This paper discusses a possible solution to the double problem that faces European governments in dealing with the future of Social Security pensions. Like other governments around the world, they must deal with the rising cost of pensions that will result from the increasing life expectancy of the population. But the European governments have the extra problem that any solution must be compatible with a European Union labor market in which individuals from any member country are free to work anywhere within the European Union. The solution to this double problem that is developed in this paper combines an investment-based system of individual accounts with a 'notional defined contribution' system financed by pay-as-you-go taxes.
This paper, a forthcoming chapter in the Handbook of Public Economics, reviews the theoretical and empirical issues dealing with Social Security pensions. The first part of the paper discusses pure pay-as-you-go plans. It considers the effects of introducing such a plan on the present value of consumption, the optimal level of benefits in such plans, and the emprical research on the effects of pay-as-you-go pension systems on labor supply and saving. The second part of the paper discusses the transition to investment-based systems, analyzing the effect on the present value of consumption of such a transition and considering such issues as the distributional effects and risk associated with such systems.
This paper examines the risk aspects of an investment-based defined contribution Social Security plan. We focus on the risk after the plan is fully phased in. Individuals deposit a fraction of wages to a Personal Retirement Account (PRA), invest these funds in a 60:40 equity-debt mix, and in a similarly invested annuity at age 67. The value of the assets follows a random walk with mean and variance of a 60:40 equity-debt portfolio over the period 1946-95, a mean log return of 5.5 percent (net of administrative costs of 0.4 percent) and a standard deviation of 12.5 percent. We study he stochastic distributions of this process by doing 10,000 simulations of the 80-year experience of the cohort that reached age 21 in 1998. The resulting annuities are compared to the future defined benefits specified in current law (the benchmark' benefits). With no uncertainty, a 5.5 percent log return would permit the benchmark benefits to be purchased with PRA deposits of 3.1 percent of payroll, only one-sixth of the pay-as-you-go tax needed for the benchmark benefits. Saving a higher share of wages provides a cushion' that protects the individual from the risk of an unacceptably low level of benefits. For example, PRA deposits of 6 percent of wages reduces the probability that the benefits are less than the benchmark to 0.17 and the probability that they are less than 61 percent of the benchmark to 0.05. PRA deposits of 9 percent of wages (half of the tax rate required in a pay-as-you-go system) would substantially reduce these risks. This pure investment-based plan is an extreme case. The investment risk can be reduced further by using a mixed system that combines pay-as-you-go and investment-based components or that makes intergenerational transfers conditional on the performance of stock and bond prices.
This paper shows how a new type of derivative product that could be provided by private financial markets could in principle be used to guarantee that an investment-based Social Security reform provides at least the level of real retirement income that is projected in current Social Security rules. In effect, future retirees could purchase a put option' that guarantees that the future retirement benefit will not fall below the level projected in current Social Security law or some other chosen level. To pay for this guarantee, they would agree to give up the part of the annuity payments which exceeds a given level, effectively selling a call option on the stream of payments. This market-based approach could be completely voluntary, leaving each individual to decide what level of guarantee he wants. The higher the minimum guarantee that the individual chooses, the more of the potentially higher returns he must give up. The financial market can thus tailor each individual's product to his own risk preferences. Alternatively, the government might require that any product that is sold as part of the investment-based Social Security reform must include at least some such market-based guarantee. Our analysis calculates some of the tradeoffs that could be provided in today's financial markets. We show that it is feasible to protect future benefits equal to those projected in current law with a combination of the current payroll tax rate and Personal Retirement Account savings equal to 2.5 percent of covered earnings. Raising the savings rate to 3.0 percent increases substantially the amount of the return that the individual can keep, raising it to 145 percent of the currently projected level of benefits. Reducing the guarantee level to 90 percent of the projected future benefits would increase this upside potential to 150 percent of the currently projected level of benefits with a 2.5 percent saving rate and 195 percent of the currently projected benefits with a 3.0 percent saving rate.
This paper uses the recent controversy between the European Union and the Irish Republic to discuss the more general relation between the European Union, the EMU and the member countries. Despite outstanding economic growth and budget surpluses, Ireland has been criticized by the European Commission because it has reduced taxes in the context of a relatively high rate of inflation. The first part of the paper considers the ways in which the EMU is likely to affect inflation and cyclical unemployment in the member countries over the longer term. The second part deals more specifically with the current Irish situation and the reasons for an EU reprimand of a very small country. That part suggests that an alternative standard, based on the principle of 'do no harm' would have lead to a different outcome. Finally, the paper describes a policy of creating investment-based personal retirement accounts that would allow Ireland to share its future budget surpluses with taxpayers in a way that does not contribute to inflationary pressures.
