President Bush has unveiled his plans to reform Social Security in the United States. Broadly this will involve a diversion of contributions currently being paid into Social Security towards a personal fund which belongs to the member. The aim is to move some of the cost of retirement benefit provision away from the state to the individual. As with any change of this type there are consequences.
Currently, the Social Security retirement benefits in America for pensioners are paid from the contributions of those working. This pay-as-you-go (PAYG) system is popular in many parts of the world including Guyana where the benefits from the National Insurance Scheme are largely met from contributions. The system is coming under tremendous pressure in many jurisdictions for a number of reasons. It may be stating the obvious to say that if contributions do not exceed the benefits being paid then eventually any surplus funds which have been built up while contributions exceeded benefits will be depleted.
If the situation is left until that time then drastic decisions will need to be made.
Either benefits will need to be cut, contributions of those currently paying increased, or some combination of the two. An increase in the retirement age is also possible, though technically this is just a cut in benefits, since benefits start being paid later and will be paid for a shorter period of time.
To maintain equilibrium in a PAYG system requires the ratio of the contributions to benefits to remain stable. However this is often not the case. Typically, the proportion of contributing workers to pensioners is getting smaller and smaller. Primarily as a result of people living longer, due for example to improvements in health care and lifestyle, more benefits are being paid for a longer period of time.
The working population is getting smaller at the same time due to falling birth rates and in some cases net emigration. The combined effect is dramatic. So much so that recent projections in Germany estimate that by 2040 there will be less than two contributing workers for each pensioner. At present the ratio is over four to one. In the USA the ratio of workers to beneficiaries has dropped from five to one in 1960, to three to 1 today. By 2033, it is expected to fall to two to 1.
Naturally, there is no way that a system can continue in its existing form if in effect half the contributors are no longer paying. Despite the writing being on the wall in many jurisdictions, reform of social security has not been placed centre stage in some of them. Cynics would say that since the problems will not surface for several years, the current administration need not deal with the problem. Whatever the case, because there is almost certainly a cost involved with revamping the system, the decisions to reform a system may be unpopular with the working population.
President Bush proposes diverting some contributions into personal retirement accounts. The question is, whether this will eliminate the problem. Essentially what happens is that people who contribute into their own plan will take a cut in their Social Security benefit.
Proponents of the plan say that the benefits from the personal account will exceed those benefits given up, acting as an incentive to making the switch.
Even if a large proportion of the current working population does opt for the personal retirement account this leaves a significant question unanswered.
Since those opting for the new plan are now contributing less to Social Security, this actually makes the problem of finding payments to meet current pensioners worse.
Where will the shortfall in contributions come from, particularly since the lower benefits of those opting for the personal accounts may not lead to cost savings because for many of them they will not retire for years?
At the Caribbean Actuarial Association annual conference last year, I participated in a presentation on the social security plans in the Caribbean. Not surprisingly, just about every one of them faced the same dilemma as is currently facing the USA. Of these Barbados has seen the most sweeping reforms, with dramatic increases in retirement age and contributions. Other countries have been slower to respond, though Guyana recently raised the contribution rate to the National Insurance Scheme.
I question that the proposals made in the USA would work here. Given the undeveloped nature of the financial markets, allowing persons to invest their own funds may lead to benefits which are actually less than those they gave up. Although having a funded plan can be argued as being more secure than relying on the next generation to pay for you, you are giving up a defined benefit in exchange for a defined contribution plan. The question is whether it is better to have a funded defined contribution plan or a promise from a defined plan which relies on the next generation being able to pay for you.
There are other possibilities to consider. One is to raise the salary ceiling on contributions to the National Insurance while keeping the ceiling when determining benefits the same. This means those above the benefit ceiling are subsidising those who fall below it.
Alternatively, private provision can be encouraged by making the proportion of salary paid in contributions free from income tax, either at source or by providers of pension grossing up contributions made out of net salary and reclaiming the difference from the revenue authority. Either of these measures would mean that individuals can contribute something while lessening the impact on their take home pay. However in a developing country, many people will not be able to afford to give up any of their net pay, so the tax breaks may not encourage provision among those who would benefit the most from it.
Ultimately, the question of private provision all leads back to whether or not the view is taken that the state should shoulder some of the burden of retirement provision. If the answer is yes, then the people must be prepared to pay for it; either by increasing contributions or reducing their benefits to pay for those who need it most.
The spotlight will shift onto the provision of retirement benefits more and more as those receiving them become a larger proportion of the population. One thing is for sure, for those countries where reforms are needed the longer they are coming the more painful they will be and the bigger the changes which will be needed when they are finally made.