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December 17, 2004

Social Security Privatization Around the Globe

Paul Krugman looks at Social Security privatization around the globe:

The New York Times > Opinion > Op-Ed Columnist: Buying Into Failure: Information about other countries' experience with privatization isn't hard to find.... http://www.tcf.org.... Yet, aside from giving the Cato Institute and other organizations promoting Social Security privatization the space to present upbeat tales from Chile, the U.S. news media have provided their readers and viewers with little information about international experience. In particular, the public hasn't been let in on two open secrets: (1) Privatization dissipates a large fraction of workers' contributions on fees to investment companies. (2) It leaves many retirees in poverty....

More than 99 percent of Social Security's revenues go toward benefits, and less than 1 percent for overhead. In Chile's system, management fees are around 20 times as high. And that's a typical number for privatized systems.... If we introduce a system with British-level management fees, net returns to workers will be reduced by more than a quarter. Add in deep cuts in guaranteed benefits and a big increase in risk, and we're looking at a "reform" that hurts everyone except the investment industry....

It's true that costs will be low if investments are restricted to low-overhead index funds - that is, if government officials, not individuals, make the investment decisions. But if that's how the system works, the suggestions that workers will have control over their own money - two years ago, Cato renamed its Project on Social Security Privatization by replacing "privatization" with "choice" - are false advertising. And if there are rules restricting workers to low-expense investments, investment industry lobbyists will try to get those rules overturned....

Privatizers who laud the Chilean system never mention that... the government is still pouring in money. Why? Because... the Chilean government must "provide subsidies for workers failing to accumulate enough capital to provide a minimum pension."... [P]rivatization would have condemned many retirees to dire poverty, and the government stepped back in to save them.... [T[he Bush administration wants to scrap a retirement system that works, and can be made financially sound for generations to come with modest reforms. Instead, it wants to buy into failure...

Posted by DeLong at December 17, 2004 11:05 AM

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Tracked on December 17, 2004 01:26 PM


'...Around the Globe', the world is proud of Paul!

Posted by: Pancho Villa at December 17, 2004 11:18 AM

I am having trouble with the math. Is Paul saying that Chile's expense ratio is 20%?

Posted by: David E... at December 17, 2004 11:34 AM

“It's true that costs will be low if investments are restricted to low-overhead index funds - that is, if government officials, not individuals, make the investment decisions.”

I don’t get this sentence. I buy Exchange Traded Funds, and I set stop loss orders. I pay less than $20 as a commission. The overhead for ETFS runs about 0.16% for broad market indices. You can diversify into small cap and foreign funds and still hold the overhead to about 1%. There are also fixed income ETFS that track broad bond market indices. I have never had a down year right through the tech bubble.

All that being said I oppose privatizing SS because I don’t want to get taxed to bail out the idiots who will lose their whole wad speculating.

Posted by: A. Zarkov at December 17, 2004 11:46 AM

A Zarkov:

I think Paul is suggesting that a set of indexed funds (or any small set of funds) would have to be chosen in order to keep costs low. Someone, either govt officials or their proxies at the private acct institutions would have to "choose" which funds were available.

I suppose costs could also be kept low by allowing ALL ETF but nothing else, but then again, we have just made a choice for the entire population.

Posted by: Scott at December 17, 2004 11:56 AM

"I am having trouble with the math. Is Paul saying that Chile's expense ratio is 20%?"

When measured against the benefits paid out, yes. In steady-state, there's a great pile of privately owned assets. In a given year, on the order of 5% of the asset pile will be distributed as benefits. If the management fees are 1% on the pile, they look terrible when compared to the benefits. Krugman's point might be somewhat intellectually dishonest; OTOH, if the 1% management fee means that only 4% can be paid out, rather than 5%, that's a real 20% decrease in the benefit level.

Posted by: Michael Cain at December 17, 2004 12:10 PM

A friend showed me a money management account with Bank America. For quite a sizable account there is a 2% Bank America management fee each year. The mutual funds that the adviser has chosen also charge an average of 2% for expenses each year. What does 4% in expenses do to investment returns? Since it opened 28 years ago, the Vanguard S&P Index has returned 12.3%. So, almost 1/3 of the gains of the S&P over a terrific investing period would be lost by adding a money management fee and investing in mutual funds with "standard" fees. Add in the turnover or transaction costs that managed mutual funds bear, and you can understand how difficult a problem costs are in money management.

Simplifying: Vanguard's S&P Index has returned 12.3% over 28 years. The expense ratio for the fund is 0.18%. Bank America charges 2% for money management and invests clients in funds that charge 2%. This is a serious cost drag to overcome.