This paper comments on five aspects of globalization: (1) the gains from international flows of goods and capital; (2) the role of foreign direct investment and reasons for its increase; (3) the preventions and management of currency crises; (4) the fluctuation of relative currency values; and (5) the segmentation of global capital market.
In an earlier paper we analyzed a method of combining traditional tax financed pay-as-you-go Social Security benefits with annuities financed by Personal Retirement Accounts. We showed that such a combination could maintain the level of retirement income projected in current Social Security law while avoiding a future increase in the payroll tax rate. The current paper extends the earlier analysis in four ways: (1) We now specify that the funds deposited in the Personal Retirement Accounts come from allocating 2 percent of the 12.4 percent payroll tax instead of being additional funds provided from outside the system. (2) We discuss the effects of the uncertain return on investment based annuities. (3) We provide estimates of the cost of permitting bequests if individuals die either before retirement or during the first twenty years after retirement. (4) We update the statistical basis for our estimates to be consistent with the 2000 Social Security Trustees Report. Our analysis shows that a program of Personal Retirement Accounts funded by allocating 2 percent of the 12.4 percent payroll tax collections can maintain the retirement income projected in current law while avoiding any increase in the 12.4 percent payroll tax. The combination of the higher return on the assets in the Personal Retirement Accounts and the use of the additional corporate profits taxes that result from the increased national saving in Personal Retirement Accounts is sufficient to maintain the solvency of the Social Security Trust Fund even though the tax payments to the fund are reduced from 12.4 percent of taxable payroll to 10.4 percent of taxable payroll. Although there is a period of years when the Trust Fund must borrow, it is able to repay this borrowing with interest out of future tax collections. In the long run, the Trust Fund becomes very large, implying that it would be possible to reduce the payroll tax further or to increase retirement incomes above the levels projected in current law.
The creation of the euro and the European Central Bank is a remarkable and unprecedented event in economic and political history: creating a supranational central bank and leaving eleven countries without national currencies of their own. The experience of the first year confirms that one size fits all' monetary policy is not suitable for Europe because cyclical and inflation conditions vary substantially among countries. Labor market policies during this first year will increase this problem in the future and may lead to more trade protectionism. The paper explores reasons why cyclical unemployment, structural unemployment, and inflation may all be higher in the future as a result of the single currency. Although some advocate the euro despite its economic problems because of its assumed favorable effects on European political cohesiveness, the paper argues that it is more likely to lead to political conflict within Europe and with the Unites States.
In this paper we study the transition from a pay-as-you-go system of Social Security pensions to an investment-based system in an economy in which portfolio returns and capital profitability are both uncertain. The paper extends earlier studies by Feldstein and Samwick that modeled the transition process in a nonstochastic environment and by Feldstein and Ranguelova that examined the implication of portfolio risk after the transition to an investment-based system has been completed. We analyze transitions to a mixed system that maintains the current 12.4 percent pay-as-you-go tax rate as well as to a system that is completely investment-based. We model intergenerational guarantees and assess the risk of such guarantees to taxpayers. We find that transitions to either a completely investment-based system or a mixed system that maintains current law benefits can be done with little additional saving in the early years (a maximum of three percent) and substantially lower combinations of taxes and saving deposits in the later years. The extra risk to retirees and/or taxpayers is relatively small, making the investment-based plans preferable to a pure pay-as-you-go system for reasonable degrees of risk aversion.
Experience in private pension plans and recent policy discussions about investment-based reforms of Social Security suggest that some form of bequest is likely to be part of any such reform that is enacted. This paper provides a first examination of the potential magnitudes of such bequests and of their effect on retirement annuities and asset accumulation. The most likely form of bequest, the preretirement bequest' made when employees die before normal retirement age, reduces the funds available for post-retirement annuities by about 16 percent or, equivalently, requires a one-sixth increase in the Personal Retirement Account saving rate to maintain the same level of post-retirement annuities. We also analyze a variety of post-retirement bequest options. The least costly option that we consider is adding a ten-year-certain' feature to the life annuity, thereby providing a bequest whenever the retiree dies before age 77. This would reduce annuities, relative to providing only preretirement bequests, by about 6 percent. The most costly option that we consider would provide a bequest equal to the remaining actuarial value of the PRA annuity at the time of death and would require reducing all annuities by about 23 percent unless the PRA saving rate is raised. We analyze the size distribution of bequests that would result under different bequest rules and consider the implications for aggregate capital accumulation.