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Mexico has recently embarked on a major reform of its Social Security system. The main element of this reform is a transition from a pay-as-you-go pension system to a fully funded system with individual accounts and a minimum pewion guarantee. Mexico's prer-ious pension system was largely based on a defined-benefit system.
Mexico has recently embarked on a major reform of its Social Security system. The main element of this reform is a transition from a pay-as-you-go pension system to a fully funded system with individual accounts and a minimum pewion guarantee. Mexico's prer-ious pension system was largely based on a defined-benefit system.
Mexico has recently embarked on a major reform of its Social Security system. The main element of this reform is a transition from a pay-as-you-go pension system to a fully funded system with individual accounts and a minimum pewion guarantee. Mexico's prer-ious pension system was largely based on a defined-benefit system.
:fits, saving during the transition [changed, the transition involves which private saving is reduced 2onse to any other tax increase. strained may choose to smoo.th 2ars and therefore save less than already liquidity-constrained will that are saving primarily for heir behavior at all. The impact of ,1 therefore be on the order of nposed. nsition that achieves a bit more in illing to give up a bit of national 2stigated the possibility of making ystem voluntary in a way that is g-out" in the United Kingdom .on to be voluntary, we can be sure ; to make households that do enter of that work thus far is that the ing is critical to the success of any goals of high voluntary participa- saving rate will in general require !s of an optimal income tax. lesson to emerge from the work by 2conomy such as the United States, velfare, not saving. When discuss- stem, the two concepts are simply mprove welfare is to remove the ng ot Social Security from future ltbout 18 percent of covered payroll est for future generations. When urity that might achieve that end, it important element of reform is the rl otherwise be incurred. The saving straightfoward. When the reform tion but a change in the promised 'ecome more ambiguous. 1997. "The Economics of Prefunding Social ling in 8. Bernanke and J. Rotemberg, eds., 1.4: National Bureau of Economic Research. 'eterogeneity and Social Security Reform." 1 Agustin G. Carstens" Mex~co, like many other countries in Latin America, has recently embarked on a major reform of its social security system. The main element of this reform is a transition from a pay-as-you-go pension system to a fully funded system with individual accounts and a mini- mum pewion guarantee. In more general terms, this is basically a transition from a defined-benefit to a defined-contribution system. Mex- ico's prer-ious pension system was operated by two public institutions: LMSS for private sector employees and ISSSTE for federal government employees. The IMSS pension system, which covers over 70 percent of the formal sector work force, was the focus of the recent reform. The most immediate motivation for the reform was the increasing financial diffi- culties the present pension system faced, rendering it unsustainable. Beneficial side effects expected from the reform include a boost to domestic 5aving, the development of stable, long-term sources of fmanc- ing, and a reduction of distortions in the labor market. Of the many factors underlying the pension system's present diffi- culties, the most salient are the following three. First was a complete dissociation between contributions and benefits. In a pay-as-you-go system, one can expect that contributions will not have a rigid relation- ship to benefits, particularly in extreme cases, that is, those of the lowest-pad or the highest-paid workers. Such a system often has some redistributive aspects. In Mexico, however, the imbalance between con- tributions paid in and benefits received became excessive. For example, a worker might contribute for only 10 years and thereby obtain the minimum pension of minimum wage for his life plus the life of his 'Director General, Department of Economic Research, Banco de Mexico. 154 Agustin G. Carstens THE REFORM OF SOCIAL SECURITY IN h/ dependents. This is equivalent to the Mex~can government issuing internal debt at a real rate of return of more than 50 percent. No doubt t hs is an extreme example. Nevertheless, for the vast majority of cases, the participation of workers in the previous pension fund system was equivalent to their investing in government debt that paid a multiple of the market's real rate of interest. A second major problem the pension systcam faced was that reserves that should have been accumulated under the pay-as-you-go system had been depleted to subsidize deficits in other programs in the social security system, such as health and maternity benefits. A third problem was the relatively high contribution rates required by !he social security system, 31.5 percent of nominal salary, which generafed incentives for massive under-invoicing and outright evasion. (This 31.5 percent accounted for disability, housing, and health insurance in addition to retirement insur- ance.) As a result, enrollment in the system was less than what was projected by pure demographics. This history ct f low enrollment, together with the aging of the Mexican population, imvlied a rapid deterioration of the elderly dependency ratio, compounding the system's financial difficulties. In my view, these three factors alone justified the reform of Mexico's pension system. The actuarial deficit of tht. previous IMSS pension system was estimated to be more than 100 percent of GDP. Had the reform not been implemented, contributions M-ould have had to increase by more than four times by the year 2020 to avoid a cash flow deficit. Clearly, such an enormous increase in contrib~ltions to the pension fund system would have generated unacceptable distortions in the labor market. What then are the major features of our pf.nsion fund reform, which will begin operating in July 1997? The reform basically involves improv- ing and strengthening the Sistema de Ahorro para el Retiro, the "SAR" system, a fully funded pension system that I.vas initiated in 1992 as a complement to the IMSS system. The former 8.5 percent of salary contribution to the previous IMSS pension sy5tem (which included both disability and life insurance) is now divided into two parts: 4.5 percent to be accumulated in individual accounts and 4 percent to go directly to the IMSS for the provision of life, health, and disability insurance for retirees. In addition, contributions to individual accounts will include the 2 percent contributions to the SAR system along with a new "social contribution" by the government, which will be a fixed amount equiva- lent to 5.5 percent of the minimum wage as of January 1997, indexed to inflation. Therefore, for a worker earning minimum wage, total contri- butions to his individual account will amount to 12 percent of his salary. For a worker earning an average wage, total cc;ntributions will amount to 8.5 percent of salary. The new regulations also allow for voluntary contributions to the individual accounts. To be eligible for a pension, a 1 The tax-free benefits depend on the vidual's working life, that is, the earned on his account. And the mir to qualify for a minimum pension h; The management of pension pension fund administrators called vised by a special government agen AFORE of their choice. As of this 1 already have affiliated. Workers t account to another AFORE once per operate several pension funds, so resources in one or several of th AFORE. AFOREs will be allowed to ck fees as a percentage of the con individual account balance, or an. responsible for the collection of coi why commissions in Mexico are c One drawback in the current regul; is the imposition of a maximum individual AFORE, starting in 19 years. Until July 1997, this restricti A crucial determinant of the 1 the nature of the transition from a 1 capitalizatio~~ scheme. This process redistributive effects, with long-te the reform, the government n0.c pensions of current retirees and o contributed to the previous pensic ment expenditures in the future, 14 reductions in other government ' debt. How these fiscal requiremenf crucially influence the net impa Debt-financing implies that in t'r capital stock will be only margin ! tudes that depend on the net effil well as on voluntary saving. On deficits are financed through tz 1 pension reform with tighter fiscz transfer of resources from curren I 1 higher rate of saving and, thus, c, follow a combination of both optic i 1 reform to have a positive impact [exican government issuing I I han 50 percent. No doubt this i le vast majority of cases, the ! I pension fund system was t debt that paid a multiple of i I y'stem faced was that reserves he pay-as-you-go system had xograms in the social security fits. A third problem was the I by the social security system, erated incentives for massive lis 31.5 percent accounted for I addition to retirement insur- tem was less than what was )ry of low enrollment, together . implied a rapid deterioration ~ndi ng the system's financial . ustified the reform of Mexico's f the previous IMSS pension 100 percent of GDP. Had the ,ns would have had to increase 10 to avoid a cash flow deficit. ~tributions to the pension fund table distortions in the labor )ur pension fund reform, which 'orm basically involves improv- lorro para el Retiro, the "SAR that was initiated in 1992 as a former 8.5 percent of salary In system (which included both led into two parts: 4.5 percent to ld 4 percent to go directly to the disability insurance for retirees. 