A Social Security System That's Putting America's To Shame

Latin American countries were once considered economically backward compared with the U.S. and incapable of sound economic management. Today, despite Mexico's currency problem, this is less and less the case. Chile, for example, has done much better than the U.S. in reining in an exploding public sector. Chile, an economic basket case in 1973, was by 1981 able to privatize its failing pay-as-you-go social security retirement system, which was projecting the kind of large future deficits America's will face early in the next century.

Chile decided to take the bull by the horns and face the deficits up front in order to rapidly phase out the state system. Since 1981, all new entrants into the labor force have been required to contribute 10% (with up to another 10% optional) of their monthly gross earnings to private pension fund accounts that they own. Everyone else was given the option of leaving the state system, except for existing retirees and those within a few years of retirement. Workers who left the state system were bought out with "recognition bonds," deposited in their private pension accounts and redeemed at retirement, for their past payments into the system.

In the first month, some 25% of Chilean workers transferred to the private system. Today, about 93% of the labor force is enrolled in 20 separate and competing private pension funds. The reform has boosted Chile's domestic savings rate to 26% of gross domestic product. Chile's economic growth rate averaged 5.4% annually between 1984 and 1992. With annual real returns on pension investments averaging 13% from 1981 to 1993, Chileans are beginning to retire with generous pensions.

A STAKE IN SUCCESS. The future benefit obligations of the state system shrank dramatically as employees transferred to the private system. But current revenues also collapsed with the abolition of the payroll retirement tax. General revenues, boosted by privatizations of state companies, are used to pay benefits under the old system. The Chilean reformers wagered that the private pension system would greatly deepen the country's capital market and stimulate economic growth, thereby generating a larger tax base to help redeem the recognition bonds as their staggered maturities come due.

With no new entrants into the state system, it will automatically terminate as current retirees pass away. Barring an explosion in spending or a decline in confidence that would threaten the government's ability to redeem recognition bonds, Chile has succeeded in replacing a job-killing employment tax with job-creating private investment, while simultaneously boosting retirement incomes and personal wealth. More important, now that practically every Chilean has an ownership stake in the economy's success, politicians have taken a more responsible approach to economic policy.

The privatization of Chile's social security system was not without political drama. Just as the American Association of Retired Persons (AARP) is a vested interest standing in the way of reform in the U.S., many Chilean interest groups had their hooks in the state social security system and did not want to let go. Labor union leaders saw an opportunity in the reform to grab the power to make the investment allocation of their members' pension contributions, thus collecting "commissions" or extracting bribes from pension fund managers. In October, 1980, 30 union leaders cornered Labor Minister Jose Pinera in an effort to hijack the reform. Pinera's wit prevailed when he told the union bosses that he could not in good conscience expose them to temptations that would threaten the salvation of their souls.

Unlike the Chilean reformers, American politicians have played fast and loose with Social Security, causing citizens to believe that their contributions are invested in a genuine trust fund. In truth, the revenues are commingled with general revenues and spent as fast as they come in. The Social Security Trust Fund is a deceptive artifact, containing government IOUs that can be redeemed only by cutting spending, raising taxes, or issuing more public debt.

Americans would be incomparably better off under a privatized system such as Chile's. In a paper to be published by the Cato Institute, William G. Shipman of State Street Global Advisors in Boston shows that Americans would receive many multiples of their Social Security benefits if their payroll taxes were invested in the stock and bond markets. Social Security not only cheats retirees but also cheats the country out of needed savings and investment. It is a sacred cow that we can no longer afford.

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