Social Security / CPP 101

So I've been thinking about social security & public pension reform over the last couple of weeks, doing some reading, trying to write a blog post explaining some of the concepts involved and to sort out my own thoughts, and a peculiar thing happened - I ended up accidentally writing an essay (It's a shame this never happened back in my student days).

I should mention that this is not exactly my area of expertise, so if any readers out there (especially my large actuarial following) sees any errors, misconceptions etc., please make your voice heard.

Anyway, here it is (cross-posted at the e-group which you should be voting for here as best Canadian blog - or at the very least, best Group blog)...


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Social Security / CPP 101

Background

Some time in the past (1937 in the U.S., 1966 in Canada) a decision was made that the state should provide funding to old (over 65) people so that they could stop working and have some rest before they died without being left destitute. In the U.S., this program is called Social Security, in Canada it is known as the Canada Pension Plan (CPP).

The Funding Decision

Governments faced a key decision in setting up these programs: how to fund them. Generally speaking, they had two choices:

a) Force people to save a certain percentage of their salary throughout their lives, save up that money over the years, and then use that same money to pay themselves benefits during their retirement (a 'fully-funded' system)

or

b) Force people to save a certain percentage of their salary throughout their lives and use that money immediately to pay benefits to people who are already retired (a 'pay as you go' system)

While there isn't really any significant predictable difference in efficiency (total money paid out vs. money paid in) between these two systems¹, each comes with it's own unique drawbacks.

Pay As You Go Drawbacks (remember #1 and #3 for later)

Problem #1: No Free Lunch

Upon implementation, the pay as you go system starts paying out benefits immediately (or soon, anyway) to people who have never contributed anything (or much, anyway) to the system. While this fortunate generation does basically get a free lunch, society doesn't get off so easily.

The catch is that because the first 'golden' generation received benefits but never contributed any savings, the system is always one generation worth of payments short on cash (it's a bit like a stable pyramid scheme). As long as each generation is willing to see its own contributions paid to their parents generation, this isn't a problem. If however, at some point you want to switch to a fully funded system or just scrap the whole idea, then you have to come up with the extra generation worth of cash or else your current crop of retired folks (who contributed to their parents generation's retirement all their lives and are now relying on their children's generation to support them) will be out of luck.

Problem #2: Temptation

Because of it's receive now, pay later, structure, the pay as you go system has a tendency to lead to regular increases in the benefits provided, which in turn leads to higher contribution rates down the road to pay for them.

Problem #3: Matching

Unlike the fully funded model where each person basically supports their own retirement, under pay as you go you have one group (those currently working) supporting a separate group (those currently retired). This creates a potential problem if the relative size of these two groups changes.

Fully Funded System Drawbacks

Problem #1: Lack of Flexibility

A pay as you go system is better suited to achieving social policy goals such as redistributing income, providing disability benefits and so on, if these are desired.

Problem #2 What to Do With All That Money

A fully funded plan creates a huge pool of savings as compared to a pay as you go plan. If managed by the government there is a risk that it will be managed poorly or politically and that it may be used to disguise a budget deficit. If managed by individuals there is a loss of risk sharing as well as higher fees and expenses. More on this later.

While the huge pool of savings may increase the countries overall savings rate and this may lead to more investment (especially if markets are in need of capital) there is little agreement or evidence on this front.

Finally, there is the question of whether a country's capital markets (stock market, bond market, etc.) are big enough to be able to effectively make use of all this money.

Problem #3: Delayed Implementation

If people have to rely on money they themselves contributed to the system, then the system will only start to pay out significant benefits as people who have been contributing for years start to retire. Doing it this way doesn't win a lot of votes from the people who are already retired at the time of implementation, since they get no benefit from the program.

The Decision:

Faced with future problems under a pay as you go method and immediate problems under a fully funded approach, both the U.S. and Canadian governments unsurprisingly chose to implement pay as you go systems.²


Remember That Matching Problem?

