Alternatives to Pay-as-You-Go Systems

Marshall Carter

Council on Foreign Relations

November 15-16, 1996

The purpose of this session is to define some of the issues, providing you some knowledge for the discussions that go on later this morning.

So, let me begin with the generally accepted definition of a pay-as-you-go system. In that, mandatory payroll taxes are withheld from workers, and those taxes are used to pay retirees. Under pay-as-you-go systems, taxes withheld from workers' pay are not normally saved or invested to finance their own benefits. Instead, the taxes go to retirees and in some countries, such as the United States, some taxes are also used by the government to pay for other programs such as aircraft carriers, national parks, overseas travel for members of Congress -- such essential things.

In the United States, for example, Social Security funds are used by the government to pay for programs. Treasury obligations are then issued for payment at some future date. Under pay-as-you-go systems, benefits that will be paid to current workers when they retire will come from the tax money of future workers. In effect, the pay-as-you-go system are transfers of funds from one generation to another and one segment of the economy to another.

Now, we've heard a good deal of discussion in recent years about the shortcomings of these systems. But before we take a quick look at them and some of the options, let's take a look at some of the advantages. It's not as though our forebears who established these systems were foolish or without the very best of intentions.

Pay-as-you-go systems work very well when there are many workers paying money to support each retiree and when the population demographics are a traditional pyramid with each subsequent generation being older or bigger than the one before it. In the past, it was common throughout the world to have worker-to-beneficiary ratios of 15 to 1 or greater. When 16 or so workers are paying to support each retiree, as was the case in the U.S. economy in 1950, the system works well. Pay-as-you-go systems also bring an important benefit: they promote a sense of community. These systems are redistributive: those that have much to share, share their resources with those that have little.

There is something to be said for a program that promotes a feeling that we are all in this together. With purely privatized systems, that communitarian sense is lost. But mixed systems have the potential of maintaining that sense of community while also benefitting the growth in the economy and the growth in the market.

That said, it's very clear that pay-as-you-go systems need to be reviewed in many countries. The need for change arises when there are few workers paying taxes to support each retiree. That's the trend we see today worldwide and the trend that was covered in some detail in earlier presentations.

So, if a country decides to go away from a pay-as-you-go government pension plan, what do they do?

The first option is the so-called defined benefit plan, which is used in part by corporations and public entities. The retirement payments, or the benefits, are prescribed and defined based upon things such as length of service with the company, salary levels, and other parameters. If you do a year's hardship tour in a developing or emerging country, you may get credit for a year and a half of service. The money is not in private accounts but managed under a trust or trustee board or a group of senior employees who hire the money managers, direct the asset allocation, and insure compliance with employee rules and regulations, or the applicable laws of the country. They also insure the actuarial correctness and the funding.

The cost of this system is generally borne by the company, not directly by the employee. The employee only has input through the group of trustees. The employee contribution in most corporations is not visible through employee salary statements; in many public entities it is visible through the salary statement as a 3 percent or 5 percent deduction. This type of system is widely used by corporations and public entities such as states, municipalities and labor unions. The money is not available for any other purpose except retirement and very seldom do these entities, especially corporations, provide cost-of-living increases. Social Security is a type of a defined benefit program because the benefit is prescribed, but it is not funded with set aside dollars in an investment sense.

Now, we hear a lot about the defined contribution plan which, in this country, carries tax benefits. In the defined contribution plan, the retirement payment or benefit is dependent directly upon how much the employee contributes through his/her lifetime and how well he or she allocates the money between investments. The money is in a private account and it is spread among options from company stock to fixed income to index funds to even self-directed equity portfolios.

Generally speaking, companies offer three to eight alternatives. Information is usually instantaneously available through 800-numbers or, through the Internet, on computer screens. The dollars are available for specific purposes under a loan program to the employee; that is, they can borrow against their retirement and pay themselves back as time permits. Many companies have made this a very popular program because they match the employee contribution, some by as much as 66 percent. Most companies match about half of the employee contribution. The employee bears the burden of paying for this system. But it is usually invisible to him because it is taken out as a reduction in the return on funds or as an administrative fee.

These are popular because of the tax deferral aspects of the contributions and because they allow the employee to invest in name-brand investment vehicles, such as a mutual fund or stocks and bonds. However, significant knowledge of the investment is necessary and many companies are really putting a lot of effort in that.

Putting the responsibility on employees to contribute to a defined plan means that they must be educated enough to manage their retirement funds. We now have about ten years experience in this country with the 401(k) . In the younger generation, the degree of expertise with which they manage their portfolio is probably better than in the generations in their 40s and 50s. Most investments, in fact 42 percent of the 401(k) pension money in this country, is in company stock, with something around 25 percent in guaranteed investment certificates. So we still see a very conservative pattern of investment of American employees.

So, there are basically these two types of systems. Now, for countries facing the problems that we have outlined, there are essentially three or four things they can do.

First, they can maintain their current system (the pay-as-you-go system)-with the modifications that were outlined in earlier presentations. Stretching out the retirement age, means testing, delaying Cost of Living Adjustments, tying the cola to something less than the increase in the Consumer Price Index--these are some of the ways.

Second, they can allow for investment of some of the taxes in private equity markets; in effect, a partial diversification, with a safety net underneath. This is similar to the plan in Britain now.

Third, they can abandon the current system, replace it with a full-privatization where all the pension money is invested in private equity markets or some other combination similar to the 401(k). And some countries have used combinations of those.

The current experience in the United States is an interesting laboratory in which to study the change. We're struggling to come to grips with the problems inherent in a pay-as-you-go system and a large baby boom generation. The presidential advisory commission on Social Security whose report was leaked in March 1996, but has yet to come out officially, laid out options that the committee members saw as strengthening the current system. These options, to one extent or another, all included some diversified investment of Social Security funds.

One option called for the government to take some of the Social Security money, about a third of the current surplus, and put it into some sort of diversified investment under fairly strict guidelines. Robert Ball, the former Commissioner of Social Security and a member of the advisory council, also proposed a series of other steps to put the system on sound financial footing.

Another option would establish private retirement accounts similar to those in Chile. Workers would be required to place 5 percent of their income in accounts that would then be invested in markets. Under this plan, the government would continue to pay a basic Social Security benefit, a sort of a minimal safety net.

Let me wrap up. It's clear that the pressures and discussions are leaning away from government systems and toward diversified private investment, but I insert a cautionary note. The transition from government to private or partially private is neither easy nor inexpensive. At some point along the line, younger generations would have to continue to pay for the retirement of current retirees because we have an obligation to do so; at the same time they must begin to set aside funds for investment for their own retirements. It's double jeopardy in a way for those generations--paying twice for retirement--but the shift requires it unless we put that burden back upon the government.

Regardless of the type of system chosen, it really must fit the country, its culture, its social objectives, and its economic system.