set up in the 1870s, and the Prudential's board at that time gave Prudential Insurance use of the Prudential name in America, unfortunately for nothing, and we do now know how the Russians feel about selling Alaska to the United States.

In 1952, Her Majesty the Queen sent out 255 telegrams. These were to people reaching their 100th birthday. In 1998, the year for which I last have figures, the number was 5,958. And I suspect in terms of the Queen's telegram bill it is only going to get worse, and the same applies as far as the cost of Social Security.

The impending explosion of the demographic time bomb has come as something of a surprise to some of the governments in continental Europe. It shouldn't have done, because the shape of population is one of the very few things that we can predict with some certainty 50 years out.

The problem in terms of making adequate provision for retirement is largely one of political time horizons. Our former Prime Minister, Harold Wilson, said that a week is a long time in politics. Well, if that is the case, 20 years is an eternity. To change social security and pensions requires a degree, a high degree of political consensus, and we have perhaps been fortunate, either by accident or design, to have that political consensus in the United Kingdom.

Bearing in mind that politics is the art of the possible, I have given some thought, based on lessons of the past, as to the shape of future U.K. pension systems going forward, and I would like to just spend a couple of minutes outlining what reforms I would make to the U.K. system, in the hope that there may be some parallels that you may be able to draw from these views.

Starting with the basic State pension, this is currently unfunded, on a pay-as-you-go system linked to general inflation rather than wage inflation. It therefore follows that the relative value of the basic State pension is diminishing over time, and in 20 years will be of very small value indeed. Indeed, at this point it is roughly about 20 percent of national average earnings, for an individual retiree, about $100 a week.

I would migrate this basic State pension over time to a funded system, with the funds vested and managed by an independent board of trustees, with asset management contracted out according to investment guidelines established for the national pension fund. And I pretty much have these guidelines in line with those set out in Gary Burtless' written testimony, which I found extremely interesting.

I would vest ownership in this basic State pension very clearly in the potential beneficiaries by following the Chilean model, at least in providing them with what I understand is a little red book which shows them their entitlement, because it is very clear from Chile that pride in ownership has been a very significant part in reinforcing the popularity of the Chilean system.

Secondly, I would have an earnings-related layer, and as at present in the U.K. this would be compulsory, and it would be either in the form of a State scheme--and at the moment this is unfunded--or with an opt-out to approve private schemes which are funded. I would change the State scheme from unfunded to funded, but still allow opt-out, and I would increase the compulsory contribution rate from about 4.9 percent at the moment to around 10 percent, which is slightly in excess of what prevails in Australia at this stage. The private sector provision: I would cap the annual management charge at 1 percent, the rate that currently prevails in the U.K. for what we call stakeholder pensions.

The third layer would be a voluntary private-funded provision with tax incentives, but limited to the relief on contributions at the basic rate of tax. And this is a substantial change, because at the moment tax relief is provided at the highest rate. This favors the savings classes, the people who would save in any event.

And I think that I would remove the earnings cap that we have at the moment but put a contributions' cap of 5 percent of earnings for the tax-privileged third layer. Contributions in excess of 5 percent could be made, but with no tax relief. Tax gains by the Treasury could be used to defray the cost of moving to a funded State system.

The final element, often forgotten, is income streaming from retirement through to death. In the U.K. there is a requirement to purchase an income stream annuity from an authorized provider on retirement, although there are some income draw-down facilities. I would strongly support continuation of this arrangement, rather than creating a generation of transient lottery winners with the opportunity to blow 40 years of savings, or even worse, leaving them on the on-deposit while making them easy prey to rapacious boiler house salesmen.

None of the changes I have suggested are without difficulty, but all fall within my test of the art of the possible. I believe there are close parallels in what I think is right for the U.K. with what might work in the U.S.A.

I would like to conclude at this point, but just add that I am very much looking forward to receiving my telegram in 45 years time from King Charles the Third, although I suspect it will be an e-mail by then, and almost certainly sponsored by Pfizer. Thank you.

[The prepared statement of Mr. Bedell-Pearce follows:]

Chairman SHAW. Thank you. Mr. Palmer?

Mr. PALMER. Thank you, Mr. Chairman. I would like to begin with a brief overview of Sweden's new pension system.

During a series of steps in the 1990's, Sweden converted a two-tier defined benefit system dating from 1960 into a combination of notional defined contribution (NDC), pay-as-you-go accounts, and financial defined contribution schemes. Reform was driven by the threat of future large contribution rate increases, redistributional unfairness in the design of the old system, and a goal of providing a framework that would promote mandatory saving through the pension system but with privately managed assets.

The overall contribution for the two schemes together is 18.5 percent of earnings, with a split of 16/2.5 percent between the notional and the financial account systems. The annuity in both schemes is based on lifetime account values and life expectancy at retirement. The accounts in the NDC system earn an economic rate of return, whereas the accounts in the financial system earn of course a market rate of return.

The main goal, I think, in the Swedish reform was to create financial stability, and this has been the overriding goal, the idea that commitments in the future should be met but people today should be able to realize that this is the underlying goal of both the pay-as-you-go and the financial account systems. In addition, the NDC and financial account system shift the costs of early exit from the labor force to the individual, and this has been a very important part of the reform in Sweden.

I might also add that there was a political consensus behind this reform. Eighty-five percent of the parliament, five of the at that time seven political parties, and certainly the five main political parties in Sweden, got together and were all behind this reform, and still are.

I am going to turn now to the financial account system. The driving forces behind the construction of the Swedish financial account scheme were desire to hold down costs while enabling people to choose among a large number of financial portfolio opportunities. In order to do this, a separate agency, the PPM, Premiepensionsmydigheten, which stands for Premium Pension Authority, was created within the social insurance administration, and they are in charge to manage the financial account system. The PPM is a clearinghouse for fund transactions. It keeps individual accounts, and it will be the sole provider of annuities in the financial account system.

Let me briefly summarize the flows of money and information in this system. Contributions to the financial scheme are collected annually, together with all other social insurance contributions and taxes in general, by the national tax authority. Information on payments is transferred on an individual basis to the National Social Insurance Board, and from them to the PPM. Money from new contributions is transferred through the National Debt Office, which administers all financial transactions in Sweden, to the participating funds, following the receipt of an order from the PPM.

The idea behind the system is really to eliminate the problem of having the high pressure salesmen beating on your doors, and to this end the PPM has been set up as a clearinghouse for all fund transactions. You might regard it as a sort of a broker for all of Sweden. Orders to buy and sell fund shares together are executed jointly on each transaction day by the PPM. The PPM is the sole provider of annuity products in this scheme, also.

Participants can choose between single and joint life annuities, and annuities can be fixed or variable rate. I should mention that lump sum payments or phased withdrawals over shorter periods than a full life are not among the products offered.

A few words about participation criteria for fund managers, fund choices, and administrative costs. All funds licensed to operate as investment funds in Sweden and/or the European Union are allowed to participate in the system. In addition, funds must conclude an agreement with the PPM, agree to provide information to the PPM upon request, agree not to charge withdrawal fees, and provide a periodic report of administration charges.

Funds are required to compute share values and report them electronically to the PPM on a daily basis. Since the PPM invests assets on behalf of participants, it is the sole client for any given fund.

Part of the agreement concluded with the PPM includes accepting a system of rebates established by the PPM. What this means in practice is that the fund can levy normal charges minus a possible rebate. The rebate depends on the amount of PPM assets held by the fund in question.

Individuals bear the costs of their own fund choices. I might choose a fund which has cost of 0.4 percent, somebody else, 1.5 percent. It is up to me.

The first fund choices were staggered throughout the country in September-October 2000. There were 460 registered funds to choose from. People were given a month to choose, and the money of non-choosers, about 30 percent of all participants, went to a public-managed non-chooser fund which has a distribution of assets 80/20 between equities and bonds.

Participants chose, on average, 3.4 funds, which gave a total of over 11.5 million fund choices. Over 72 percent of those making a choice chose an equity fund. The market fund getting the largest share of total assets got 4 percent. The 10 largest funds got 23 percent of all assets. The conclusion, then, is that the assets were fairly well distributed among very many funds.

Administration costs, let me conclude with these. The costs actually depend on individual choices, since I can chose a fund which could cost 0.4 or 1.5 percent of assets held. The average for choices made in the year 2000 was 0.65. The PPM can charge a rate of 0.3, which gives for 2000 an average administration cost of 0.95 of total asset holdings.

Finally, I should mention that unless individuals make new fund choices, contributions are distributed in accordance with their last fund choices. Information on fund values is available daily through the major newspapers, and by internet, through the administration.

How have people reacted? I think, according to the mass media response, which has been very positive, and the high rate of participation, it seems as if this has been very well accepted by the Swedish public.

Thank you.

[The prepared statement of Mr. Palmer follows:]

Chairman SHAW. Thank you. Dr. Orszag?

Dr. ORSZAG. Mr. Chairman and members of the Subcommittee, thank you for inviting me to testify. My testimony this morning will focus on the United Kingdom, and I want to underscore the importance of looking to the U.K. for lessons on voluntary individual accounts.

Unlike many other countries that involved in adopting individual accounts, the U.K. is an industrialized economy like we are. It shares many of our traditions, our language, and it is more similar to us than many of the other countries to which we often look for insight into individual accounts.

But, more importantly, the U.K. is the only industrialized economy that has adopted a voluntary system of individual accounts, in which individuals can partially opt out of the State-run system and into an individual account. As you know, President Bush has endorsed such a voluntary approach to individual accounts in the United States. Other OECD, Organization of Economic Cooperation and Development, countries have adopted individual accounts, but they have been mandatory. The U.K. is the only advanced economy that has made them voluntary, and therefore it is particularly telling to see what we can learn from the U.K. experience.

Now, voluntary accounts probably sound innocuous at worst and quite promising at best when you first hear about them. After all, how can you be opposed to something if participation is voluntary? What I want to emphasize is that the U.K. experience underscores many of the problems associated with voluntary accounts, and I want to focus on five issues associated with the U.K. experience.

First, one crucial challenge in a voluntary system is how to provide advice to workers about whether to opt into the individual accounts. In the United Kingdom, as already was mentioned, in what has become known as the mis-selling scandal, individuals were deceived as to the benefits of individual accounts by financial firms. High pressure sales tactics were used to persuade workers to switch out of occupational funds and into unsuitable individual account plans. Financial firms are now being forced to repay amounts estimated at more than $15 billion to the individuals who were misled.

Second, to offset the incentive of younger workers to disproportionately opt into individual accounts, the U.K. has adopted an age-related rebate scheme. The government places a rebate into your individual account, but the amount of the rebate depends on how old you are. And you need to do that in order to offset the inherent tendency of younger workers to disproportionately opt into individual accounts relative to older workers, basically because the power of compound interest operates for more years for younger workers than older workers.

In any case, age-related rebates have not entered the U.S. debate at all. They are very confusing to many workers, but if you don't implement such a system, younger workers have a much stronger incentive to opt into individual accounts than older workers.

Third, in designing a system of voluntary accounts, you have to worry about the incentives to opt into the individual accounts by earnings level. Higher income taxpayers generally get a less good deal under Social Security than lower earners, and therefore would have a stronger incentive to opt into individual accounts. This is exactly what we find in the U.K. The partial withdrawal of higher income workers has left behind a pool of disproportionately lower earners in the State-run system in the U.K.

Issue number four is annuitization, that is, converting upon retirement the accumulated balance in your account to a payment per month or per year that lasts as long as your lifetime. In the U.K., the balance that you build up from the tax rebates funded by the government in an individual account, the so-called protected rights, must be converted into an annuity upon retirement, and that annuity is restricted so that it ends with the life of the annuitant or the spouse, leaving nothing for heirs after annuitization.

A final and crucial issue associated with the U.K. experience involves administrative costs. Along with two colleagues, I recently completed an exhaustive World Bank study of administrative costs in the United Kingdom. We concluded that over a working career, fees would reduce account balances for the typical worker by 43 percent relative to the balances that would accrue in the absence of administrative costs. Other studies by actuaries and financial analysts in the United Kingdom have reached similar conclusions.

This 43-percent estimate includes the cost of converting the account balance to an annuity upon retirement. Without such annuitization costs, the administrative costs in the U.K. system would reduce account balances for the typical worker by 36 percent. These high administrative costs dramatically reduce the retirement income from individual accounts. They also indicate that competition alone is not sufficient, or at least was not sufficient in the U.K., to reduce fees to reasonable levels.

Indeed, in response to the high charges imposed on individual account holders, the U.K. government has recently adopted reforms to cap the fees that can be charged by individual account providers. The political viability of such caps--their fees are now capped at 1 percent per year--in the United States is unclear.

In conclusion, although they may initially sound attractive, voluntary individual accounts involve a variety of very difficult administrative issues. The experience in the United Kingdom should serve as a particularly forceful indicator of the potential problems associated with such voluntary accounts.

The U.K. has witnessed a scandal in which vulnerable members of society were given misleading advice regarding the benefits of individual accounts, and has suffered from high administrative costs that sharply reduce the retirement benefits associated with such accounts. The government has recently been forced to impose a cap on the fees that can be charged on individual accounts by financial firms. In summary, although voluntary accounts may sound innocuous, the experience in the U.K. suggests that they may not be that at all.

Thank you, Mr. Chairman.

[The prepared statement of Dr. Orszag follows:]

Chairman SHAW. Thank you. Mr. Rodriguez?

Mr. RODRIGUEZ. Thank you, Mr. Chairman, distinguished members of the Subcommittee.

In 1981 Chile replaced its bankrupt pay-as-you-go retirement system with a fully funded system of individual retirement accounts managed by the private sector. That revolutionary reform defused a fiscal time bomb that is ticking for countries with pay-as-you-go systems, under which fewer and fewer workers have to pay for the retirement benefits of more and more retirees. More important, Chile created a retirement system that, by giving workers clearly defined property rights in their pension contributions, offers proper work and investment incentives; acts as an engine of, not an impediment to, economic growth; and enhances personal freedom and dignity.

Since the Chilean system was implemented, labor force participation, pension fund assets, and benefits have all grown. Today, more than 95 percent of Chilean workers have voluntarily joined the system; the pension funds have accumulated $36 billion in assets, a figure that is equivalent to about 35, 40 percent of Chilean GDP; and the average real rate of return has been 10.9 percent per year.