A study done in the mid-1990's in Canada suggested that [thanks to longer lifespans and declining birth rates] the ratio of workers to retirees would decrease from 5:1 at the time, to 3:1 by 2030. This is exactly the matching problem (#3) that was a risk under the pay as you go plan. A similar trend has occurred in the United States.

With the ratio of people 'paying in' to people 'taking out' in steady decline, the system needs to be rebalanced to avoid ending up unable to pay the full benefits it has promised people. There are basically 3 ways to bridge the gap between the amount of money in the system and the amount of money to be paid out:

1) Reduce the money you pay out (cut benefits, raise the retirement age, etc.)
2) Increase contributions (raise taxes, force the current generation to save more to support their parents)
3) Increase the rate of return earned on the money in the system (i.e. money that has been saved but hasn't been paid out yet.)

Over the years, the Canadian and American governments have used a mixture of these approaches to deal with the matching problem.

U.S. Reaction - 1983

In 1983, the U.S., foreseeing trouble ahead, applied a combination of methods 1 and 2. Specifically,

"The National Commission on Social Security Reform was created in response to the actuarial unsoundness of the system. The commission called for 1) an increase in the self-employment tax; 2) partial taxation of benefits to upper income retirees; 3) expansion of coverage to include federal civilian and nonprofit organization employees; and 4) an increase in the retirement age from 65 to 67, to be enacted gradually starting in 2000. Again, Social Security was declared actuarially sound. Payroll taxes were 10.8%."³

In order to smooth out the rise in contribution rates, the U.S. decided to raise rates more than was necessary at the time, in order to build up a surplus of funds, and then draw down that surplus as necessary once the demographic crunch really started to arrive.

Canadian Reaction - 1999

Canada attempted to build up a similar reserve fund, but by the mid-90's actuaries were estimating that the fund would be fully drawn down by 2015, after which retirees would not be able to receive the full benefits they had been promised. In order to maintain full benefits, contribution rates would have to gradually rise from the current (at the time) 5.6% to 14.2%.

Canada followed the U.S. example of 1983, but applied all 3 possible remedies, reducing benefits, increasing premiums, and attempting to raise the rate of return on the reserve fund (by moving to a partially (20%) funded model, building up a reserve of 5 years worth of payments and switching from a policy of investing only in bonds to investing in stocks as well).

Specifically, of the funds required to bridge the funding gap:

25% came from the switch to partial (20%) funding combined with equity investing
28% came from benefit reductions
13% came from an increase in the payroll tax (to 9.9%)
34% came from one specific benefit reduction: freezing the annual taxable earnings exemption (no longer indexing the basic amount of income which was exempt from CPP - frozen at $3,500)⁴

Similar to the U.S. plan of 1983, the 9.9% rate was designed to be high enough to be a 'steady state' figure - i.e. stable in the long term. Unlike the U.S., Canada built in an automatic stabilizer by which benefits would be automatically reduced (by no longer being indexed to inflation) in the event that the 9.9% rate no longer seemed high enough to ensure the long term health of the system. So far, the 9.9 rate has been sufficient (the steady state rate is now estimated at 9.8%).

Whereas in the years leading up to the 1999 changes there was a flurry of warnings about a crisis in the CPP and the need for privatization, the years since have been remarkable for their silence on the issue (Google: '"Canada Pension Plan" Crisis' or 'CPP Pyramid Scheme' and you'll see what I mean).

U.S. Reaction - 2005

Unfortunately for the U.S., the adjustments made in 1983 have not yet been quite sufficient to fully close the funding gap in Social Security. Of course, as Paul Krugman notes,

"The date at which the trust fund will run out, according to Social Security Administration projections, has receded steadily into the future: 10 years ago it was 2029, now it's 2042. As Kevin Drum, Brad DeLong, and others have pointed out, the SSA estimates are very conservative, and quite moderate projections of economic growth push the exhaustion date into the indefinite future."⁵

Unlike in previous solutions, the President has ruled out options #1 (benefit cuts) and #2 (contribution increases), leaving #3 - increasing the rate of return as the only possible solution. Based on the debate in the U.S. so far, the option of having the government invest the surplus money in stocks does not seem to be being considered. This leaves the only option as having individual investors invest the money in stocks themselves. But this can only happen in a fully funded system.