Posted by: anne at December 17, 2004 12:19 PM

Talking points for Democrats:

"Twice the cost and half the benefits
That is the Presidents social security deform
The president is a good clear speaking man
But he has been misinformated on this one
We are doing him a favor by making sure it dies on the order paper. We're helping him preserve his legacy with the American people."

For use of these points during media events please send cash or money order to...

Posted by: Scott McArthur at December 17, 2004 12:34 PM

The problems will come because the vast majority of citizens are astoundingly ignorant when it comes to financial matters. Without strict regulation and government intervention, they will be gulled into accounts featuring management fees that effectively wipe out any gains.

And, of course, there will be untold numbers of scam artists who will prey upon the ignorance and gullibility of the public to fleece them out of their private accounts. But I guess we can invoke social Darwinism and just leave all the unfortunates to rot in the street.

Posted by: Derelict at December 17, 2004 12:37 PM

When the S&P pays 12%, and investment costs are 4%, the investor loses 1/3 of the return to costs. The average mutual fund expense level is above 2% according to John Bogle. Add another 2% for a money manager and watch how much of your return is swallowed by costs. Paul Krugman was quite right.

Posted by: anne at December 17, 2004 12:47 PM

Has anyone taken a run at calculating the future of SS starting with Bush administration economic forcasts, then switching to the gloomier (e.g. CBO)models?

Posted by: Tom at December 17, 2004 12:51 PM


Is there anything for economists comparable to disbarment for lawyers? Greg Mankiw was on ... I think it was Morning Edition yesterday, but I can't find the link. At one point he said that the $2 trillion borrowing for Bush's Soc Sec "plan" wasn't really unfair to later generations, then a few sentences later he said that we should fix Soc Sec now, so we don't leave the problem to our children/grandchildren. I'm not getting it all down perfectly, but as he said it, the contradiction between his two statements was glaring. This seems like the sort of professional misconduct we ought to have standards for.

Posted by: Karl at December 17, 2004 12:57 PM

Is paying $1-$2 trillion over the next ten years to pay a $3.7 trillion expense over 75 years a good deal? It does not seem so to me.

Posted by: ted at December 17, 2004 01:04 PM

I have a completely unrelated question...OK, semi-related...given this increase in the debt, and so forth related to Social Security....

1. If our economy grows at 4% a year (in dollars) , BUT...

2. The Euro increases in value at 10% a year...

Hasn't our economy really declined when valued in Euros?

Posted by: mumon at December 17, 2004 01:06 PM

I don't know what precisely Krugman is saying, since he provides no back-up, but to provide some context: If SS charges 1% to manage the whole thing, that's way more than pretty much all institutional actively managed accounts in this country, let alone index funds. Altogether, there are over 4000 open-end funds in the US that charge less than 1%.

Posted by: walons at December 17, 2004 01:09 PM

Walons wrote, "If SS charges 1% to manage the whole thing, that's way more than pretty much all institutional actively managed accounts in this country, let alone index funds. Altogether, there are over 4000 open-end funds in the US that charge less than 1%."

(1) Many of those funds have limits on the minimum account size;
(2) Those funds don't include the cost of providing an annuity, which (like all insurance) costs extra;
(3) Those funds don't do other things like providing disability insurance. (Though perhaps Krugman's 1% figure omits that.)

Posted by: liberal at December 17, 2004 01:50 PM

Walons, liberal: you're comparing apples and oranges. The SS costs are per dollar of *contributions*; the mutual fund fees are per dollar of *assets*. If SS were a mutual fund paying current benefit levels, it would have more than $10 trillion in assets, and its fees would be less than 0.05 percent of assets.

Posted by: anon at December 17, 2004 02:02 PM

Walons (& liberal),

Krugman is talking about % of payout. You're talking about % of principal. % of payout is the standard way of measuring costs.

So: SS costs are under 1% of payout, and a vanishingly small % of principal. In Chile, as Krugman says, costs for private accounts are 20% of payout, and some lower % of principal. (I don't know exactly how much... maybe 1%?)

The point is, the cost of running private accounts is FAR higher than the cost of SS, and over time it adds up in a big, big way. Which is, of course, why Wall Street likes the idea so much. Those "costs" are money in their pocket.

Posted by: A Tiny at December 17, 2004 02:12 PM

God, I love this blog!

Confusing everyone is Bush's plan and letting someone with credibility as an economist lead the charge is great because all the right wing talking heads can point to this guy like they used to tout the Laffer Curve.