If imitation is the sincerest form of flattery, the Chilean system should be blushing from the accolades that it has received. Since 1993, eight other Latin American nations have implemented pension reforms modeled after Chile's. In March of 1999, Poland became the first country in Eastern Europe to implement a partial privatization reform based on the Chilean model. In short, the Chilean system has clearly become the point of reference for countries interested in finding an enduring solution to the problem of paying for the retirement benefits of aging populations.

Although the basic story of Chile is well known, it is worth recapping briefly. 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. Those companies invest workers' savings in a portfolio of bonds and stocks, subject to government regulations on the specific type of investment and the overall mix of the portfolio. Contrary to a common misconception, fund managers are under no obligation, nor have they ever been, to buy government securities, a requirement that would not be consistent with the notion of pension privatization.

At retirement, workers use the funds accumulated in their accounts to purchase annuities from insurance companies. Alternatively, workers can make programmed withdrawals from their accounts. The amount of those withdrawals depends on the worker's life expectancy and those of his dependents.

The government provides a safety net for those workers who, at retirement, do not have 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 contributed at least 20 years, the cost to the taxpayer of providing a minimum pension funded from general government revenues has so far been very close to zero. Of course, that cost is not new. The government also provided a safety net under the old program.

The bottom line is that workers are retiring with better, more secure pensions and increasingly at an early age. For instance, since the early retirement option was introduced in 1988, the average monthly pensions for workers retiring early have ranged from $258 to $318. By comparison, during the period of 1988 to 1998, the representative worker in the United States retiring at age 62 under Social Security is getting monthly benefits that range from $506 to $780.

That is an indication of the efficiency of the private system in Chile, not just in comparison with the old Chilean government-run system but also in comparison with the government-run system here in the United States, a country where per capita income is more than five times higher than in Chile. Chilean workers who retire at 65 are also getting benefits that are higher relative to per capita income than the benefits U.S. workers get under Social Security.

Through their pension accounts, Chilean workers have become owners of the means of production in Chile, and increasingly of the means of production of other Latin American countries, and consequently have grown much more attached to the free market and to a free society. This has had the effect of reducing class conflicts, which in turn has promoted political stability and helped to depoliticize the Chilean economy. Pensions today do not depend on the government's ability to tax future generations of workers, nor are they a source of election-time demagoguery. To the contrary, pensions depend on a worker's own efforts and thereby afford workers satisfaction and dignity.

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 and the industrialized countries of Europe. Some of those criticisms are misinformed.

For example, administrative costs are about 1 percent of assets under management, a figure similar to management costs in the U.S. mutual fund industry. To the extent the criticisms are valid, they result from a single problem, excessive government regulation. And I would be happy to discuss during the Q and A how government regulation creates distortions and how those distortions could be eliminated.

All the ingredients for the system's success--individual choice, clearly defined property rights and contributions, and private administration of accounts--have been present since 1981. If Chilean authorities address some of the remaining shortcomings with boldness, we should expect Chile's private pension system to be even more successful in the years to come than it has been in the first 20 years. And unlike a pay-as-you-go system, a fully funded individual capitalization system can anticipate fewer problems as it matures.

Thank you very much.

[The prepared statement of Mr. Rodriguez follows:]

Chairman SHAW. Thank you, Mr. Rodriguez. Mr. Harris?

Mr. HARRIS. Mr. Chairman, members of the Committee, I am pleased to have the opportunity to discuss the social security reform experiences of Australia.

For many countries, the need for social security reform is becoming more chronic as populations rapidly age. Moreover, through generous promises linked with social security programs in many developed nations, major economic and social reforms will likely have to be implemented against the backdrop of either cutting benefits or increasing associated contributions to social security programs like that found in the United States.

It should be stressed from the outset that I do not think that one particular country has provided solutions to all the challenges of executing successfully social security reform. Moreover, I believe international experiences provide a composite of important emulations or experiences that the United States can take on board.

Thus, in the case of Australia, many cultural links and social behaviors are shared in common, which can help smooth or translate important features into the American context. Both countries, for example, experienced a sharp baby boom in the middle part of the 20th century. In effect, both countries' demographic profiles are very similar.

I will now turn to the current Australian retirement system. The old age pension in Australia is seen by many as providing both a foundation and an important source of income for those retirees who have limited resources to sustain themselves in retirement. In effect, it is a non-earmarked pay-as-you-go system. Its origins date back to 1909, where a flat rate benefit was provided to individuals upon reaching a prescribed retirement age. Policy planners during this period in Australia turned their back on the notion of an earmarked pay-as-you-go model that Bismarck had used to forge a single Germanic state.

A common perception in the past by many workers with regard to their old age pension was that they were entitled to an old age pension after paying taxes throughout their working lives. Largely, this view was encouraged by many governments, but in the 1980's increasingly the commonwealth treasury and the Federal Government expressed concerns over the direction of expenditure for providing for the first pillar in Australia's retirement framework. Increasingly, expenditures in providing the first pillar were linked to a greater concern that the population of Australia was rapidly aging. Today these benefits are means-tested and equate to a maximum of 20 percent of male total average weekly earnings.

Clearly, to engineer or make such a significant shift in the overall retirement structure of any country requires a strong political resolve, a basis of consensus between political parties, and a vision for the future of the nation's citizens. In Australia's case, more through coincidence and luck, a popular Federal Government, through trade union support, was able to convey to the nation the impending problem that Australia would confront if it did nothing about addressing its aging population.

I want to stress to you today, it was a social democratic, trade union supported political party, like the Democratic Party of the United States, that continues to support the need for ongoing retirement reforms. For trade unions, which had strongly supported the election of a Federal Labor government in 1993, increasing superannuation coverage was seen as a major priority.

Before the introduction of mandated second pillar superannuation accounts, the extent of coverage of superannuation was limited only roughly to 40 percent of the work force. Typically, employees who were covered by superannuation were middle class, white collar jobs that usually denied benefits of coverage to women and people from minority groups.

By 1986, circumstances were ideal for change. A compulsory 3-percent employer contribution was generated through centralized wage-fixing. Such an approach proved difficult to administer, and did gain increases in the levels of contributions. Again, the time was ripe for change, and by 1992 the Superannuation Guarantee Charge Act implemented, saw employees required to contribute up to 9 percent of their salary by July 1, 2002, into a retirement or individual retirement account. Additionally, Mr. Chairman, it should be noted that on average, average contributions to individual accounts on a voluntary basis equate to 4 percent on top of the compulsory level.

Another method by which the Federal Government was able to engineer significant change was through a comprehensive public education campaign in 1994-1995. The Australian Government spent $11 million educating the people on the value of their individual retirement accounts.

I would like to speak just briefly with regard to the taxation of superannuation in Australia. Australia has pursued a course which is quite unique, and which on the whole I cannot agree with, in terms of the design and the overall rate of taxation applied. Australia has adopted a tax-tax-tax approach to its retirement, taxing the contributions at 15 percent, taxing the return at 15 percent, and taxing the contribution at over 15 percent. While this is quite unique, increasing criticism and increasing debate centers on whether this approach will continue.

The profile of the second pillar of Australia's retirement system depicts both a diversity and an adequacy of return that reflects strong and vigorous competition amongst financial services participants. I would like to now turn briefly to the mechanics associated with selling, distribution, and withdrawal of benefits from superannuation accounts.

As a former insurance regulator, I can suggest one of the reasons why Australia has been so successful in keeping administrative costs low and also avoiding problems associated with mis-selling is through an effective, cost efficient system of regulation. Strict rules govern how superannuation policies are sold.

It should be also noted that today individuals have between five to seven investment choices associated with their superannuation accounts, on average. This intense competition between market participants has led to, in part, returns being maximized and administrative fees being minimized. The success of consumer policy and integrated distribution platforms has meant that large scale consumer detriment has been minimized in Australia.

I would like to now just briefly turn to some of the statistical and demographic highlights. By March 2001, the Australian superannuation system had $497.1 billion invested, or $253 billion U.S. dollars. For just over 9 million workers, this level of retirement savings is considered to be quite significant, with the level of coverage of the population being 91 percent. It is important to know that 19.8 percent of these assets are invested internationally. It is also worth noting that out of these assets, 42 percent is invested into equities.

Like the United States, Australia has a demographic profile that depicts a significant baby boomer population, and this is depicted in Appendix 1.

Just moving on, administrative costs 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. Through an authoritative survey conducted by the Association of Superannuation Funds of Australia, an average estimate of $1.28 Australian or 65 cents U.S. per member per week was made for overall administrative costs. It should be noted that this figure has declined significantly in the last two years. Expressed in another way, cost as a percentage of assets in June 2000 was calculated to be 1.29 percent. It is anticipated that the levels of costs as a percentage of assets will decline as the system matures.

It should be noted for the record, as an aside, that in respect to the administrative data presented by Dr. Orszag from the United Kingdom, I must concur with the reservations expressed by Edward Whitehouse of Axia Economics in his paper, 1999, that criticizes the associated analysis and assumptions.

My conclusions are, for the United States, the challenges of Social Security reform may seem immense if not impossible from initial observations. Yet what countries like Australia demonstrate is the ability for a nation to give its people a greater ability to craft out a sufficient and appropriate level of retirement wealth to meet expected future needs and demands.

Certainly no one country's experience with regard to social security reform can be easily translated to another. Yet what countries like Australia can demonstrate to public policy planners in the United States is the strong propensity that the individual is ideally placed to determine his or her own retirement needs.

Having worked, finally, in the United States and as a member of the Social Security Trust Fund, I look forward to the progress of Social Security reform in this country that I admire greatly. Thank you.

[The prepared statement of Mr. Harris follows:]

Chairman SHAW. Thank you. Thank you, Mr. Harris.

I think, in listening to the various testimonies of the witnesses with regard to other countries, I think there is a tendency in the United States to feel that we invented everything that is good, which of course is not true. And I think that the purpose of this hearing is to reach out to other countries who have had, and I think as Mr. Hewitt correctly stated, perhaps a worse problem than we have but nevertheless the same problem that we have. And just as we followed, I knew we followed Chile and now I know that we followed Australia in setting up a social security system, I think it is also important that we listen to the other countries that have aging populations as we do.

When Social Security was first put in existence, I think in 1935 or thereabouts, I am close, there were about 40 workers per retiree. This made a very, very flattened and very efficient pay-as-you-go system as a triangle or as a pyramid. But as the age of the population grows, we find now we have gone from 40 workers per retiree down to a little over three workers per retiree.

One of the witnesses correctly stated, it was Mr. Bedell-Pearce, I think, that aging of population and demographics of population is probably one of the most accurate predictions that we can make, and those in the position of making predictions tell us that we are going to be shrinking down to a little over two. Obviously, we have to do something. Obviously, a pay-as-you-go system cannot continue to work.

Mr. Matsui mentioned the bill that Mr. Kolbe filed last week, talking about the--and that particular bill actually showed, at least the newspaper account showed actually a diminution in the benefits for people that were 10 years from retirement. That is exactly what I am hoping that, by acting now, we can avoid.

Mr. Burtless, you made reference in your testimony to the tremendous coverage that we have and the advantage that we have as to many of our workers covered by private pension. What I was listening for and didn't hear is, how are we going to continue to hold the benefits at this level for those that are not covered by a private pension?

The Social Security Administration, under the previous administration, told us, and they have been very specific about this, that we are facing about a $22 trillion deficit over the next 75 years. How do you propose to pay those payments, if we maintain the system as it is today?

Mr. BURTLESS. Well, I have testified before this and other committees frequently on this subject. I favor an increase in the normal and early age at retirement. I favor modest increases in the payroll contribution rate. And I think it is okay if the trust fund is invested in higher yielding securities than U.S. Treasury bonds. I am not strong on that because I don't think economically it makes much difference what we invest them in, but it certainly lowers the contribution rate that would be required of workers.

Having said that, let me say I am no opponent of individual or company pensions. I favor them. In fact, I would favor an obligation that employers establish programs so that their workers can save simply. For small employers, if this obligation is too burdensome, I think that the Federal Government should provide the withholding and the recordkeeping of contributions to individual accounts. This would permit pension contributions to occur at very little cost to the small employer community.

Chairman SHAW. How, to what age? Do you have a model that you have developed showing this, and if so, how high would we have to raise the retirement age in order to sustain the benefit level that we have today? And how high would the taxes, the payroll taxes on American workers, have to be raised in order to sustain the system at its existing level with a higher retirement age?

Mr. BURTLESS. I think that the best source of information about what an increase in the retirement age, either the early or the normal retirement age, the impact of that on the balance and the long-term solvency of Social Security can be obtained from Steve Goss, the Chief Actuary of Social Security. I don't pretend to be an expert on the actuarial calculations.

Chairman SHAW. Are you telling us that you don't know how high you would have to raise the taxes or how high you would have to go on the retirement age in order to sustain the--

Mr. BURTLESS. Well, we know. We know that roughly a 2-percentage point increase in the current payroll tax for old age and survivors and disability pensions, bringing it from 12.4 to 14.4 percent of wages, would cover the expected cost of the system over the next 75 years.

If, in addition to that tax increase, you changed the investment portfolio of the Social Security Trust Fund from all government bonds to some combination of other assets, a safe combination, then that 2-percentage point increase is not entirely needed. You could increase the contribution rate less because the investment earnings of the fund would cover a larger share of the benefits.

Chairman SHAW. So what you favor is the trust fund actually investing in the private sector. Is that correct?

Mr. BURTLESS. I don't think--

Chairman SHAW. There is no other place to go, if you are not investing in government securities. I assume you would be buying stocks and bonds in the private sector.

Mr. BURTLESS. Yes. I think that, at a minimum, we could invest in mortgage-backed securities, in corporate bonds (where there is no issue of how the government votes the shares), and in real estate. There are a lot of assets that the government can hold with an arms-length relationship, and that would have higher expected yield over 75 years, than Treasury bonds.

Chairman SHAW. Am I correct, in summing up your testimony, that you would agree that the existing system is not sustainable unless we raise the retirement age, increase taxes, and/or invest the trust funds in something other than government securities, or a combination of all three?

Mr. BURTLESS. That is exactly right. That is what it takes to fix Social Security.

Chairman SHAW. Thank you. I wanted to be sure that that was--

Mr. BURTLESS. You could also do large transfers from the rest of the government budget, of course. That was proposed by President Clinton.