So the current (Bush administration) plan is to switch from the pay as you go system to the fully funded system. And this is why I said you should remember problem #1 with the pay as you go system - the enormous cost of switching away from it.

This leaves us with 3 questions:

Will increased returns from investing the money in stocks solve the funding gap?
Is it better to have individuals manage their accounts vs. the government?
What will be the cost of switching systems, and how will it be paid?

Will the increased returns from investing the money in stocks solve the funding gap?

On its face, this is a simple actuarial question. In the same way as it was estimated that switching to some stock investment for the CPP would cover 25% of the Canadian funding gap in 1999, it is possible to work out a similar figure for the current U.S. situation. Thanks to the 1983 reforms, the funding gap isn't that large (with solid economic growth in the next couple of decades it won't exist at all), so I wouldn't be surprised if reasonable stock returns wouldn't cover much of the gap.

However, there are other, murkier aspects to this question. What will happen with people who do better than average with their investments? Will they be allowed to keep them? If so, it will be harder to close the gap. What about people who do poorly? Will they be left to suffer? If so, doesn't that defeat the whole purpose the program was set up for in the first place? If not, and we have to supplement their returns, this will make it harder to close the gap as well. If we are going to hold people to an average return anyway, shouldn't we just make them invest in index funds and save the commissions?

And of course, just how much will people end up paying in commissions and fees? Experience in other countries suggest that from 1-2% of the return will be taken up by them⁶ - a significant dent.

Furthermore, a lot of people may not even want to be bothered with having to manage another account and to the extent that they do take the time to figure out what to do with it, the opportunity cost of everyone in the country putting in even just a few hours to manage their account could be enormous.

Finally, what if people throw all their money in stocks and the market has a long spell of poor performance (it's happened). Or what if the stock market performance over the last few decades has been unusually good (there's reasonable evidence to support this.⁷) Or what if people are conservative and don't put much money in stocks at all? Either way, the gap may not be closed much.

To boil it down, there's a reason stocks have a higher rate of return than bonds: they're more risky. And when combined with a plan whose motivation is to provide a consistent, basic return to everyone rather than just a good average return, significant losses to fees and commissions, and a likely end to a period of higher than usual stock returns, it's possible (perhaps even likely) that the gains from investing in stocks will be pretty small.

Is it better to have individuals manage their accounts vs. the government?

Just because a system is fully funded doesn't mean it has to have private accounts (Singapore, for one, has a fully funded, centrally run pension plan⁸).

On the one hand, people like to manage their own money and don't trust government enough to feel comfortable leaving a huge pile of money in its hands. On the other hand, government will end up paying far lower commissions, will take vastly fewer man hours to make the investment decisions and would be expected to earn a higher (or at least equal) rate of return as the average individual (it's possible that it is purely random and hand picked experts couldn't do better than average returns, but there's no reason to think they'd do worse than average).

It's also worth noting that both countries already have systems whereby those who want to manage their own retirement savings have a tax free vehicle (RRSP in Canada, 401K in the U.S.) which allows them to do this.

Plus, we have to consider all the potential problems with managing above and below average returns that we mentioned in the last section. These problems don't arise in a government run system (or in the optional RRSP / 401K systems). They are the reason (along with containing fees) that many countries which have set up private accounts have put tight restrictions on how they can be invested, which kind of defeats the purpose.

What will be the cost of switching systems, and how will it be paid?

As mentioned earlier, this is the cost of paying people their benefits when the people they were expecting to provide them (current workers) are now keeping the money for themselves (as happens under a fully funded system). It's the delayed cost of the free lunch you get at the start of the pay as you go plan.