Since most Americans can't even do compund interest problems on paper, let alone with a calculator, the admin's plan will gather many adherents who rehash what Rush and Hannity say while selling their kids' futures out to the nearest financial advisor.

This is the chance for the little guy to play with stocks and bonds. I'ts gonna be like the game Life except the bankruptcies will be real and the disillusionment will be real and somehow, the right wing propaganda machine will make this the fault of the left and the dems.

Posted by: matt at December 17, 2004 02:23 PM

The Chilean example is troubling, but even more so when you realize that in this country, the government might not be able to step in and pour more money to prevent vast,expanded poverty among the elderly. The Chileans still care enough as a society about their elderly that it seems socially unacceptable to abandon them, even at great cost.

But a while back I read an article in Slate in which one of their contributors argued that we shouldn't care so much about the health care crisis because people can't expect to keep living past 60. This was apparently unreasonable. That attitude is becoming quite socially acceptable among right-wing circles, and might color what we could do to save ourselves after we jump off this particular cliff.

Posted by: Susan at December 17, 2004 02:36 PM

Walons/liberal (again),

If you're confused by our two simultaneous answers, payout=contributions over the long haul. So anon and I are saying the same thing.

Posted by: A Tiny at December 17, 2004 03:23 PM

Zarkov -

Paying $20 to trade an ETF works fine if you've got an account with $50K or more of assets. These accounts will be tiny. They're the type of accounts that custodians would normally charge an annual fee against, they're so small, until you've contributed for 30 years or so.

If you listened to the President, he said he was considering emulating the federal Thrift Savings plan. That is a plan that has about five choices - a stock plan, a bond plan, an international fund and a couple others.

These have very low overhead because everyone gets the same thing. Also, the funds are broadly diversified, so you will approximate a broad market performance, limiting risk.

The govt can't afford to let people have more than a measured amount of risk, since everyone in these programs is essentially insured for losses. So, you get very limited choice. And very low overhead, considering how tiny the accounts are by normal investment account standards.

Most of the people who've studied this enough also say you should be forced to shift into an annuity as you approach retirement age. Meaning, whatever you've collected will be spread out through your retirment years. You won't be allowed to outlive your assets, again, because the government would be on the hook to bail you out.

This isn't too different from the scenario in which the govt would simply invest trust fund assets like a pension manager. That would be a much lower cost option, and would require a smaller government participation - in part, because the program would remain just an old age and disability program, rather than allowing you to own and pass on the assets.

You know, don't know, that the death benefit of "owning" the assets requires a much bigger program than something that simply provides living insurance?

Posted by: Charlie at December 17, 2004 03:30 PM

K. said: "More than 99 percent of Social Security's revenues go toward benefits". I understand SS revenues to be what goes into the system, and benefits as what SS pays out. If I'm wrong, I'll be happy to admit it, but yet grumble at K. for using confusing terminology.

Posted by: walons at December 17, 2004 04:21 PM

Now we have Don Luskin pushing some guy named Tim Worstall who says Krugman is full of it. I am not sure who to believe, but I am willing to give Krugman the benefit of a doubt, since almost anything touched by Luskin and his ilk turns to shit.

[Why are you not sure who to believe? Isn't there a track record here?]

Posted by: Brian at December 17, 2004 04:30 PM

What I don't understand is, how does someone smart enough to have substantial financial assets in the first place end up paying a 2 percent management fee for a bank to buy a mutual fund for him?

Posted by: trostky at December 17, 2004 05:04 PM

What matters is the drag of the administrative costs on your rate of return net of dividends. Expense ratios for actively managed no-load mutual funds average about 1.5% (which is a lot), but there are some exceptions such as Dodge and Cox, which posts an expense ratio of 0.54% for their actively managed stock fund. The rate of return for Social Security would depend on when you were born, and when you started to pay your FICA tax. Certainly that first cohort, those who were eligible to collect benefits in 1937 got a near infinite return since they paid in little or nothing. I suspect the baby boom generation will get a very small, even negative rate of return on their SS contributions when they retire, especially those who made the maximum contribution. So I’m not impressed by the 1% administrative cost of SS. Just putting your FICA taxes into a Vanguard S&P 500 and buying disability insurance on the side would put most people way ahead of SS. Of course SS is a pay-as-you-go system, the legacy of giving a nearly free ride to those early cohorts. Nevertheless we are stuck with what we have and the most sensible thing to do is to leave it alone and reduce benefits as the ratio of retirees to workers increases. The message to young people is start saving and consume less because you are going to get less.

Posted by: A. Zarkov at December 17, 2004 09:56 PM

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