Chairman SHAW. Yes.

Mr. BURTLESS. In other words, there is a fourth solution. The three that you mentioned are the three that would fix up Social Security in the more or less traditional way that Congress has used to fix Social Security--

Chairman SHAW. I assume that all of the witnesses, then, would certainly agree--perhaps you would disagree as to the solution to the problem, but you would agree that the existing system as a pay-as-you-go system cannot be sustained. Am I correct on that? Even though you may disagree with how we should go about changing it.

[Witnesses nod.]

Chairman SHAW. I thank you. Mr. Matsui?

Mr. MATSUI. Thank you, Mr. Chairman.

Let me say this. Mr. Burtless, when the Chairman mentioned $22 trillion being the amount of obligation, by your not responding to that number, you are not suggesting that number is correct, are you? Because the Social Security actuaries have actually said that the amount of the deficit over the next 75 years is $3.1 trillion.

Chairman SHAW. Would the gentleman yield on that?

Mr. MATSUI. Well, no. Let me ask him a question. And if you bought out the system, it would be between $8 and $11 trillion, not $22 trillion. Is that your understanding?

Mr. BURTLESS. My understanding is that the liabilities of Social Security, if we closed it down tomorrow, we stopped taking in new revenues and we just delivered on the promises that have already been made, we are talking about $10 trillion, roughly.

Mr. MATSUI. Right, right.

Mr. BURTLESS. We have $1 trillion in the bank, and the $9 trillion difference represents the amount of money that we have given to our parents, grandparents, great-grandparents over the last 50 years in excess of their contributions into the system and the investment earnings that their contributions have earned. That is the unfunded liability at this point.

Mr. MATSUI. And that comes to about $3.1 trillion.

Mr. BURTLESS. I think the $3.1 trillion is a different calculation. It is the following: How much money is promised and will continue to be promised from now on, and how much revenues can we see coming into the system from now on? Now, let's discount those two numbers back to the present. The $3 trillion is that difference.

Mr. MATSUI. Let me, if I can complete my questions, in terms of this about raising taxes or cutting benefits or investing in the market, if you have private accounts, can you solve the problem overnight and not do any of those things?

Mr. BURTLESS. I served on a commission that examined issues connected with privatization, and I thought every member of this panel agreed that privatization in and of itself doesn't solve any of the problems. There is one political problem that it may reduce. Many people are fearful that if the government owned a portfolio that included voting shares in America's companies, that is a very dangerous thing to do. And so if instead the surplus were accumulated in 140 million little accounts of individual workers, this political problem would disappear. But privatization does nothing to alleviate the economic problem facing Social Security.

Mr. MATSUI. If I could just interrupt you, then you are basically saying no. It doesn't solve this problem just by private accounts.

Mr. BURTLESS. No.

Mr. MATSUI. In fact, if you read the Richard Stevenson piece in the New York Times on Sunday, on the Kolbe-Stenholm legislation, one would find that actually taking out 16 percent of payroll or 2 percent of 12.4 percent, actually makes the problem worse. I think in the article it said that instead of 2016, the shortfall begins to occur in 2007. Is that correct?

Mr. BURTLESS. That is right. If the system is left unchanged, it is going to run out of funds in 2038. If we give away 2 percent of payroll taxes to individual contributors over the next 38 years, well, the cookie jar will be empty much, much sooner.

Mr. MATSUI. Right. Dr. Orszag, you mentioned only the British system, and you didn't mention Sweden and Australia and obviously other systems as well, particularly Chile. Was it because you didn't study those, or have you studied those systems?

Dr. ORSZAG. The real reason that I focused on the U.K. in my testimony is that it provides the best example of a country that does what President Bush has suggested.

Mr. MATSUI. And the other ones really are not comparable.

Dr. ORSZAG. They all differ in some way. Either the system is mandatory, unlike what President Bush is proposing, or it is employer-based, unlike what President Bush is proposing.

Mr. MATSUI. And with respect to Chile, you know, there is this talk about general fund monies. Chile, if I recall, Mr. Pinochet was still the leader of Chile in 1981 when they went over to the privatized system, and weren't they disposing of a lot of the government-owned property and selling it, and so that went into the overall budget of Chile. Is that correct?

Dr. ORSZAG. There were a lot of changes that were occurring at the same time, including privatization and--

Mr. MATSUI. And we don't know what went into the pension system and what didn't. Is that correct?

Dr. ORSZAG. That's right, money is fungible. It is very hard to trace what dollar went to what purpose.

Mr. MATSUI. And in the English system, when they converted over to that second tier, which is the private tier, you know, voluntary private tier, there was some general fund monies as well. Is that correct?

Dr. ORSZAG. The tax rebates reduce tax revenue, yes.

Mr. MATSUI. Right, and the tax rebates would have gone to the general fund otherwise.

Dr. ORSZAG. That is correct. They would have been part of the National Insurance Fund.

Mr. MATSUI. Right. Let me, if I may just ask, let me ask in terms of the British system, my understanding is, just from reading some of the British newspapers, that there is a $15 billion pound problem in terms of the so-called mis-selling. Can you explain that? That comes to, I think, U.S. dollars, anywhere from $15 to $20 billion. Is that correct?

Dr. ORSZAG. Yes. The numbers vary. And just to explain very briefly, the problem really involved people who had been in an employer-provided plan, an occupational scheme, and were lured into individual accounts, and the question is whether that was an appropriate change for them or not. And the numbers that you are mentioning, $15 to $20 billion, are the amounts the financial firms are now ponying up to make the individuals whole who were misled.

Mr. MATSUI. And apparently, and I know my time has expired but I think we will get a second round, 1.5 million people actually have this problem, and not all of them have been paid yet. This has been now, what, three or four years. Is that right? Five years, perhaps?

Dr. ORSZAG. The numbers are still a bit fuzzy because it hasn't all played out yet.

Mr. MATSUI. And let me just, Mr. Burtless, I read your written testimony and you talked about going all the way back to 1871 and then projecting I guess 30 years in terms of, you know, the market and how much the market actually would have benefitted individuals. And you indicate a one year difference between 2000, if a person retired, and then if a person retired in 2001, there would have been a reduction of one-third of one's Social Security benefits. Can you just explain that, because I think that was a fascinating analysis that you did.

Mr. BURTLESS. How much risk is associated with the high returns people are sometimes promised in individual retirement accounts that are invested in the United States stock market? The calculation is this: Workers start to work when they are 22, and they stop working when they are 62. They save 2 percent of their salary every year, and then when they retire they take their savings to an annuity company and they purchase an annuity. How much money do they have, if we just follow the actual stock market performance over the last 130 years?

Well, you can look at about 90 or 91 different workers, because that is how many 40-year periods there have been in those 130 years, and you can say, "Okay, well, what would this person's pension have been upon retirement under this assumption?" And the calculation that you just mentioned was performed for someone who retired at the end of March 2000, and performed again for a person who retired at the end of March 2001.

The reason that there was such a big decline is because of course the stock market declined in real terms in the United States by almost 30 percent. But in addition the annuity company, the company that sells you an annuity, has to invest its funds. It makes its guess about how much it is going to be able to earn on the funds it invests by what the yield is on Treasury bonds. The Treasury yield, the long-term yield, fell considerably between March 2000 and March 2001.

So there were two things that adversely affected the retiree. Number one, the stock market fell, so the value of his lifetime savings fell about 30 percent. And, then in addition he had to pay a higher price to get an annuity. The result was that the value of the annuity fell from an all-time high in March 2000, by roughly a third in March 2001.

Mr. MATSUI. It was a third, I thought, or 30 percent. So if I could just conclude, two people who had the same investment in stock, basically the same stocks, if one retired 12 months sooner than the other, they would have about a third reduction in their lifetime retirement benefits or projected retirement benefits. Is that correct?

Mr. BURTLESS. That is correct. If the government received many letters on the Social Security benefit notch, which was far, far smaller than this, you can imagine the flow of mail into Capitol Hill if this kind of a plan is adopted.

Mr. MATSUI. Yes. If we thought the notch baby was a problem, well. Thank you, Mr. Chairman.

Chairman SHAW. Mr. Matsui, are you speaking of treating the next generation different than this generation?

Mr. MATSUI. I don't understand what you mean.

Chairman SHAW. As far as creation of a new notch?

Mr. MATSUI. No, not at all. In fact, that is what I am worried about.

Chairman SHAW. That is exactly what this Committee is worried about, and that is why we are having a hearing, because I very much want to be sure that we do everything in our power not to treat our children any differently than we are treated. I don't want them having to pay a higher payroll tax, like Mr. Burtless referred to. I don't want them having to work any longer unless it is just simply for a question of them living longer.

And particularly by the legislation that we are going to pass, and I want to just give Mr. Burtless just an opportunity--

Mr. MATSUI. Mr. Chairman, in view of the fact that you responded, may I just respond back to you? Because we talked about the younger generation. My concern about the younger generation is that if you take 2 percent of payroll which they can put in an account, or 16 percent of the payroll tax in an account, and you make whole the current generation of retirees, you have got to come up with the difference someplace, and that means you probably have to increase taxes on that young population. And so you are basically double-taxing them for one set of retirement--

Chairman SHAW. Well, every witness here has said that the present plan cannot be sustained, and actually the memorandum that you, Mr. Matsui, sent out to your Democrat colleagues pointed up the fact that it could not be, that the present system could not be fully funded at its existing level--

Mr. MATSUI. Oh, no one is questioning that.

Chairman SHAW. Unless something is done. But I do want to give Mr. Burtless an opportunity to correct something that he said, and I don't think you meant to be as flip about this. When you talk about giving away some of the payroll taxes, surely you are not saying that putting money in an individual retirement account which is going to be used to offset an unfunded liability of the Social Security Administration upon retirement of that worker is giving it away, is it? You didn't mean to say that, did you?

Mr. BURTLESS. From the point of view of the obligations of the existing Social Security system, yes, it is giving it away. Because of all the calculations--

Chairman SHAW. Wait a minute. How in the world can you say that? If we set up individual retirement accounts for future workers that are going to retire 20 years from now, and as a requirement they are going to take those individual retirement accounts back to the Social Security Administration and they are going to be used to help fund their retirement, you call that giving it away?

Now, I am not one of those that is in favor of taking the individual retirement accounts out of the payroll taxes, and the plan that I have produced does not do that. What I do is simply take the money out of the Treasury and send it away. But I don't think putting money away for tomorrow's retiree is giving it away.

Dr. ORSZAG. Mr. Chairman, if I may, I might be able to clarify one thing. What you are referring to is using the income from an individual account and offsetting the Social Security benefits.

Chairman SHAW. Well, the income and principal.

Dr. ORSZAG. Right. Without that linkage between the income from an individual account and the traditional Social Security benefit, then it would be giving it away, from the perspective of Social Security. That linkage is crucial for your plan, and I think Mr. Burtless would agree that given that linkage, then there could be some effect on the actuarial balance. But the linkage is the key, between the income from the individual account and the traditional benefit.

Chairman SHAW. Yes. Well, I can understand that, but also when we talk about the deficit, the pending deficit in the Social Security Trust Fund, and we start talking about it being $3 trillion, that is in terms of today's dollars if you had that money to put away somewhere and let it grow, which we don't have over $3 trillion to set it out some way and let it grow. So in terms of today's dollars, you might be able to say that.

But when you are talking about what is going to be the deficit over the next 75 years, I think all, everyone would agree that it is going to be $22 trillion. And it is not in terms of today's dollars, it is in terms of what is going to be mounting up over a period of time. And the real disaster out there, and we will all be dead and gone by the time it really gets out there, but when you get into the 75th year, it is growing so quick every year that if you take it out to 100 years, God knows what it is. It is huge, and it would bring down the economy of the United States. It would bring down any economy. And this is exactly what we are trying to avoid, and this is what we have got to plan for.

Mr. Lewis?

Mr. LEWIS. Thank you, Mr. Chairman.

Mr. Harris, did you want to weigh in on this? You looked like you had something to say.

Mr. HARRIS. I think there is--you know, we can argue about the facts, the figures and the numbers. I think we have to really look closely here at empowering not so much the baby boomer generation but generation X and beyond.

And I think what we did in Australia did, and certainly in the United Kingdom, and there has been a lot of criticism in the United Kingdom, but the most productive thing that both these countries have done is given the individual generation X's and Y's or whatever the ability to craft out their own retirement needs, to harness cynicism and be constructive about crafting out their own retirement needs. And I think that is positive, I think this is healthy, and I think that is what this country was built on, was the individual and individual aspirations.

Mr. LEWIS. Well, I agree. I have a son and a daughter that are going to be burdened with a substantial and significant increase in their taxes, payroll taxes, and then what are they going to get for that? They are going to get an increase in their age limit to retire, and then get less benefits. So I think that is not fair in any--

Mr. HARRIS. It is going to be tough political to ask a Congressman like yourself, do you cut benefits or do you increase taxes? I wouldn't like to be in that position.

Mr. LEWIS. Well, as the Chairman mentioned a while ago, we are talking about a pyramid here. It was fine in the beginning, but when you are on the short end of that stick, you are going to come up losing, and that is exactly what is happening.

Mr. Burtless, you mentioned that the elderly in this country compare unfavorably with other countries in regards to poverty. Wouldn't increasing taxes or reducing benefits to achieve solvency increase elderly poverty even further?

Mr. BURTLESS. Increasing taxes on the working-age population in order to protect the guaranteed pension under Social Security does not boost the poverty rate of the aged at all. It--

Mr. LEWIS. But reducing benefits?

Mr. BURTLESS. But reducing benefits, exactly as you suggest, would tend to increase the poverty rate of old Americans, depending on how the reduction in benefits is structured.

Mr. LEWIS. Okay. Thank you.

Chairman SHAW. Mr. Becerra?

Mr. BECERRA. Mr. Chairman, thank you very much. To all the witnesses, thank you for your testimony, for being here.

Let me ask a question that takes us away a little bit from the questions that have been asked earlier, and ask if any of you have a particular comment with regard to the fact that we have had an increased amount of immigration in this country over the years as compared to some of the other more industrialized nations, the G-5 nations which are often compared. Has immigration in this country over the last couple of decades helped our country deal with the impending problem of Social Security and funding it into the future?

