TCS Daily

The Social Security Debate's Red Herrings

By Tim Worstall - December 23, 2004 12:00 AM

Heard the (new) news on Social Security privatization? According to Michael Kinsley it cannot work in theory and according to Paul Krugman it's been tried and did not work in practice. I guess that just about wraps it up then and we can all go home, eh? Well, not quite, as I shall explain.

Paul Krugman writes in the New York Times, in part, about the British experience of privatizing the pension system:

"In Britain, which has had a privatized system since the days of Margaret Thatcher, alarm over the large fees charged by some investment companies eventually led government regulators to impose a 'charge cap.'"

I would never claim to be the world's greatest economic historian but there are a few little bits and pieces here which jar slightly, don't quite ring true. I am English and all and this just doesn't sound like the system that I know and love. A few points might clarify why.

1) The UK has a State Pensions system remarkably similar to that of the US Social Security system. A payroll tax (National Insurance) is levied on wages, paid partly by the worker and partly by the employer (although as we know the net effect is that all is paid by the worker) from whatever money is earned slightly above a pittance to a capped amount. It is a pay as you go system with current taxes paying for current benefits. About the only major difference we have is that in the UK we don't even pretend to have a trust fund or a lock box. The promises of future pensions are exactly that, a claim in the future on future tax revenues. There is no way on this planet that this system can be described as "privatized". It is also worth noting that the similarities are not coincidental, for your system was based on ours which was, in turn, based on that which Bismarck introduced in Germany.

2) Since the mid-1970s we have had a second pension scheme, aimed at securing a higher pension for those earning higher wages. This was funded by an addition to the National Insurance charges and was called SERPS (State Earnings Related Pension Scheme). What the Blessed Margaret did was in 1987 bring in a system whereby, at the request of the individual, those extra taxes could be diverted into private investment accounts. This was called contracting out of SERPS. You still had to make the extra savings, but you had a choice to put them into the loving, caring arms of the State, or into the hands of the cut-throat rip-off merchants who run private investment vehicles. This looks remarkably like one of the proposals in the US at present, doesn't it?

3) There have been no caps placed upon the fees which may be charged to those private accounts.

4) After Tony Blair's Nu Labour party won power in 1997 great concern was expressed about pension provision for the poor. That is, just to make it blindingly obvious, those who do not have the higher earnings which would enable them to take advantage of either SERPS or of contracting out of it. How to encourage these people to save for their old age? This new scheme did indeed have charge caps imposed upon it. 1% of assets per year. This might or might not be a good figure (if people are saving sums like $100 a month, who would really want to run a pension plan for a $12 fee annually?) but the failure of these plans was entirely predictable. For, the level of benefits guaranteed by our welfare state is higher than the money coming from the basic state pension (currently about 105 pounds a week and 90 pounds a week). If some deluded poor person actually attempted to save for their crumbling years, at whatever level of fees charged by the financiers, the income from those savings would be clawed back by the State in lower welfare benefits.

I agree that technically Margaret Thatcher privatized part of the pension system, technically there has been a charge cap, but I think the reasons for and implications of these things are rather different than what the Professor wants us to think. We then get this:

"The same thing is happening in Britain. Its Pensions Commission warns that those who think Mrs. Thatcher's privatization solved the pension problem are living in a 'fool's paradise.' A lot of additional government spending will be required to avoid the return of widespread poverty among the elderly - a problem that Britain, like the U.S., thought it had solved."

I agree again that this statement is correct in its technical sense. There are indeed huge problems with pension provision in the UK. To enumerate just a few:

1) Pensions are uprated in line with inflation, not with rises in wages. As poverty is measured in relative terms, if pensions rise slower than wages then obviously those who depends upon such pensions will be getting relatively poorer. As one of the things we want to happen in the economy is that wages rise faster than prices then, perversely, the declining value of the pension relative to average earnings is a sign that the government's management of the economy is not too bad (I cannot bring myself to say good of the current shower).

2) One of the first things that the Dear Leader and his acolytes did on gaining power in 1997 was to remove certain tax breaks from privately run and funded pension plans. Specifically, dividend income to pension plans used to be tax free (it was boringly more complicated than that but the net effect was the same) and now it is not. This has taken a 5 billion pound a year bite out of the returns that such funds make on behalf of the future pensioners.

3) Various rules on capital requirements for pension funds (whether they be company or mutual) have been tightened. This has led to less investment in shares and property and more in bonds, to, of course, the long-term detriment of the amount of pension that will be received in the future.

4) The elephant in the living room is in fact nothing to do with pensions for those in the private sector, nor those on low incomes nor even for those expecting a State pension. It is those who are expecting an occupational pension but who work for the public sector, for the Government itself or all the myriad lower levels of the all embracing welfare state. The current value of these future liabilities has recently been estimated at around 500 billion pounds, or 50% of current GDP. These pensions are entirely unfunded, no investments in anything whatsoever to back them, just claims on future tax revenues.

Yes, there are problems with pension provision in the UK but as you can see from the above, none of them has anything to do with the part-privatization that occurred nearly two decades ago and is now proposed for the US.

Recall, the creation of private accounts being proposed in the US is what we in the UK called contracting or opting out of SERPS. The last word on the effectiveness of that should properly belong, I guess, to Her Majesty's Treasury, responding to some questions by a Committee of the House of Commons:

The report's main findings were that:

- the vast majority of people (between 96 per cent and 99 per cent) stood to gain from opting out of SERPS;

- where prospective losses arose, losses per case were small, averaging between £33 and £78 a year in reduced pension rights;

- fixed charges were a major factor in most of the cases where loss was expected, as they slowly erode small or closed policies.

This is why the Treasury's evidence was that most people stand to gain from opting out of SERPS into a personal pension.

Now I realize that the US is the greatest country on the planet, that there is absolutely nothing that us euro-weenies can teach or show you about anything, but don't you think a 96-99% success rate for a government program is pretty good going?

The Good Professor's objections to this proposed change in Social Security, at least as they reflect the UK experience, seem to be based on, how shall we put this, a slight confusion as to the realities of the UK experience? It would also seem to show that putting your trust in cut-throat rip-off merchants is better than putting your trust in the promises of politicians.

Michael Kinsley's objections are slightly easier to deal with. He posted at Andrew Sullivan's asking for bloggers to put him right. The economist Brad DeLong has an interesting round up of theoretical answers and as he says, any and all of them could be true in part or full but that does not mean that political or government action could not negate them. My answer is rather simpler... here's the last two lines of Kinsley:

And therefore, privatization cannot work.

My answer? It's been tried, it did work and it might work in the US. Q.E.D.


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