Can Privatization Save Social Security? Let's Look to Chile

My recent A&Q on how the U.S. can salvage Social Security questioned several solutions for how the program can pay out what was promised beyond 2034, including ways to increase revenue by raising taxes or reducing benefits. The most pertinent question is finding a solution that both feels fair to Americans and will make it through Congress. A reader offers this solution, which is to take Social Security out of the government altogether:

Answer

I would love to see the U.S. transition to something closer to the Chilean model; a mandatory retirement account placed in a broad range of bonds and index mutual funds. The money is yours, and you can pass it along to your descendants.

QUESTION

How could I forget about Chile? This is actually a great example to look at, as it is one of how privatizing public insurance—an idea supported by many Republicans—isn’t as easy as it sounds. The Chilean program, introduced in 1981, is a system of privately managed individual accounts that replaced its previous public system, which faced some similar problems as the U.S. system. Unlike your normal retirement savings account though, the Chilean program is mandatory. Workers in Chile contribute 10 percent of their monthly earnings to their account by law, and the maximum contribution is 20 percent. The argument for the privatized system is that it would increase national savings, as returns on private securities are riskier, but notably higher than Treasury securities.

But the Chilean private program hasn’t been problem-free.

First, many Chileans ended up falling outside of this new private system: women who didn’t work, those who were paid in cash, and the self-employed. In Chile, this added up to roughly half of the labor force. Reforms were made in 2008 to improve coverage for the country’s poorest citizens using tax funding.

Secondly, transitioning to a private accounts system didn’t solve all of Chile’s pension problems. The private program reported a shortfall, with the government subsidizing it so that minimum pension payments would be met. Further, some Chileans found that high administrative fees ate into their meager retirement savings, which often meant that they got less than they would have under the old public system. So much so that in the mid-2000s, the private program became an important political issue as many Chileans were upset at how high overhead costs actually are for private pension programs.

According to an NBER paper by Peter Diamond, an economics professor at MIT, assessing the merits of the Chilean program:

The Chilean reform gets high marks for defending the system from political risk and for its effects on capital accumulation and on the functioning of the capital market. The Chilean reform gets low marks for the provision of insurance and for administrative cost. Perhaps the most surprising aspect of the Chilean reform is the high cost of running a privatized social security system, higher than the 'inefficient' system that it replaced. Valdes-Prieto has estimated that the average administrative charge per effective affiliate while active is U.S. $89.10 per year (for 1991) which is 2.94% of average taxable earnings. This is close to 30% of the 10% mandatory savings rate. The cost per person is not far from costs observed in other privately-managed pension systems, such as defined- benefit private pensions in the U.S. However, it compares unfavorably with administrative costs in well-run unified government managed systems. The issue here is the administrative efficiency of reliance

Something similar happened in Britain. The government ended up imposing a charge-cap, and yet pension fees continue to be a hotly debated regulatory issue. And perhaps that’s one small thing we can celebrate about Social Security: the overhead is less than 1 percent of its revenue.