Mr. HEWITT. I would be happy to take a shot at that. It has had a huge impact.

Mr. BECERRA. Positive or negative?

Mr. HEWITT. A very positive impact. Immigrants have a higher rate of birth when they first come here. Eventually they adopt the birth rates of the majority. But most of the population and labor force growth that we will experience over the next 50 years, which sets us apart from the other industrial countries, is the direct result of assumed high rates of immigration. So our demographic profile is different precisely because of that reason.

If I can also just throw in a side issue here, it is, the fact that the U.S. population is slated to grow by 46 percent over the next 50 years is one of the main reasons why it is so much more difficult for the United States to meet the Kyoto environmental accord requirements, because then our major trading partners like Japan and the European Union, because their populations are slated to shrink over this same period, and part of that is indeed because they accept lower rates of immigration.

Mr. BECERRA. And I don't want to make light of the fact that we have to watch population growth trends, regardless of what country or any part of the globe, but does anyone disagree with what Mr. Hewitt has just said with regard to immigration?

Mr. HARRIS. Thank you, Congressman. I wouldn't tend to disagree with Paul's comments, but there is some divided opinion on whether immigration or increased levels of immigration ultimately solves your aging population. I refer to Robert Brown of Canada, who is a leading academic in the field of actuarial science, where he has expressed concerns that Canada and Australia, two leading countries with large levels of immigration have seen immigration levels increase but at the same time family reunion schemes increase as well. So the net initial factor is that there is a younger immigrant coming in, in the case in Canada and Australia, initially, but then increasingly family reunion schemes see older, if you like, immigrants coming in and following on. So, if you like, the impact of the benefit of immigration in the long term is diluted slightly.

Dr. ORSZAG. If I could just add that in the United States, the Social Security actuaries have examined this question. If you look at the partial effect of higher levels of immigration, it clearly shows up as an improvement in Social Security's long-term financing.

Mr. HEWITT. If I can just add one minor point--

Mr. BECERRA. Very quickly, if I could get to--

Mr. HEWITT. The U.N. has estimated that if the United States were to use immigration to retain the same level of old age dependency, workers/retiree ratio, that by 2050, 72 percent of the U.S. population would be immigrants or their children.

Mr. BECERRA. Wow. Dr. Orszag, let me ask you a question with regard to private accounts and the creation of those accounts. Some have said that when you talk about savings, that this country has not done its best job in trying to get our country, our people, to save, whether private accounts or national savings altogether, which includes government savings as well.

Some folks have also said that if you create these private accounts, you might just displace current savings activities by individuals who would view these private accounts as a way to continue the savings they are otherwise doing, whether it is a savings account, a regular savings account, passbook savings account or checking account, or maybe in the stock market, but now you are required or called upon to save in these private pension accounts or Social Security accounts, that that might just displace your own private or personal activity in savings accounts. Is there a chance that, in creating these private savings accounts, all we are doing is supplanting current savings activities that Americans undertake?

Dr. ORSZAG. Yes, and in answering that question, I want to emphasize the importance of the recent bipartisan agreement to ensure that Social Security surpluses are devoted to paying down public debt. Given that, if you divert revenue from the Social Security Trust Fund into individual accounts, and individuals don't respond at all in their behavior, all you are doing is reducing government saving by $1 and increasing private saving by $1 with no increase in national saving. Then you need to consider how individuals could respond. For example, if $1 in an individual account is more tangible than $1 of reduced public debt, and so someone says, "Well, I've got $1 in my individual account, I don't need to put as much into my 401(k) or IRA or other type of saving," the net effect could actually be a reduction in national saving.

Mr. BECERRA. Thank you. Thank you, Mr. Chairman.

Chairman SHAW. Mr. Pomeroy?

Mr. POMEROY. Mr. Chairman, over here? Really? Great.

Chairman SHAW. I was looking at him, indicating that I wasn't going to go to him, I was going to go to you.

Mr. POMEROY. No one has ever been that nice to me before. I want to thank you for calling on me to inquire, and for holding this hearing. I think this has been one of the more interesting panels that I have had the opportunity to listen to as a member of this Subcommittee. I appreciate it a lot.

I think that the perspective we can learn from international experience is very important. On the other hand, I do think it also has to be kept in perspective. Some of those, you wonder what the reaction of some would be that so favor, for example, the Chilean experience, if it was proposed to them, "Well, Chile has reduced their crime rate. We should adopt the Chilean crime code." I mean, you know, they would say, "Let's look at it but let's not, I mean, let's make our own judgments here. This is a very different country, a very different circumstance." So, too, is it as we evaluate the situations leading up to the reforms and how they are implemented.

Mr. Harris, you used to be an insurance regulator?

Mr. HARRIS. Yes, sir.

Mr. POMEROY. So did I.

Mr. HARRIS. Yes, I know that.

Mr. POMEROY. A very twisted and shared common experience.

As you say at the end of your testimony, the individuals are ideally placed to really shape their own decisionmaking. Would you include in that voluntary, whether or not they ought to participate in private accounts as a voluntary matter, and whether or not the decision to annuitize should be voluntary?

Mr. HARRIS. I have got some sympathy for this view. I think the individual is best placed to determine the requirement for having, if you like, the appropriate tools for ideal public education facilities, information. What was crucial in the Australian experience, and other countries, but certainly Australia, was that politicians like yourself mounted a very effective public education campaign to allow the individual to have necessary, if you like, information appropriate decisions.

Going on to your second question about annuitization, I think I have some support for compulsory annuitization. I am concerned in some countries, in our case in Australia, where individuals had in the past relied on lump sum payments and saw them quickly eroded.

Mr. POMEROY. I think that is going to be a very major issue facing our private retirement system under our defined contribution experience, and Mr. Chairman, I would commend that topic to you for one we should explore on the private savings side, somewhere, whatever committee has jurisdiction of that one, or the whole committee.

The Chairman, the co-chairman of this, President Bush's retirement or Social Security Commission, Senator Moynihan, has spoken favorably about the voluntary nature of a private account system and the opposition to mandatory annuitization. Mr. Burtless, what would be the compound effect of those two features in a private account format that could be contemplated?

Mr. BURTLESS. Well, I agree with Peter Orszag that a problem with voluntary withholding from the Social Security system is that the people who are likely to opt out are the people such as myself who have high earnings and therefore have very good investment opportunities outside of Social Security. But it is unfortunately the case that it is also people like me that pay for the benefits of a lot of older people and people with lower incomes. So I fear that the selective withdrawal of people from the traditional Social Security system is going to adversely affect the level of benefits that we can pay under the guaranteed pension program to the people who remain in the traditional system.

Mr. POMEROY. Right. In other words, right now a moderate wage earner gets a higher portion of their income replaced under Social Security than a more affluent level wage earner. Is that correct?

Mr. BURTLESS. Yes.

Mr. POMEROY. And making it voluntary, you would tend to have the higher earners opting out, leaving the lower earner, probably leaving the lower earner with a lower income replacement rate, in other words, less relative benefit. Correct?

Mr. BURTLESS. I think the loss of revenues from my contributions to Social Security, and from people like me, would mean that the basic guaranteed pension under Social Security would have to be scaled back more than would be the case if we just tried to reform the current compulsory system.

Your second question had to do with compulsory annuitization upon retirement. In my testimony I suggested if we do have a system of individual accounts, then prudence requires that we require people to annuitize at least enough of their saving in this plan so that they do not immediately spend all of that nest egg and then become eligible for means-tested benefits.

Mr. POMEROY. Right. I have got one more question I have got to ask, but I do think those two points, voluntary participation and voluntary annuitization, show that in the end choice, although wonderful, can vastly undermine the security of the Social Security system.

Mr. BURTLESS. Right, right.

Mr. POMEROY. A final question for Mr. Palmer. At the outset of your testimony, you indicate that there was an unfairness, a redistributional unfairness in the design of the old system. Would you--I am really out of time, so I am trying to figure, will we have a chance to go around?

Chairman SHAW. Well, let me, I am going to get the feeling of everybody.

Mr. POMEROY. All right. I yield back. Thank you, Mr. Chairman. I will get to you later.

Chairman SHAW. Mr. Hulshof?

Mr. HULSHOF. Thanks, Mr. Chairman. As you know, a couple of weeks ago when you came to my district, for those of you who perhaps were unaware, we had an official field hearing of the Social Security Subcommittee in Columbia, Missouri, which is my home town, and it was a very interactive format, I think roughly 250 to 300 people on the campus. We had all age groups represented.

And it was very interactive in the sense that we had Ron Gephartzbauer. Probably many of you know Ron, who is an actuarial expert, and he presented various options to fix the long-term solvency of Social Security, and then we had people at tables who tried to come up with a 100-percent solution. And we weren't thrusting our opinions upon them, but we really were listening.

I am happy to report to you, Mr. Chairman, that one of the college classes who spent that afternoon with us, Dr. David Weber's class, then took that hearing as their beginning point, and each of the students, the 20 or so students from probably 20 years of age to 25, then wrote papers on this long-term solvency problem, and probably 18 out of those 20 papers that were turned in, I am told, focused on some individual personalization or private account as part of a solution. So I hope, Mr. Harris especially, you talked about cynicism, and perhaps skepticism is a milder term as far as what our task is, and I hope that we can get beyond that, and I think I certainly appreciate you all being here today.

Just in the couple of minutes that I have got, Mr. Burtless, you mentioned the flow of mail that Members of Congress receive and have received on the notch issue. I don't plan to be here in the year 2038, I will just make that public announcement now, at least in Congress in 2038. I don't want to be a Member of Congress, or it would be interesting to converse with a Member of Congress about flow of mail if inaction is what Congress ultimately concludes to do as far as those benefit cuts that are inevitably going to occur if we do nothing.

Were you a member of the Brookings Institute back in 1983, during the--

Mr. BURTLESS. I was.

Mr. HULSHOF. During the Greenspan? Because I wasn't here then, either, but reading back, higher taxes, lower benefits, that sound eerily familiar to something, that discussion that occurred 18 years ago. And I thought that the Greenspan Commission, by increasing payroll taxes and raising the retirement age, that is, lowering benefits, was going to fix Social Security, and yet here we are just 18 short years later talking about, at least from your testimony, talking about the same solutions.

Mr. BURTLESS. It is certainly true that if you establish a fully funded pension system, and people are willing to live with the pensions that the financial markets will deliver to them on their retirement, it is certainly the case that you can fix the problems of the pension system once and for all.

But, bear in mind, that is the system we had in 1935. Americans found it unsatisfying then. They thought that relying completely on private markets to give them their retirement incomes, six years after the 1929 crash, wasn't really enough. They wanted some other source of support that doesn't depend on how financial markets operate over the course of their career. In particular, workers didn't want to depend solely on financial markets, which might fall very near the point of their retirement.

Mr. HULSHOF. Mr. Bedell-Pearce, this is just a comment to you, but the mark of a good American politician is to take an unrelated subject and try to weave it into something completely unrelated, so let me attempt to do that.

Mr. Burtless, you mentioned that the liberalized pension laws that we have passed, and you are exactly right, the tax relief measures that the President signed have liberalized those pension laws. I would be remiss, however, if I didn't say to my colleagues, though, as you know the Senate put a sunset on those pension changes, and H.R. 2316 that Mr. Ryan and I have cosponsored would make permanent those tax relief measures, and I would urge your sponsorship of that legislation.

How did I do, Mr. Bedell-Pearce? Did I weave that in appropriately?

Mr. BEDELL-PEARCE. Very well.

Mr. HULSHOF. Thank you. I do want just, seriously, in about the 30 seconds or a minute that I have left, Mr. Burtless, in your testimony in answer to Mr. Matsui you talk about potential variation of retirement income due to stock market fluctuations. In your example, you assume that everyone remains 100-percent invested in the stock market up until the time they choose to retire. Was that part of your assumptions?

Mr. BURTLESS. Right, but this is based on a larger research program in which I also look at different kinds of investment strategies that people could follow.

Mr. HULSHOF. I thought the answer, though, to Mr. Matsui's question was 100-percent participation in the stock market.

Mr. BURTLESS. That is exactly right. That is what gives you the highest expected return over your career, but also exposes you to larger than average risk. That is the trade-off.

Mr. HULSHOF. So therefore, if workers in their advancing years gradually phase out of stocks into less variable investments like Treasury bonds--

Mr. BURTLESS. They would have a smaller expected pension but they would have a less variable one.

Chairman SHAW. Okay. In the interests of time, thank you. We are going to try to finish up. Mr. Cardin?

Mr. CARDIN. Thank you, Mr. Chairman. And Mr. Chairman, I want to make a brief statement and then ask a question. If it could be answered for the record later in writing, I would appreciate it. And then I would yield to Mr. Doggett, so that we can get to the floor for votes.

It seems to me that we are talking about two separate issues here on which there is virtually no disagreement. They are very much related. The first deals with adequately financing our current Social Security system, and I think, Mr. Burtless, you pointed out, and rightly so, that if all of a sudden we are going to change the philosophy and go to 100 percent away from pay-as-you-go and we want to fund it completely, we just transfer $9 trillion and take over that liability, send it to an insurance company. No, we don't even send it to an insurance company. They would probably do a little less because they get a better return. But that is what it would cost.

No one is talking about that. No one is talking about moving completely away from having current workers help pay for current retirees, but that if we want to finance it under the current system, then we either have to put some new revenues in equal to about 2 percent of payroll--we can do that through a better return on the Social Security system, or transferring in general tax revenues to do it, that will work--or reduce benefits, which we use different terminology for, such as raising the age of retirement or integrating with private accounts, but it is a reduction of the obligations of the Social Security system.

The second issue is one there is also no disagreement, and that is, we have got to do a better job of enforcing private accounts in this country. We have got to increase individuals' ability to put money away for their own retirement. I don't think anybody disagrees with that. And the only part of the tax bill that I really liked was that bill that had the name Portman-Cardin attached to it and was signed by the President, that sort of helped that along.

I guess my point, though, is that as we look at moving towards individuals taking on more personal responsibility, one thing is clear: When you are moving from a defined benefit system to a defined contribution system, you not only have the market risk that Mr. Matsui refers to, and rightly so, but you have the investment risk, whether individuals really will get adequate education and be informed, and how do you deal with the inherent conflicts that are out there, with people who are selling products also being involved with giving advice?

