Social Security Privatization: What the Candidates Can Learn from Central Europe and Latin America

In recent weeks, all but one of the Republican Presidential candidates (Jon Huntsman) have made comments favoring privatization of social security, that is, its replacement or partial replacement with privately managed individual investment accounts.  This was the approach advocated by President George W. Bush, unsuccessfully, after his reelection in 2004. The candidates’ renewed interest in social security privatization is striking given the recent volatility of financial markets and the losses that Americans have incurred in their 401(k) and other private investment accounts.  It is perhaps even more striking given the large body of analysis showing that privatization would disadvantage low- income workers while benefitting the wealthiest Americans. This was, for example, a key finding of the U.S. Government Accountability Office (GAO) evaluation of three Texas counties that withdrew from social security in 1981 in order to establish such accounts for public workers – a move that has recently been praised by Rick Perry and Herman Cain.

Yet redistribution toward the wealthy is not the only difficulty with privatizing social security.  There are other stumbling blocks that have not come to public attention, either in the brief exchanges among the candidates or in media commentary on them.  These are evident in the recent experience of Central Europe and Latin America, where many governments adopted social security privatization along the lines advocated by former President Bush and now have actual results to examine.

Three warnings stand out in this experience. First, in times of recession and fiscal imbalance, the high costs of privatization can destabilize government finance. This is because, in countries with pay-as-you-go social security systems, the shift to individual accounts creates a double financial burden. Workers and employers must pay for benefits for current retirees while building up the new, capitalized accounts for future retirement. In Poland, for example, which privatized its pension system in 1999, this double burden amounts to 1.5 – 2 percent of the country’s annual GDP for four decades, with cumulative transitional costs approaching 100 percent of GDP. In the wake of the global financial crisis, these costs have become unaffordable for many governments. Argentina (2008) and Hungary (2010) terminated their private accounts, restored the affected workers’ rights to receive public pensions, and used the account balances to shore up public pensions and reduce government deficits.  Meanwhile, facing similar fiscal pressures, Poland (2011), Latvia (2009), and Lithuania (2009) reduced the rate of contributions to individual accounts by two-thirds, and Estonia, by half (2011).

A second warning from abroad is that volatile financial markets may result in substantial differences in benefits for workers with similar wages and contributions.  This can be observed most clearly in Chile, the first government to privatize its national pension system (1981) and thus the country with the longest experience with paying benefits from privately managed investment accounts.  Herman Cain, who is now running ahead among Republicans, has proposed that the US emulate the Chilean pension model.  However, looking at benefit payouts, it is difficult to understand why. Due to differences in the performance of private funds, as well as in the timing of workers’ retirement in relation to financial market ups and downs, two Chilean workers of the same age, with the same wages, and with the same number of years of work may receive very different pension amounts, with one amounting to as little as a third of the other. These differences have fueled widespread dissatisfaction and social unrest. Workers in Chile’s civil service established the “Association of Public Employees for the Redress of Pension-related Injury” to petition the government for relief for the losers from privatization.  They also applied to the International Labor Organization (ILO) under its social security standards for redress of this disparate treatment.

Third, international experience points to a risk that workers’ investments will be eroded by high private management fees. When governments require workers to save in private accounts, they create captive markets in which the funds shun price competition and keep fees high.  In Hungary and Poland prior to the retrenchments described above, fees reduced account balances by 15-20 percent of workers’ lifetime accumulation. In Chile, they reduce worker account balances by more than 25 percent over a full career.

The candidates should take a close look at countries where social security privatization is a reality.  Based on their findings, they should explain to the public how they would meet its high transition costs, avoid erosion of worker accounts by private management fees, and deal with workers who are disadvantaged by financial market volatility. Informing themselves on these issues can help to move discussion of social security privatization from abstract claims to actual results.  Their willingness to do so is an important measure of their capacity to manage the nation’s largest and most successful social program.

* Elaine Fultz is the former director of the International Labor Organization office for Russia, Eastern Europe, and Central Asia. As a social security specialist with the ILO, she provided technical assistance to reform national retirement systems in Central Europe, Russia, Central Asia, and Southern Africa. Fultz has been a member of the National Academy of Social Insurance since 1993 and is speaking at NASI’s 24^th annual conference, Social Insurance in a Market Economy: Obstacles and Opportunities, January 26-27, 2012 in Washington, DC.