Coming up with the total should be a fairly straightforward actuarial question - the estimates I've seen have been upwards of $2 trillion. In order to finance a similar transition, Chile ran many years of budget surplusses (and devoted the surplus funds to the transition costs), privatized a number of state enterprises, cut benefits, raised taxes and still was left with significant borrowing⁹. Argentina financed a similar transition with pure borrowing, but given the financial (debt/currency) crisis/meltdown they were hit with a few years into their experiment, we'll never know for sure how that would have worked out.

Given that the U.S. is already fairly significantly in debt, and somewhat resistant to raising taxes, the only way to finance the transition (without cutting benefits) would be through issuing yet more debt. This will have two costs:

1) Interest - even at U.S. government borrowing rates, the interest on $2 trillion+ is likely to be significant. Although in a sense you are just trading the liability of switching systems someday for the liability of repaying government bonds someday, there is a big difference in that you have to pay interest (now) on government bonds, while you don't on theoretical future obligations.

2) Higher interest rates /reduced market confidence - in financial markets you pay a penalty for risk and even the U.S. government starts to look a bit more risky when it adds $2+ trillion to an already large debt load. Also, by increasing demand for money, the government is likely to push up interest rates, which will have a negative impact on the economy.

In a nutshell, the cost is hard to estimate exactly, but it's going to be high.

Conclusion

There are good reasons to prefer a fully funded system to a pay as you go one (and vice versa). If I was starting a new system myself, I'd probably go with a fully funded one, mainly because I don't like the idea of constraining the choices of future generations. But that ship has already sailed and it's too late to start from scratch.

Given the heavily indebted state of the Canadian and (especially) the U.S. governments, taking on another huge financial burden just for the unproven potential benefits of changing funding systems or for the creation of private accounts which are likely to do as much harm as good seems deeply unwise.

Rather than take on huge costs and risks for an uncertain gain, the better path would be to make the minor but politically difficult changes necessary to keep the existing system functioning according to its intended purpose into and beyond the foreseeable future.


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¹ The growth in funds (rate of return) for a fully funded system depends on real interest rates (i.e. posted interest rates - inflation) if invested in bonds or growth in corporate profits if invested in stocks. If real interest rates/corporate profit growth rates are high it does better, if they are low, not so good.

In a pay as you go system the growth in funds (rate of return) depends on the growth in wages (from which contributions are made).

Whether the real interest rate, corporate profit growth rate or the wage growth rate will be higher is hard to predict. In the 50's and 60's, wage growth was higher but in more recent years real interest rates have typically been higher. Corporate profit growth rates have been high over the last few decades but many would argue that this performance is unsustainable.

² Actuaries / government officials of the time may argue that they did it not for political expediency but because the economic variables at the time (as described in note 1) suggested a pay as you go system would be more efficient. I wasn't there so I can't say for sure, but I'm a bit cynical so I tend to think they went for expediency and immediacy rather than aiming (incorrectly as it turned out) for efficiency.

³ From this website pushing Social Security Reform. It's slanted and their understanding of pay as you go systems is a bit lacking, but if you ignore the subjective parts, it's a good, well organized source of facts on the Social Security system.

⁴ Figures from this report on the changes made to the CPP in 1999, prepared by employees of the Social Security System in the U.S. The focus is on the decision to invest some of the reserve in stocks and how this was handled, but it has a good background on the whole situation.

⁵ Frustrated with trying to get his point across in 700 word columns, Paul Krugman wrote this (slightly) longer piece in which he debunks three myths about Social Security with typical style.

⁶ Taken from a paper by the U.S. congressional budget office reviewing experience with Public Pension 'Privatizations' in other countries (Australia, Britain, Mexico, Chile and Argentina). Interesting subject but fairly dryly written, you have to read between the lines a bit to figure out what the authors really think.

⁷ Krugman has a good explanation of this in the same article.

⁸ I found out about the Singapore system from this paper written on the pros and cons of privatizing Mexico's pension plan. It does a good job of explaining some of the trickier concepts, such as why there's not much difference in efficiency between a fully funded or pay as you go system.

⁹ The original NY Times article is in the pay archive, so I'm linking to where I saw it quoted at Tech Central Station.