And I would be curious as to how other countries have dealt with that. We don't have time for a verbal response. If there is a written response or material, I would appreciate that.

And the second is, how do you deal with protecting to make sure that individuals don't invade those funds? Under our current retirement systems, you can invade and pay a penalty, or without penalty, use it for education or health care or first time home ownership and all these other temptations that are out there. How do you make sure that it is really there for retirement, if we are going to be relying more and more upon individuals' own private investments in retirement in the future?

And if you all could help us with what is happening in other countries in regard to those two issues, I would certainly appreciate it.

Mr. Chairman, I would yield the balance of my time to Mr. Doggett.

[The following was subsequently received:]

Cato Institute
Washington, DC 20001-5403

1. There are three points that I would like to make. First, in Chile there was a roughly six-month period between the day on which the reform was approved (4 November 1980) and the day on which the new system started (1 May 1981). In that time, the architect of the reform, Dr. José PiZera, who was then the Chilean Minister of Labor and Social Security, would appear once a week on national television for three minutes each time to explain different features of the system.¹ Second, the Pension Fund Administration companies also perform an educational campaign, explaining the main features of the system in flyers that are available at the branch offices of those companies.² During a recent trip to Chile, I walked into a branch office of a Pension Fund Administration company in downtown Santiago and I asked the saleswoman some basic questions about the Chilean system. I found her to be very polite, helpful and knowledgeable of the system. Third, the Pension Fund Administration companies are supervised by a highly technical and very transparent government agency that imposes stiff penalties to those companies that commit fraud or provide misleading information to their clients. Furthermore, that regulatory agency provides very clear and concise information about the private pension system.³

2. In Chile, workers are only allowed to use the savings accumulated in their pension savings accounts for retirement purposes. If a worker has enough funds accumulated in his account to obtain an annuity that is equivalent to at least 120 percent of the minimum pension, as defined by the Chilean congress, and to 70 percent of his average salary over the last 10 years of his working life, that worker may withdraw in a lump sum those excess savings and use them for any purpose.

Other countries, such as Mexico, for instance, allow workers who have been unemployed for at least 45 days to withdraw the lesser of 10 percent of the cumulative balance in their account or the equivalent of 75 times their daily taxable base salary if they have contributed to the account for at least 250 weeks and have made no withdrawals in the previous 5 years. Workers with 150 weeks of contributions may withdraw from their account the equivalent of their monthly salary if they are getting married. Although it would probably be best that the savings be used for retirement purposes only—especially in the presence of a government guarantee of some kind, which creates a moral hazard—workers should be the ones deciding what to do with their money.⁴

L. Jacobo Rodriguez
Assistant Director

1. See José PiZera (1991) El Cascabel al Gato. Santiago: Editorial Zig-Zag.

2. I would like to request that the Subcommittee make the attached copies of those fliers part of the congressional record.

3. The official website of the Superintendencia de AFPs, as the regulatory body is known, can be found at http://www.safp.cl.

4. See L. Jacobo Rodríguez "In Praise and Criticism of Mexico’s Pension Reform." Cato Institute Policy Analysis no. 340, April 14, 1999.

Chairman SHAW. Mr. Doggett?

Mr. DOGGETT. Thank you very much, Mr. Chairman.

Our colleagues, Mr. Kolbe and Mr. Stenholm, I think their proposal was referred to earlier in this hearing, have come forward with a proposal that recognizes that if Social Security cannot indefinitely meet all of its obligations as currently structured, that you have to do one of two things, either raise taxes or cut benefits, and they propose a little of both. I don't agree with their proposal, but I think they are at least honest in the way that they look at this whole issue.

And I would suggest, after listening to the recommendations of the President's Commission, that the most instructive experience from abroad that we have is not necessarily that that we received some testimony on today, but it is a few hundred years back in the era of the alchemist. Because if we have a Social Security fund that is already stretched now in its ability to meet its responsibilities, and we suddenly siphon off some percentage of it for private individual accounts, out of that same fund that is already stretched to the limit, unless alchemy has received a new level of ability to generate something from nothing, we will put even more demands on the fund and we will reduce guaranteed benefits to many Americans.

We had Secretary Thompson testify about Medicare here a few weeks ago in front of the Committee, and he made it clear that the discussion of guaranteeing benefits was going to be only for those who are nearing retirement, that is, people about my age or just slightly lower at maybe 50. And everyone else who might have been paying into the Social Security system for 20 or 25 years has no guarantee that their benefits will be there. They are left to the risk of the market.

And so I think it is interesting to hear about the experiences in other countries. We can learn something about it. But we face the basic mathematics that this is a fund that we need to work on to be sure that it can indefinitely meet its current responsibilities, and you don't do that by siphoning off the money for a new social experiment, which is what the President's Commission with all of its members committed to do that before they were ever selected for the Committee.

With those brief comments, I would yield to my colleague from North Dakota, who I know had another question.

Mr. POMEROY. Just a very quick one for Mr. Palmer. Looking at the chart that is attached to Mr. Burtless' testimony, you see the United States at 12-percent poverty rate in seniors, Sweden at 1 percent. Looking at that 12-percent figure for the United States, a very unfortunate way to be a leading country in that category, I think you would have a hard time making the case that our benefit structure under Social Security is unfairly redistributed. Do you have a comment on that?

Mr. PALMER. Yes. I could perhaps respond to your first comment also.

Sweden does very well in its present system, and most probably in the future system, in taking care of low-income earners. In the future there will be a guaranteed benefit which will cover all low-income earners in Sweden, so I would suspect that we will continue to be as we are today in that respect.

Chairman SHAW. I am going to have to break this up now so we can make the vote, but I do want to at least point out here that this is the last hearing where we will have Jeff McLynch, who is the Democrat staff member on this Committee. He leaves us effective this week. We want to thank him for his service to the Committee. We have worked together on some occasions, and it has been a pleasure, Jeff, to have you, and we wish you Godspeed.

[Applause.]

Chairman SHAW. I also want to thank this fine panel. In our rush to get to vote, I don't want to neglect you. We do have some more questions that we will send to you and ask for your response in writing.

[Whereupon, at 12:04 p.m., the hearing was adjourned.]
[Questions submitted from Chairman Shaw to the panel, and their responses follow:]

Center for the Strategic and International Studies
Washington, DC 20006
September 10, 2001

1. “You spoke about changes in the old-age dependency ratio as a disadvantage of pay-as-you-go systems.  Could you describe the economic, demographic, and political risks to which pay-as-you-go systems are exposed?  Do you believe, as some have argued, that the United States (or for any country for that matter) can economically ‘grow’ its way out of the funding crunch?”

Pay-as-you-go systems rely on tax payments, and as such are prone to financing crises when tax receipts do not grow as fast as beneficiary populations.  In most developed countries the pension population is expected to rise by roughly 70 percent over the next forty years, while real GDP is expected to grow by roughly half that much.  In addition, European and Japanese working age populations are destined to shrink by roughly 10-15 percent over the same period—producing a near-doubling of “dependency ratios” of pensioners to workers.  This leaves huge unfunded health and pension shortfalls that eventually could require a tax increase equivalent to 20 percent of payroll or more in most developed countries.  Because such tax increases may prove economically counter-productive and could generate tax resistance, especially in continental European countries where payroll taxes already average above 30 percent, there is a significant political risk to current and future benefits.  Finally, to the extent that these shortfalls could lead to large budget deficits in countries that already carry a high national debt burdens, pay-as-you-go systems pose an economic risk as well.

Demographic risk is heightened by the uncertainty surrounding medical technology.  Currently, U.S. retirees collect Social Security for an average of 19 years.  Each additional year of life expectancy therefore adds about five percent to retirement costs.  Since 1950, average life expectancy has grown by 11 years in Europe, 8.6 years in the U.S.; and 17.6 years in Japan.  Over the next 50 years, life spans are projected to rise another 6.1 years in Europe; 5.1 years in the U.S.; and 6.5 years in Japan.  In other words, governments are forecasting a significant slowing of longevity gains.  Yet, many leaders in the biomedical field predict that we are nearing significant breakthroughs in cures for a number of diseases which attack the aged.  Clearly, such breakthroughs, while welcome, could dramatically worsen financing pension prospects.

Europe and Japan are facing unprecedented economic risks as a result of depopulation.  Shrinking numbers of workers and consumers will constitute a worsening drag on economic growth for the foreseeable future.  After 2025, Europe’s economic growth rate is projected to average .5 percent a year, while in Japan it is projected to average 6 percent.  For this tepid growth to occur, however, productivity gains will need to remain at their historical average of 1.4 percent a year.  Militating against rising productivity in depopulating countries is the fact that shrinking domestic markets (with fewer consumers each year) will tend to see very low returns to capital.  Such trends would tend to drive domestic savings abroad in search of higher returns. 

While America does not expect to undergo depopulation between now and 2040, very slow growth among working age populations (20-64 years), will remove what has been an important source of economic stimulus.  The workforce expanded by about 11 percent a decade from 1950-2000, but will slow to less than 2 percent a decade from 2010-2040.  After 2025, GDP growth in the U.S. will slow to about 1.6 percent a year—again, assuming historical rates of productivity growth.  For the U.S. to “grow its way out of” fiscal strains resulting from the deteriorating dependency ratio under its pay-as-you-go financed social security system, productivity growth would have to remain significantly above the long-term trend for decades.

2. “Do you think that more countries will turn to using individual accounts in their social security systems as populations age, and why?”

Clearly, there has been a trend toward the adoption of individual accounts as mechanisms for compulsory retirement provision.  This trend is likely to continue for three basic reasons.

First, being defined-contribution schemes, individual accounts are fully funded and, as such, do not contribute to deficit spending pressures.  Moreover, where governments provide financial guarantees for retirement security, as underscored by the experience under the U.S. Employee Retirement and Income Security Act (ERISA), it is less costly insure a funded than an unfunded retirement system.  Second, individual accounts can help to insulate populations in depopulating countries from adverse national economic trends.  In countries where declining numbers of workers and consumers combine to limit returns on investment, the ability to invest in faster-growing markets abroad will become a key source of retirement security.  Third, defined contribution schemes entail no actuarial penalty for delaying retirement.  Both rising longevity and the prospect of worker shortages suggest that longer work lives may be in store in most of the developed world.

3. “What has been the experience of countries that invested through Trust Funds rather than through individual accounts?  Have they performed well?  Have their investment decisions been influenced by political considerations?  Are they doing better or worse than countries that invest through individual accounts?”

According to the World Bank, the investment of Provident Fund moneys by the governments of Malaysia and Singapore have achieved lower rates of return, on average, than have individual account investments in other countries.  It should also be pointed out, however, that Japan, which has a robust private pension system, has also experienced low rates of return.  Meanwhile, in Canada, initial reports are that trust funds being invested by the government have achieved returns on par with privately managed pension funds.  Under ERISA, private pension managers are required to invest retirement savings solely in the best interests of the client.  These strictures seldom apply elsewhere in the world, but conceivably could be applied to the investment of U.S. trust funds.  Meanwhile, provident fund moneys have been invested in infrastructure and other government programs, which have tended to lower rates of return.  There are concerns that similar pressures would arise in the U.S., should Congress decide to invest trust fund assets in markets.  In Canada, for example, 80 percent of trust fund moneys must be invested in domestically registered companies.  But rates of return on individual accounts can also be reduced by the imposition of non-economic fiduciary rules—such as the requirement that a share of pension funds be invested in government debt instruments or within national borders.

4. “What do you think the U.S. could learn from the pension reforms in Sweden, Chile, the United Kingdom, and Australia?”

There are four main lessons.  First, individual accounts are popular where they have been introduced.  Working people tend to like them for their transparency, and to feel more secure once they are in place.  This is inevitably the case where concern about governmental fiscal capacity is the principal source of individual retirement security.  Second, administrative costs can be held to acceptable levels.  While it is difficult to implement individual accounts for the entire working population, it is possible to hold costs down through passive investing and limiting opportunities for course-correcting by the account holders.  Third, the transition from unfunded to funded retirement systems can be expensive and take a long time to implement.  In the cases of Sweden, Australia, and Chile, the individual account was financed through additional payroll levies.  Fourth, the experiences of these and other countries that have moved toward individual accounts in recent years belies the argument that privatization is an “ideological attack” on social security.  As often as not, the reformers have been from the “left”.  Rather, reform has come from the frank recognition that government finances in the future will be too precarious for individuals to depend on for a comfortable retirement.

Paul S. Hewitt

Prudential plc,
London¹, England
September 11, 2001

Question 1. Why did the United Kingdom decide upon asset-based fees for the new stakeholder pension rather than contribution-based fees or flat fees?

The UK wants stakeholder pensions to be as simple as possible for the customer. In particular it is important that the charges are transparent and easy to compare. This leads to the conclusion that there should only be one type of charge (be it asset-based, contribution-based or flat fee), otherwise comparison is difficult. The UK has used the overall reduction in yield as part of disclosure of more complicated charging structures for several years, although it is not clear that customers understand that concept.

Flat fees would be inappropriate since they would have been comparatively large for lower rate contributors, who are one of the target groups for stakeholder pensions. However, flat fees can be charged for advice in addition to the asset-based fee.

The choice between asset-based and contribution-based fees should reflect the actual incidence of costs for the provider and the way those vary during the lifetime of the investment. Given the option to vary the type of asset held, this indicates a need to reflect the actual asset choice, which may vary from one year to the next. It is clear, however, that neither a contribution-based fee nor an asset-based fee truly reflects the actual incidence of costs.

To quote from the Government’s paper on the proposed charging structure:

• “Requiring charges to be levied as a percentage will be beneficial to those with relatively small pension funds.  Where charges are levied as a fixed cash sum, there can be a disproportionate effect on those with small savings.  In cases where members stop paying into a scheme, a fixed charge can erode the value of savings if the investment returns are lower than the fixed charge. 
• Requiring schemes to apply only percentage charges will mean some pooling of costs between scheme members.  This is a feature of most collective arrangements.  The Government considers that pooling of costs in this way within stakeholder pension schemes is appropriate, in order to deliver the benefits of transparency and flexibility which a percentage charge brings.”

Question 2. Could you describe how regulation of personal pensions works in the United Kingdom?  What agencies or organizations are involved and what are their responsibilities?  How have the regulatory structure and requirements imposed on personal pension providers changed since the mis-selling scandal to avoid future incidents of mis-selling?

