IS DEFINED CONTRIBUTION A PANACEA FOR DEFINED BENEFIT SOCIAL SECURITY FUNDING PROBLEMS? LESSONS FROM TWO COUNTRIES by ProQuest

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									       IS DEFINED CONTRIBUTION A PANACEA FOR
       DEFINED BENEFIT SOCIAL SECURITY FUNDING
       PROBLEMS? LESSONS FROM TWO COUNTRIES
                                         Doug Andrews* and Robert L. Brown†


                                                             ABSTRACT
         Many countries are changing their social security retirement program from a defined benefit (DB)
         to a defined contribution (DC) basis. Other countries, such as the United States, are discussing
         the introduction of a DC component. The replacement of a DB social security retirement system
         by a DC system raises many important social and economic issues. Thoughtful consideration must
         be given to the choice of criteria for prioritizing objectives and outcomes, as well as in weighing
         the advantages and disadvantages between different cohorts. For example, if any DB obligations
         are not fully funded at transition, a double burden will rest with transition generation(s). Moreover,
         economists tend to assess the value of the system based on measures of economic efficiency and
         the lack of impediments to a freely operating labor market. But such an assessment may not give
         adequate recognition to factors such as individual wealth/poverty, an individual’s ability to make
         optimal investment decisions, and transaction costs associated with operating individual accounts.
         Indeed, some countries have suggested that notional defined contribution (NDC) accounts may
         be the best way to address such issues.
            Focusing on the adoption of a funded DC social security retirement program in Chile and the
         adoption of a pay-as-you-go NDC social security retirement program by Sweden, this research
         identifies factors of financial markets, economics, and demographics necessary to enable a move
         to DC accounts. In addition, it identifies the characteristics of the financial markets necessary to
         support payments (wealth transfers) to retirees from a DC social security retirement program.
            The paper considers the questions of social security funding and plan type (DB vs. DC) and
         attempts to assess the suitability of certain reform options for the United States. It approaches the
         issue by identifying the features of each type and the strengths and weaknesses associated with
         those features. A significant part of this analysis is the illustrative description of two real-world
         plans, Chilean and Swedish. It then uses the theoretical considerations and the experience of
         those plans to draw conclusions about reform proposals in the United States, particularly the
         President’s Commission to Strengthen Social Security Model 2.




* Doug Andrews, PhD, FCIA, FSA, CFA is Senior Lecturer at the University of Southampton. dwa007@hotmail.com.
†
  Rob Brown, FSA, FCIA, ACAS, HONFIA, is Professor and Director of the Institute of Insurance and Pension Research, University of Waterloo.
rlbrown@uwaterloo.ca.

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1. INTRODUCTION                                                          private investment managers.4 A number of other
Many countries with pay-as-you-go defined benefit                          Latin American countries followed Chile’s exam-
(PAYGO DB) social security retirement programs                           ple in modifying their social security programs.
are changing to a defined contribution (DC) ba-                           In this paper the Chilean system will be used as
sis.1 The change is often motivated by financial                          the example of FDC from which to draw insight.
pressures to make the system affordable in face                             In 1999 Sweden replaced its PAYGO DB sys-
of demographic pressures requiring an increase                           tem, primarily with a notional defined contribu-
in contribution rates, a reduction in benefits, or                        tion system (NDC), which will be another focus
both. In 1997 Canada introduced parametric                               of this paper (this system also included supple-
changes to its PAYGO DB system to provide for                            mental funded individual accounts). Sweden’s
financial stability for the foreseeable future.2                          NDC has been widely discussed even though Swe-
Other countries, such as Chile and Sweden, chose                         den is neither the only country nor even the first
to replace their PAYGO DB systems with a DC                              to adopt NDC.5 However, because of its innovative
system, a structural change. Although a dramatic                         automatic balancing mechanism (ABM),6 its sys-
structural change in the system, especially one                          tem has been selected as the NDC example to
that reduces or postpones benefits, may extend                            analyze.
financial sustainability, it is also true that often                         In 2001 U.S. president George W. Bush estab-
such a major reform is better received politically,                      lished the President’s Commission to Strengthen
because it gives the appearance of having taken                          Social Security (PCSSS). The PCSSS proposed
dramatic action, than if the required changes                            three alternative models to modify Social Security
were made through tweaks to the existing sys-                            to improve its projected financial position (as was
tem’s parameters.3 Moreover, a change to DC                              required by the principles established
								
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