Approval of personal pensions is initially required from the Inland Revenue in order for the scheme to be given the tax advantages granted to UK pensions. The pension providers have to operate the scheme within the rules of approval in order to maintain those tax advantages.

Personal pension schemes are provided by institutions currently regulated under the Financial Services Act (to be replaced by the Financial Services and Markets Act as from 30^th November 2001). The overall regulator is to be the Financial Services Authority (FSA), which will regulate both the prudential supervision and the conduct of business of the relevant financial institutions.

Pensions mis-selling was one of many issues that informed the thinking about regulatory arrangements. The switch from separate regulators to a single regulator (the FSA) will ensure consistency of treatment of all regulated institutions and allow the regulator to act more quickly than was possible under the previous system of self-regulation.

One aspect of regulation not covered by the FSA is on employers involved in the processing of premiums. Responsibility for ensuring the pension contributions deducted at source by an employer are transmitted efficiently to the scheme rests with the Occupational Pensions Regulatory Authority, who have a similar role in relation to occupational pension schemes  (OPSs) – they are responsible for the regulation of all aspects of  OPSs covered under the Pensions Act 1995.

The requirements upon personal pension providers have not changed fundamentally – they were, and still are, required to avoid mis-selling. It has always been clear that encouraging employees to leave their active membership of an OPS and join a personal pension was very likely to be bad advice. The training and competence scheme for salespeople has been improved since the mis-selling of 1988 – 1993.

Before the regulators’ mis-selling review in 1993, most personal pension providers had already started to introduce systems to allow someone thinking of transferring the value of their past benefits to compare the deferred benefit that they were proposing to give up under their OPS to the benefits that they might reasonably anticipate under an alternative personal pension.

The mis-selling review itself clarified the scope of the Financial Services Act. Although membership of an OPS was not, itself, classified as an investment under the Act, “best advice” did require someone to be encouraged to find out more about the OPS alternative if it could be better than a personal pension. Since most employers in the UK do not contribute to an employees personal pension, an OPS is very likely to be the individual’s best choice.

Question 3. Could you describe the types of information the public is required to receive regarding investment choices and what entity provides that information (e.g. the government, the fund manager, etc)?  Why did the United Kingdom decide to deliver information in that particular way?

Again this is undergoing a process of ongoing development, not least with the introduction of the Financial Services and Markets Act which gives the FSA responsibility for promoting public understanding of the financial system². The FSA is also reviewing the current system of disclosure in the light of technological developments and increasing access to the Internet, together with customer research suggesting that some aspects of the detailed information disclosure are failing.

There is already a thorough system of disclosure. Anyone seeking advice is required to be given suitable advice, which requires initially that the flow of information be from the individual to the adviser. Based on that fact-find, the advisor will explain the choice of investment products, and within that the choice of provider and the choice of investment from the product/provider combination. The adviser will pass on information prepared by the providers, which will include the investment principles relevant to the particular funds. The adviser will also prepare a letter explaining the significant features of the background fact-find on which the advice was given. This combines delivery both face to face and in writing (and potentially over the Internet), with generic and individual advice reflecting the particular needs of the person being advised.

During the course of the accumulation of a pension, the private schemes are required to provide annual benefit statements. This annual disclosure of information is gradually being extended to include further information regarding the specific scheme investments. Pension providers are increasingly expected to publish their statements of  investment principles including any investment policy that they might have on ethical and environmental issues. Projections of an individual’s State benefits are also available on request.  

Both the regulator and the Government produce generic information on other aspects of the investor’s choice, including the operation of State entitlements. The regulator has also introduced a set of “decision trees” to help an individual in the choices associated with the new stakeholder pensions. Again, this combines face to face and written material, since a number of pathways on the decision trees highlight the need for individual advice.

In order to help simplify the investment choice for someone who has chosen to contribute to a stakeholder pension but does not want to take advice over the choice of individual funds, every stakeholder scheme is required to nominate a suitable default investment option.

Question 4. The United Kingdom's system allows people to opt back into the second tier of the government pension plan if they are unhappy with the private system.  What percentage opts back into the government program, and what is the primary reason for doing so?

Although the UK system allows for opting back in, the individual is not required to give a reason for so-doing. However, our experience is that in almost all cases the decision to opt back into the State second tier pension is based on advice from the private pension provider. This advice relates to the comparative advantage of the rebate offered by the UK Government as compared with the benefit being given up. For example, there is a cap on the maximum rate of rebate (which is age-related) which means that at the oldest ages the individual would be best advised to rejoin the State second pension.

The advice to opt out may also depend on the salary of the person involved, since the second tier of the government pension plan is earnings related. It may also depend on the individual’s other on-top voluntary contributions. Hence, as an individual’s circumstances change, it may be natural to opt back in.

Question 5. The United Kingdom's system has been criticized for having high administrative costs.  Is it correct that the government's rebate to persons contracting out to Appropriate Personal Pensions (APPs) takes into consideration that administrative costs are higher and provides a more generous rebate?  Does the government end up absorbing some of the additional administrative costs?

The level of the rebate depends on the type of private scheme that the individual is contracting out into. As explained in the answer to question 6 below, the type of private scheme determines the method and timing of the payment of the rebate and this is reflected in the level of the rebate. For example, the rebates to contract out to an appropriate personal pension³ (APP) are age related, whereas those for those contracting out into a defined benefit pension scheme they are not.

The level of rebate recommended by the Government Actuary to the Secretary of State depends on a number of assumptions, of which the administrative costs are one. However, it is not surprising that the assumed administration costs are higher where the scheme can be a standalone APP with no additional voluntary contributions as compared with a defined benefit scheme offering larger overall benefits.

Question 6. How much time passes between the time personal pension contributions are earned and when they are paid to the worker's account?  Are the contributions invested or credited with interest in the interim?

Contributions are invested as soon as they are received. Employers are required to ensure that contributions deducted from salary are paid to the provider, by the 19^th of the following month, for investment in the workers’ accounts. No interest is credited in the interim.

Contributions are paid net of basic rate tax relief. Tax relief is reclaimed by the provider directly from the Inland Revenue and is received on average 2 weeks after the contribution. Providers can choose whether they regard the tax relief as also being invested at the time when the net contribution is received, or invest the two elements separately on their different dates of receipt.

If the question relates to the rebate, they are paid to the personal pension scheme after the end of the year in which they are earned. They will not be triggered until the employers tax returns for the fiscal year concerned have been submitted. On average, rebates are received about 6 months after the end of the tax year. There is no interest specifically paid for the time that has passed, although this is allowed for in the calculation of the rebate. This also partly explains a difference between the rebate on an APP and an OPS. The Government has decided that in the case of an OPS, the employer simply pays reduced National Insurance contributions and hence there is almost no delay in crediting this to the scheme.

Question 7. Peter Orszag stated that administrative costs eat up 43% of an account's value over a worker's lifetime.  However, research by Edward Whitehouse indicates costs are much lower.  Would you agree that Dr. Orszag's calculation is too high, and why?

Dr Orszag’s work was surprising, not least because it represented a very particular form of analysis. 43% is a very startling figure until you recognize that it compares an investment being administered with an equivalent investment giving exactly the same investment performance but assuming no costs whatsoever. The analysis demonstrates particular issues, and could usefully be extended to similar products in other regimes, provided it fully reflects the potential negative consequences of not administering the product in that way.

One area of particular surprise to providers was that quarter of the overall cost calculated came from the purchase of an annuity. It is generally recognized that people are living longer than was assumed when annuities were purchased – this should imply that there is an overall benefit to the individual and this appears not to have been built in to the analysis. Instead, the costs reflect the fact that annuity providers base their assumptions on the profile of people who purchase annuities rather than on that of the population in general.

The other reason why Dr Orszag’s work is potentially misleading is that although it indicates what lessons can be learned from such analysis, they relate to a regime which has progressed. The personal pension regime in the UK is generally falling into line with stakeholder pensions. Here there is a maximum fund charge of 1% per annum and there is no charge on transfer.

Edward Whitehouse’s paper published by the OECD⁴, provides a useful comparison across 13 countries including the UK, Australia and Sweden. We note that he refers to Dr Orszag’s analysis, concluding that this “substantially overstates the average charge burden resulting from transfers”. He calls upon evidence from the British Household Panel Survey to question the rates of transfer extrapolated by Dr Orszag.

Question 8. How much do you think companies will charge for investment advice on top of the maximum stakeholder fee?

Many in the UK believe that the market for investment advice in the UK will move over to a fee basis. This will be fully transparent and will be paid by all those seeking advice including those who make no investment as a result. This will allow the fee to reflect the time spent in the consultation.

Question 9. Will companies be able to profitably operate with the 1% limit on fees in stakeholder plans?  How will they cut costs to stay profitable?

Commercial companies are choosing to operate in this market where the charge cap applies. It should be assumed that companies believe that they will be able to operate profitably within this limit.

The product offering is more limited than was the case with personal pensions. The UK has a history of operating a type of fund investing predominantly in equities where the overall return is smoothed to reduce volatility. These “with-profits” funds offer guarantees and demand capital support that cannot be met from within the 1% limit. These products are thus, in general, not being offered in stakeholder plans. There is a particular emphasis on tracker funds in order to keep costs to a minimum.

The UK market is following the US in seeking to encourage the maximum use of technology using a business to business approach, whereby an employer provides front-end administration on their Intranet. By so-doing, the individual and the human resources function can ensure that employer aspects of salary deduction are in place, leaving the stakeholder plan to focus on the operation of the pure scheme-related administration. Even so, the charge cap in the UK is lower than the charges that would currently be made on equivalent schemes in the US⁵.

Question 10. Under what circumstances can the personal pension be passed to the worker’s estate?

Personal pensions will almost invariably provide a death benefit of the return of the fund if death occurs before retirement. If death occurs after retirement, the appropriate personal pension, used for contracting out, has to provide a joint life benefit which will continue to the surviving spouse. The annuity arising from voluntary contributions will depend on the individual’s choice at retirement. Annuities purchased with a guarantee that payments will continue for 5 or 10 years irrespective of the survival of the individual will be paid into the worker’s estate.

Since 1995, there has been an alternative method of taking income from a personal pension. Instead of purchasing an annuity, income can be withdrawn from the fund within limits set by the Government Actuary. There are detailed rules, but the important aspect in relation to the question is that the fund that remains on the death of the individual will be passed to the worker’s estate. Income drawdown cannot continue beyond age 75⁶ at which point an annuity must be purchased and the circumstances referred to in the previous paragraph apply.

Question 11. How are personal pensions handled in cases of divorce?  Are married workers required to take a joint and survivors annuity at retirement?  How much does the annuity provide to the surviving spouse?"

 A personal pension fund forms part of the total assets to be split between the divorcing parties. Wherever possible, divorcing couples will try to ensure that existing arrangements do not require costly sale and repurchase (of, for example, a house) and hence they are similarly likely to keep personal pension arrangements unchanged. However, either before or after retirement, pensions can either be shared (ie. payment to both parties but contingent on the combined circumstances of both) or split (ie. payment as required at the time of divorce and with the future operation of the distinct funds contingent on the circumstances of each individual partner).

Married workers with a personal pension are not required to take a joint and survivors annuity at retirement, except for the Appropriate Personal Pension element wherein they are also required to include a limited level of protection against price inflation.

In general a spouse’s pension is likely to provide 50% of the amount that would have been payable to the original scheme member. The payment to the surviving spouse will then continue to be paid in the same manner (for example, with limited price inflation).

Keith Bedell-Pearce
Executive Director

2. Extract from the FSA strategy document for promoting public understanding of the financial system.
“Work to achieve this aim falls under two main headings:

• Education for financial literacy – to provide individuals with the knowledge aptitude and skills base necessary to become questioning and informed consumers of financial services and manage their finances effectively;
• Consumer Information and Advice – to provide impartial information and generic advice to help enable consumers to plan their finances and make informed choices, while not being prescriptive or recommending individual products and services, or telling people to save.”

3. Personal pensions are an alternative to the State Earnings Related Pension Scheme (SERPS). These instruments are similar to IRAs. Investments in personal pensions are composed of the rebate the worker receives from for contracting out of the SERPS plan along with any additional voluntary contributions. The part of the personal pension that comprises the rebate is known as an Appropriate Personal Pension.

4. Private Pension Series, Private Pension Systems – Administrative Costs and Reforms, No 2.

5. Whilst it may be difficult to compare like with like, a fact-finding visit to the US in 1999 by a group of pension specialists reached the conclusion that the equivalent charge in the U.S. was between 1.4% and 1.7% depending on the level of technology support, in practice this being internet access and self-service.

6. There is ongoing debate in the UK about the requirement for compulsory annuitisation at age 75.

National Social Insurance Board
Stockholm, Sweden
September 12, 2001

Note that the publicly mandated financial account scheme, translated literally from Swedish the Premium Pension System, is managed by a public agency, Premiepensionsmyndigheten, which is referred to here using its Swedish acronym, the “PPM.”

Question 1: Could you explain more about how Sweden minimizes individual investment risk (e.g. minimum benefit guarantees, etc.)?

1. The individual bears the risk of his or her own portfolio choice(s) in the Swedish financial account scheme. To help minimize the risks involved and to aid the participant in making an informed choice the following can be observed:

A) The basic requirement for a fund to operate in Sweden is that the fund complies with the rules of the EU directive on Undertakings for Collective Investment in Transferable Securities, the UCITS- directive. The Swedish regulations are an implementation of the directive. The Swedish regulations contain however some provision with regard to the disclosure of costs that are not included in the directive. However, to participate in the public scheme funds must provide share price information electronically to the PPM on all banking days. Fund values are published in the major newspapers on a daily basis and people can change funds at any time, if they so choose.

B) The PPM has produced two publications – the Fund Catalogue and the brochure with instructions, guidance etc. The information includes systematically presented and easily comparable measures of risk and historical data on returns for all funds. People can gain some assistance in judging their personal risk profile with the help of questions in one of the brochures. The same information – and considerably more, for example on fund particulars, can be found on the PPM web site "http://www.ppm.nu/">www.ppm.nu

C) There is a general guarantee level that is available from age 65 and is financed with general revenues from the state budget. A full guarantee requires 40 years of residence in Sweden between the ages of 16 and 65. An individual has a right to a full guarantee amount if he or she no earnings-related benefit at all. Otherwise, the guarantee works as a supplement to whatever the individual has from the NDC and FDC schemes up to the maximum level that is guaranteed.

Question 2: Does Sweden provide any special accommodations for small FDC accounts? If so, what accommodations?

2. Sweden provides no special accommodations for small FDC accounts. Accounts are kept for everyone who has been registered in the system at sometime. Note that fund transactions can occur on any working day, but all transactions for a given fund are performed daily on a net (all purchases minus all sales) basis. The participating funds keep no individual accounts.

Question 3: How much time elapses  between when contributions are earned and when they are deposited in the worker's investment choice? Are the funds invested or credited with interest during the iterim?

3. Around 18 months lapse on average between when funds are collected and when they are actually available for individual investments. This is because of the general taxation procedures: By law, Sweden establishes how much a person has earned (and contributions that should have been paid) after individuals and employers have filed their yearly tax returns. Money is kept on an interim account at the National Debt Office (Treasury) and earns a bond rate of return.

Question 4: How often can workers change their investment choices? Are they any additional charges for frequent changes in investment allocations?

4. Workers can switch funds as often as they like, free of cost to themselves. This way of dealing with switching is seen as being important especially in the initial years of the scheme. Also, fund switches have no tax consequences (like capital gains tax), which is a difference compared to the treatment of normal holdings in private investment funds.

Question 5: You mentioned in your testimony that the average administrative costs are less then 1%. Do you expect that the government's 0.3% share of the total charge will decrease as the system matures? Do you think the investment funds charges will decrease as the system matures?

5. Firstly, the fee that PPM charges, 0.3 per cent, is at present not sufficient to cover total PPM costs, so the PPM is building up a debt in the National Debt Office. As the system grows, the money corresponding to the 0.3 per cent will grow too  and after a few years the PPM will be able to pay back its debt. The debt will be fully paid off by the year 2018. From then on the PPM fee will be lowered to, perhaps, 0.1 per cent. (In fact, the PPM  will probably have to lower the fee to 0.25 or 0.20 earlier to make the debt “last” all the way to 2018).

Secondly, as the system grows, the total assets held by funds will also grow. The PPM’s rebate system reduces the actual fee for PPM as a fund’s holdings of PPM assets increase. This will press fees down towards a level of 0.4 per cent – according to the PPM rebate schedule. This means that the long-run fee for the PPM and the average fund held by individuals could stabilize within the range of 0.5-0.7 per cent, depending on the distribution of individual choices among .private funds and where the PPM fee actually ends up.

Question 6: Is Sweden concerned that advertising and competition to attract investors could drive up administrative costs?

6. The Swedish scheme is designed to minimize advertising. There was considerable advertising when participant’s made their first choices, probably because fund managers realized that most people would not switch very often. There will be advertising peaks every year as people receive their account statements. However, there was relatively little advertising when account statements were sent out in 2001. This suggests that advertising costs will not be high. However, even here we will have to wait a while and analyze what happened.

Question 7: What is the administrative cost for annuitization?

7. The cost of creating and managing annuities is included in the overall fee of the PPM (see above).

Question 8: You mentioned workers receive an overall replacement rate of 54% from both the government-run pension and the employer pension, at a conservative interest rate. What do you estimate is the replacement rate for just the government portion of benefits (notional defined-contribution benefits plus funded defined-contribution benefits)?

8. Assuming a 5 % real rate of return on financial assets, the public system, including both the NDC and FDC components, will give a replacement rate of around 52 % at age 65 and 56 % at age 66, for an individual who works all years from age 22 – given present life expectancy estimates. (This can be derived from Table 2 in the appendix to my written statement.)

Question 9: How do you share individual accounts in the event of divorce? Can a man voluntarily give a portion of his account to his spouse if he chooses?

9. Spouses and registered partners can transfer their yearly FDC account increments to each other. The transfer must be one whole year’s account increment. Spouses notify the intended transfer to a local insurance office by January 31 in the year in which the contributions are paid. The transfer continues, unless one of the spouses notifies the insurance otherwise. Money cannot be transferred back again, and the contribution is reduced by 14 % upon transfer.

The reduction factor of 14 % reflects the PPM actuary’s assumptions about:

• how much more money will be transferred from men to women than vice versa
• how much longer women will live, compared to men
• an estimate of average fund returns
• to what extent transfers will be determined by the participant’s knowledge of his or her own health conditions.

Question 10: How will the government invest the funds of a worker choosing a fixed annuity at retirement?

10. People can choose to keep their money in the investment funds of their choice even during the withdrawal period, or they can transfer all their funds to the PPM and claim a fixed annuity. The PPM will invest its funds in accordance with the rules in the Insurance Business Act (1982:713), i.e. the same rules that apply to private life insurance companies. This means a mix of equity (at present 25 per cent) and bonds of different kinds (75 per cent) but also an opportunity to expand some time in the future into, for example, real estate.

Question 11: Why did the government decide to include stocks in the "non-choosers" fund?

11. It was believed that on average the equity market would perform better than the bond market and that for this reason a mixed portfolio would be “fairer” than a pure bond fund  for persons with little or no knowledge of financial markets, and who presumably would be among the main “participants” in this fund.

Question 12: Who decides how the non-choosers fund is invested? How does Sweden insure political considerations do not influence the fund's composition?

12. The Board of Directors are responsible for formulating a strategy for the “non-chooser” fund and the manager for executing it. The fund is to operate according to normal fund principles, and is audited. In principle, the audit should uncover investments that are not motivated by normal financial market considerations. (At the time of the introduction of the new system, Sweden already had some experience of public funds investing in the private equity market. Even within the framework of the old system, a small share of the reserve assets were invested in equities. The first equity fund in the PAYGO reserve system was established in 1974, and has been rated as one of Sweden’s most successful funds on the equity market.)

Edward Palmer

CATO Institute
Washington, DC 20001-5403

1. What percentage of retirees draws a minimum pension from the government?  How is that figure expected to change over time as personal accounts build up?

As of January 1999, the last month for which I have data, the government had supplemented 19,715 pensions, including 6,050 old-age pensions, out of over 300,000 pensions, in its role as the financial guarantor of last resort in the new private system.  Because the new system has tougher requirements to qualify for the minimum pension and is far more efficient than the old one, the cost to the Chilean taxpayer of providing a general safety net is lower than under the old system.  I would expect that figure to decrease over time, if the pension funds continue to have returns that are above 4 percent in real terms.

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 2.3 percent of taxable wages, by the total contribution (10 percent plus the commission).1  This calculation fails to take into account that the 2.3 percent includes the life and disability insurance premiums (about 0.7 percent of taxable wages on average) that workers pay, which are deducted from the variable commission, and thus overstates administrative costs as a percentage of total contributions.2  Also, if, for instance, the mandatory contribution were lowered to 5 percent of total wages instead of 10 percent, then administrative costs measured as a percentage of the total contribution would increase from 18.69 percent to 31.51 percent (2.3/(2.3 + 5)), even if those costs measured in absolute terms or as a percentage of assets under management remained the same.

When administrative costs are compared to the old government-run system, the criticism is not accurate.  Chilean economist Raúl Bustos Castillo has estimated the costs of the new system to be 42 percent lower than the average costs of the old system.3  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.

Furthermore, the Congressional Budget Office reported in 1999 that, “In Chile, the country with the longest experience with private retirement accounts, [administrative costs] can be equivalently expressed as 1 percent of assets, which is similar to costs of mutual funds in the United States.”4  The CBO report goes on to say that, “It is difficult to convert a charge on contributions to a charge on assets (typical for a U.S. mutual fund).  The calculation depends on the rate of return and the length of the investment horizon and therefore does not yield a single figure.”5  Chilean economist Salvador Valdés has 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, which is lower than the average cost of the mutual fund industry in Chile but higher than other savings alternatives.6

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.

Another reason administrative costs are not as low as they could be is that AFPs have a monopoly in the administration of pension savings accounts.  Mutual funds, banks, insurance companies, and individuals themselves are not allowed to manage those accounts.  The existence of this monopoly (which is part of the fragmentation of the financial services industry in Chile across product lines) prevents the establishment of one-stop financial supermarkets, where consumers can obtain all their financial services if they so choose.7  Such supermarkets would substantially reduce administrative costs by eliminating the duplication of commercial and operational infrastructure.

The average rate of return net of administrative costs for the average retirement savings account has ranged from 7.18 percent to 7.50 percent, depending on the type of account, from 1981 in April 2001, according to the Chilean government agency that regulates the industry.

That claim is partially accurate.  It is true that women and low-wage workers are likely to accumulate less than the average worker.  Women because they tend to earn less than men, have more irregular professional lives and may stop contributing to their accounts at age 60 (that age is set at 65 for men).  (Women also tend to live longer, a factor that also contributes to making the average pension for women lower than the average pension for men, all things being equal.)  All those characteristics are common to women everywhere and not just Chilean women and should not be considered features of the Chilean system.  Since the new system gives every worker property rights in his or her contributions, every worker with 20 years of contributions will receive at least the minimum pension.  That was not the case in the old pay-as-you-go government system, a system that especially penalized women (and other workers) with irregular professional lives.

Low-wage workers in general accumulate less than average workers because they are low-wage workers.  Low-wage workers also tend to start working at an earlier age than other workers, which conceivably can make up for the smaller amount contributed per period, and to have a shorter life expectancy, which conceivably can allow workers to make larger withdrawals per period of time than other workers with a longer life expectancy.

Therefore, it is not correct to say that women and low-wage workers will disproportionally end up receiving the minimum pension.  The reform was undertaken under the assumption that if a worker contributes to his account 10 percent of his salary for 35 years, and the real rate of return on his investment is 4 percent on average, he will have enough funds accumulated in his account upon retirement to fund a pension that is equivalent to 70 percent of the average salary over the last 10 years of his working life.

I think that focusing on whether income disparity increases under a private system or not is mistaken.  What matters is that poor workers (as well as rich ones) have property rights in their contributions and can invest their savings in productive investments, so that they live their old age with comfortable means, even if other workers are much wealthier.  The income disparity between Bill Gates and I, for instance, matters nothing to me.  What matters to me is that Bill Gates has developed the tools that allow me to become a more productive worker and, consequently, earn a higher salary, which in turn allows me to live more comfortably now and in my old age.

AFPs are not allowed to offer discounts for permanence, for making voluntary contributions, for groups, or for maintaining a specific balance in an account.  For instance, if workers were able to negotiate group discounts, then their bargaining power would significantly increase.  That would allow them to negotiate lower commissions, which would benefit low-wage workers the most.  Funds would continue to seek out low-wage workers so long as the marginal cost of administering the account of a low-wage worker (of a group of low-wage workers) does not exceed the marginal revenue derived from administering those accounts.  If the administration companies were allowed to adjust their service to the ability and desire of workers to pay for those services, low-wage workers would have nothing to lose if the commission structure were liberalized.  Those concerned that the services provided to low-wage workers would drop to unacceptable low levels need not be, as the government already mandates a minimum of services that AFPs have to provide to their clients.

If a worker dies before retirement, the balance in his account belongs to the beneficiaries of his estate, as workers now have property rights in their contributions.  If a worker dies after retirement and if he chooses the programmed withdrawal option, then the balance in his account belongs to the beneficiaries of his estate.  If he chooses to purchase an annuity from an insurance company, the balance in his account upon retirement is used to purchase the annuity and the account is closed, so money is left to the beneficiaries of his account.

Increases in flat fees and reductions in variable fees would eliminate the cross-subsidy from high-wage workers to low-wage workers that is present today.

When the system began, AFPs were allowed to charge fixed and variable commissions on assets under management, fixed and variable commissions on contributions, or any combination thereof.  AFPs were not allowed to offer discounts for permanence, group discounts, discounts for making voluntary contributions, or for maintaining a specific balance in the account.  In 1987, the commission structure was changed by eliminating all commissions on assets under management.8  This change had the effect of providing a cross subsidy to (1) workers who do not contribute to their accounts regularly, because the fund manager is still providing a service (administering the account of those workers) for which he is not receiving compensation; and (2) to low-income workers, because the administrative costs of managing the account of wealthier workers are not proportionally higher than the administrative costs of managing the accounts of low-income workers, although the commissions paid by high-income workers are proportionally higher than those paid by low-income workers.  In that sense, it cannot be said that the commission structure is fair, because some workers are paying more than others are for the same type of service.9 

The rigidity in the commission structure prevents the AFPs from adapting the quality of their service to the ability to pay for that service of each segment of the population and also explains why the AFPs have an incentive to capture the accounts of high-income workers and attempt to do so by offering them better customer service.10  AFPs will continue to spend money until the marginal cost of trying to capture new accounts is equal to the marginal revenue derived from those accounts.  In addition, the AFPs generally do not charge entry fees, even though the law allows them to do that, which means that consumers do not pay a penalty by changing from one AFP to another.11

There is free entry and exit into the industry, even for foreign companies, provided that certain capital requirements, which are specified in advance, are met.  The minimum capital required to create an AFP is 5,000 Unidades de Fomento (UF), a Chilean indexed unit of account.  If an AFP has 5,000 affiliates, then the minimum increases to 10,000 UF; if it has 7,500 affiliates, then it increases to 15,000 UF; and when an AFP reaches 10,000 affiliates, the minimum capital requirement increases to 20,000 UF.  By specifying clear and simple rules in advance, the whole process of creation of management companies is completely depoliticized.  The government agency that regulates the industry sets, within the framework of the law, general investment rules in conjunction with the Central Bank of Chile.  Both the Central Bank and the regulatory agency are highly technical and independent agencies.

Each year each AFP must guarantee that the real return of the AFP is not lower than the lesser of (1) the average real return of all AFPs in the last 12 months minus 2 percentage points and (2) 50 percent of the average real return of all AFPs in the last 12 months.  If the returns are higher than 2 percentage points above the average return of all AFPs over the last 12 months, or higher than 50 percent of the average return of all AFPs over the preceding 12 months, the “excess returns” are placed in a profitability fluctuation reserve, from which funds are drawn in the event that the returns fall below the minimum return required.  For instance, if the industry’s average return for the preceding 12 months is 10 percent and an AFP has a return of 17 percent, then the “excess returns” are 2 percentage points (10 percent plus 50 percent of the average return, which is 5 percent, equals 15 percent, which is the threshold in this case).  If, on the other hand, the industry’s average return is 2 percent and an AFP has a return of 4.5 percent, then the “excess returns” are 0.5 percentage points (2 percents plus two percentage points equals 4 percent, which is the threshold in this case, since it is higher than 2 percent plus 50 percentage of the average, 1 percent, which would be equal to 3 percent.  Should an AFP not have enough funds in the profitability reserve, funds are drawn from a cash reserve, which is equivalent to 1 percent of total assets under management.  If that reserve does not have enough funds, then the government makes up the difference and the AFP is liquidated.  To date, no AFP has gone bankrupt, although three have been liquidated for not meeting the minimum capital requirements, so the cost to Chilean taxpayers has been zero.  It is also worth noting that the system establishes two different legal entities for the management company and the fund it administers, which is the property of workers.  So, it is possible that a management company go bankrupt (that is, its net worth is negative) without it affecting the fund.

The new private system provides workers with three different types of retirement benefits:

a) Old-Age Pensions. Male workers must reach the age of 65 and female workers the age of 60 to qualify for this pension.  However, it is not necessary for men and women who reach these respective ages to retire, nor do they get penalized if they choose to remain in the labor force.  No other requirements are necessary.

b) Early-Retirement Pensions.  To qualify for this option, a worker must have enough capital accumulated in his account to purchase an annuity that is (1) equal to at least 50 percent of his average salary during the last 10 years of his working life; and (2) at least 110 percent of the minimum pension guaranteed by the state.12

c) Disability and Survivor’s Benefits.  To qualify for a full disability pension, a worker must have lost at least two thirds of his working ability; to qualify for a partial disability pension a worker must have lost between 50 percent and two thirds of his working ability.  Survivor benefits are awarded to a worker’s dependents after the death of said worker.  If he did not have any dependent individuals, whatever funds remain in his pension savings account belong to the beneficiaries of his estate.

Types of Pensions.  There are three retirement options:

a)    Lifetime Annuity.  Workers may use the money accumulated in their accounts to purchase a lifetime annuity from an insurance company.  This annuity provides a constant income in real terms.

b)    Programmed Withdrawals.  A second option is to leave the money in the account and make programmed withdrawals, the amount of which depends on the worker’s life expectancy and those of his dependents.  If a worker choosing this option dies before the funds in his account are depleted, the remaining balance belongs to the beneficiaries of his estate, since workers now have property rights over their contributions.

c) Temporary Programmed Withdrawals with a Deferred Lifetime Annuity. This pension option is basically a combination of the first two.  A worker who chooses this option contracts with an insurance company a lifetime annuity scheduled to begin at a future date.  Between the start of retirement and the day when the worker starts receiving the annuity payments, the worker makes programmed withdrawals from his account.13

In all three cases a worker may withdraw in a lump-sum (and use for any purpose) those funds accumulated in his account over and above the money necessary to obtain a pension equal to at least 120 percent of the minimum pension and to 70 percent of his average salary over the last 10 years of his working life.

If a worker outlives the balance in his account, then the government provides the minimum pension, as defined by the Chilean Congress, if that worker has contributed to his account for a minimum of 20 years.  If a worker does not have at least 20 years of contributions, he may apply for a welfare-type pension that is lower than the minimum pension.  So, yes, there is a safety net under the Chilean private pension system, as there was one under the old government-run system.  However, since the new system is far more efficient than the old one, the cost to the Chilean taxpayer is considerably lower.

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.

L. Jacobo Rodríguez
Assistant Director

1 2.3/(10+2.3) = 0.1869, or 18.69 percent.

2 Commissions are also overstated in the case of workers who receive gifts or outright lump sums from sales agents as an enticement to transfer from one AFP to another.

3 See Raúl Bustos Castillo, “Reforma a los Sistemas de Pensiones: Peligros de los Programas Opcionales en América Latina.”  In Baeza and Margozzini, pp. 230-1.

4 See Congressional Budget Office, Social Security Privatization: Experiences Abroad, sec. 2, p. 7 (January 1999).

5 Ibid., sec. 3, p. 11.

6 See Salvador Valdés, “Las Comisiones de las AFPs ¿Caras o Baratas?”  Estudios Públicos, Vol. 73 (Verano 1999): 255-91.

7 Allowing banks and other financial institutions to enter the AFP industry might present potential conflicts of interest.  In principle, so long as those institutions compete under the same rules as other market participants, they should be allowed to administer the pension savings accounts of Chilean workers.  It is likely that in a market environment banks would have to develop effective separations between the banking department and the administration of pension accounts to attract and protect workers’ investments.  Furthermore, the banks may invest in instruments of a higher quality to allay any fears that the public might have about the safety of the investments.  

8 The issue of the commission structure has generated a vast literature in Chile.  See, for instance, Salvador Valdés, “Comisiones de AFPs: Más libertad y menos regulaciones.”  Economía y Sociedad (January/March 1997), pp. 24-26; Salvador Valdés, “Libertad de Precios para las AFP: Aún Insuficiente.”  Estudios Públicos 68 (Spring 1997), pp. 127-47; José de Gregorio, “Propuesta de Flexibilización de las Comisiones de las AFP: Un Avance para Corregir las Ineficiencias.”  Estudios Públicos 68 (Spring 1997), pp. 97-110; and Alvaro Donoso, “Los Riesgos para la Economía Chilena del Proyecto que Modifica la Estructura de las Comisiones de las AFP.”  Estudios Públicos 68 (Spring 1997), pp. 111-126.   

9 The unfairness does not come from the fact that some workers are paying more than others for the same type of service.  In a free-market economy sellers should be able to price discriminate if they wish to in order to capture the consumer's surplus.  The problem here is that the government is mandating this price discrimination.

10 Critics of privatization often point to the giving of toasters and other consumer goods as incentives to switch from one AFP to another as proof of the excesses of the Chilean system.  Retail banks in the United States engage in similar practices on college campuses without any negative effects to the banking system or consumers.  Of course, these practices have decreased as the banking industry has been deregulated and banks in the United States have found other ways of competing with each other, such as offering better interest rates or lower fees.

11 Entry fees are usually given back (or a part thereof) by sales agents as a rebate to their customers as an enticement to switch from one AFP to another.  Exit fees are not allowed by law in an effort to promote competition.

12 There is now a bill before the Chilean congress that would increase the percentage from 110 percent of the minimum pension to 150 percent.

13 This option is ideal for workers who are about to retire at a time when the value of their accounts is down.

Watson Wyatt Worldwide
Surrey, England

Congressman E. Clay Shaw, Jr.
Chairman
Subcommittee on Social Security
Committee on Ways and Means
B316 Rayburn House Office Building
Washington, DC  20515
UNITED STATES

Dear Congressman Shaw:

Social Security and Pension Reform: Lessons from Other Countries – Questions

Thank you for the opportunity to speak before the Subcommittee on Social Security concerning Australia's approach towards social security reform.  Detailed below are my responses to your questions in respect to my testimony of 31 July 2001.

Question 1: Could you explain what steps Australia takes to minimize individual investment risk?

1. Australia in respect to its second pillar does not adopt a position whereby systematic attempts are made to minimize individual investment risk.  Indirect methods are used to provide consumers with an ability to identify and evaluate investment risk through effective disclosure of key features linked to associated retirement products.  In effect regulators argue that through increasing the 'transparency' of the retirement vehicle consumers will be best placed to evaluate their individual propensity towards investment risk.  Additionally the role of the intermediary is in some part crucial in minimizing investment risk for the consumer.  Central to the intermediary/ client relationship is the 'know your client' rules whereby the intermediary should highlight or be aware of adverse investment risk that could affect consumers.

Question 2: How does Australia accommodate lower-wage workers to help insure their accounts are not consumed by administrative costs? Could you tell us more about Retirement Savings Accounts and the extent to which workers choose this type of account?

2. The structure of the superannuation industry in Australia accommodates lower-wage workers through specific types of low cost, high volume retirement accounts.  Industry funds that are largely affiliated with trade unions offer retirement accounts with low fees as a result of lean administrative structures and distribution structures that are highly efficient and effective. Secondly Retirement Savings Accounts (RSAs), offered largely by banks provide low cost/high volume alternatives for consumers and product providers alike.  These products have limited investment options and are mainly invested in fixed interest securities.  In effect these products contain or reduce risk and minimize associated administrative costs.  Such products are ideal for consumers who enter or leave the workforce on a regular basis.  RSAs are in part similar to certain aspects of the Thrift Savings Plan (TSP) in terms of providing consumers with easily understandable, low cost alternatives to that provided by commissioned intermediaries.  An annual statement is normally provided to consumers that reflect the overall balance, fees charged and rates of return generated on the account.  With the relatively high levels of market returns linked with equity based retirement accounts in recent years, the comparatively low investment returns generated by RSAs has meant that these accounts are generally unpopular.  Additionally with little if any commissions being associated with intermediaries who sell RSAs such products have only reached a level of $A3.1 billion at March 2001.  This is a growth of 6.1% since March 2000 with the share of total superannuation assets in RSAs remaining at less than 1%.

Question 3: Could you provide a brief description of the regulatory structure and rules that govern how superannuation policies are sold and switched? Could you describe the type of information workers are required to receive when buying superannuation products and on a regular basis?

3. Comparatively speaking Australia has suffered little if any consumer detriment linked with the sale and distribution of superannuation products.  In 1998 the Australian government decided to separate regulatory responsibility for superannuation accounts between solvency (Australian Prudential Regulatory Authority) and consumer protection regulators (Australian Securities and Investment Commission).  In respect of the selling of superannuation accounts consumers are required to have a needs analysis prepared by the intermediary that provides an analysis of his or her financial position and also details the recommendations made or attributed to the corresponding retirement product.  Such use of a needs analysis is fundamental to the 'know your client' rules that are central too much of the regulation surrounding the selling and switching of retirement policies.  Equally for switching a retirement policy, a needs analysis has to be completed by the intermediary justifying the move of the policy based on sound economic or financial grounds.  Along with being provided with a needs analysis the consumer is required to be given a customer information brochure (CIB) that details the key features and policy illustrations of the product and also how complaints will be handled on both an external and internal basis.  Finally a Customer Advice Record (CAR) is provided to the consumer that details the financial relationship that the intermediary has with the product manufacturer.

Question 4: Why did Australia choose to not regulate the structure or level of administrative charges, except in the case of small accounts?

4. Sound economic advantages exist for why administrative charges were not regulated in Australia with respect to financial services.  It was the Federal Labour Government's view of the day that market forces were best placed to set associated fee or administrative charges on these retirement products.  It was felt that with appropriate disclosure consumers would be best placed to evaluate fee and commission levels and thus move towards product manufacturers who offered retirement products that were better value for money.  Additionally the Federal Government was concerned that if fee levels were set at a very low level market distortions would take place and that limited distribution of superannuation policies would take place.  On an economic basis it was also argued that market efficiencies would be stifled if companies simply set administrative fees at a maximum permissible level.

Question 5: The Australian system has been criticized for having a substantial portion of the population take their account as a lump sum and end up receiving need-based benefits.  What fraction annuitizes their accounts? How will the affect government expenditures on retirees in the future relative to the system prior to reform?

5. This criticism is quite dated and outmoded with respect to individuals taking lump sums versus annuity benefits.  Alterations in taxation policy have meant that in recent years it has become less favourable for individuals to take a lump sum benefit.  Often retirees take a retirement benefit as a lump sum, pay out their mortgage and invest the remainder in an allocated pension product.  An allocated pension has grown sharply in Australia since their introduction in 1992.  The product operates through a calculation of life expectancy versus the sum invested.  Using associated actuarial calculations, an annual pension is paid until the initial amount capital plus net returns are exhausted.  Such products are more advantageous compared with traditional annuity products in that the rates of return have been significantly higher and that the consumer has greater flexibility to pass capital residues onto their spouse or siblings.  Lump sums, excluding outward transfers, accounted for 79% ($5.6 billion) of the benefits paid during the March quarter.  The remaining 21% ($1.5 billion) of benefits were paid in pensions.  Outward transfers accounted for 57% of all fund withdrawals during the March quarter.  As mentioned, much of the lump sum payments are reinvested into traditional allocated pension products.  You will note in my testimony that I provided estimates of Australia's expenditure as a percentage of GDP for its corresponding first pillar.  Anecdotal evidence indicates that overall expenditure will be contained as average superannuation balances progressively increases over time.

Question 6: Why do so few workers annuitize their accounts, and why do even fewer choose a lifetime annuity despite tax incentives to do so?

6. This question has been largely answered in Question 5.  I would add that annuity rates in Australia are low by comparison with Europe and North America as a result of a smaller population base.  In contrast pension streams generated by allocated pension products are much higher which has led to a rapid increase in this type of retirement product held by Australians. It seems on a cultural level that Australians are more reluctant to purchase annuities as they see life insurance companies largely benefiting if an individual dies to early rather than living to long.

Question 7: How many investment choices are workers in corporate, industry, or public sector funds provided?

7. The number of investment choices varies widely between the various types of superannuation schemes.  As an average between 5-7 investment choices are largely provided by superannuation schemes as whole.  Moreover employees are demanding greater investment choice in their superannuation schemes as they recognize that a diversified portfolio is crucial in maximizing overall retirement returns.  In general industry funds have lower levels of investment choice compared with corporate or retail superannuation, although this general observation is changing rapidly as industry funds increase their abilities to publicly offer services to the broader workforce.

Question 8: What happens to account balances if a married worker divorces or dies before retirement?

8. The question is largely dependent on the approach and the rules linked with the superannuation trust deed.  Generally pre-determined spouse benefits will be provided by the plan based on certain levels of coverage and membership of the superannuation scheme.  Intended legislation will see superannuation balances considered in the divorce settlements of married or defacto couples in Australia.  At this stage some ambiguity still exists over how differing types of superannuation accounts will be treated after divorce.  This point is particular relevant with regard to corporate defined benefit plans and how associated superannuation will be segregated or transferred into the non-members' (spouse's) name.

Finally on a more personal level Congressman Shaw I would like to express my deepest regret over the terrorist attack launched against the United States of America this week.  I do hope that the Committee and its staff are safe and well and that this senseless act can be resolved speedily.

Yours sincerely,

David O. Harris
Consultant