1 accounts will include the 2 2m along with a new "social will be a fixed amount equiva- as of January 1997, indexed to ; minimum wage, total contri- 3unt to 12 percent of h s salary. -a1 contributions will amount to ons also alIow for voluntary THE R!:FORM OF SOCIAL SECURITY IN MEXICO 155 TI) be eligible for a pension, a worker must be at least 65 years old. The tax-free benefits depend on the balance accumulated over an indi- vidual s working life, that is, the contributions paid in plus returns earned on his account. And the minimum number of contributing years to qualify for a minimum pension has been increased from 10 to 25 years. The management of pension funds will be entrusted to private pension fund administrators called AFOREs, to be regulated and super- vised b? a special government agency. Participants may affiliate with the AFORE of their choice. As of this writing, more than 8 million workers already have affiliated. Workers will have the right to transfer their account to another AFORE once per year. Each AFORE will be allowed to operate several pension funds, so workers will be able to invest their resources in one or several of the pension funds managed by their AFORE. AFC)REs will be allowed to charge freely determined management fees as a percentage of the contribution flows or the outstanding individu.tl account balance, or any combination thereof. IMSS will be responsible for the collection of contributions. This is one of the reasons why commissions in Mexico are currently the lowest in Latin America. One draw-back in the current regulations on the operation of the AFOREs is the imuosition of a maximum market share of 17 percent for any individua! AFORE, starting in 1997 and continuing for the next four years. Until July 1997, this restriction had not been binding, however. A crucial determinant of the pension reform's long-term success is the nature of the transition from a pay-as-you-go system to a fully funded capitalization scheme. This process will have important fiscal and income redistribut:ve effects, with long-term implications. As a consequence of the reforrr, the govemment now faces the problem of paying the pensions OF current retirees and of honoring the claims of workers who contributed to the previous pension system. This implies higher govem- ment expenditures in the future, which could be financed by more taxes, reductions in other govemment expenditures, or the issuance of new debt. How these fiscal requirements are financed over the transition will crucially intluence the net impact of the reform on national saving. Debt-financing implies that in the short run, national saving and the capital stock will be only marginally affected, and primarily by magni- tudes that depend on the net efficiency gains of the financial system as well as on .ioluntary saving. On the other hand, if these future fiscal deficits are financed through taxation, this will essentially combine pension reform with tighter fiscal policy. This strategy would imply a transfer of re3ources from current to future generations, encouraging a higher rate 01 saving and, thus, capital stock formation. Mexico plans to follow a combination of both options, which in principle should allow the reform to have a positive impact on national saving. The fiscal costs of the reform in net pr-esent value are estimated at roughly 80 percent of GDP. The incidence 0;' this cost ~7ill be between 0.8 and 1.0 percent of GDP per year in the comng years, but it will increase through time, reaching a peak of about 3.C percent of GDP in approxi- mately 35 years. Several studies have analj zed the transition under the assumption that it will be partly debt-fin.~hced. The results obtained predict increases in net saving of between 2 to 3 percent of GDP in the near future, independent of the impact of voluntary saving. The latter could make a sigruficant contribution to sal ing, given the fact that with the reform a large portion of the populatioll will for the first time have access to saving services in the formal financial system, whichshould translate into more efficient intermediation of saving in the economy as a whole. In addition, the pension reform will prcduce a significant long-term increase in the availability of financial rescuces to the economy. Ths should promote further financial specialization and the creation of new financial instruments, in particular, mediun- and long-term securities. These are urgently needed in Mexico, give11 that most lending is now concentrated in loans tied to short-term interest rates, with maturities of less than a year in most cases. The pension fund reform should also promote the development of the stock market in Mexico. Estimates indicate that within 25 year;, the reform could double financial savings in Mexico. The availabil-ty of these resources will promote financial deepening and long-term investment, which should have a significant impact on growth. For the Mexican economy to grow at a minimum of 5 percent annually, it requi-es an investment rate of 25 percent of GDP. For this to be possible without excessive reliance on foreign saving, domestic saving ~7ill need to :ncrease in the coming years by between 5 and 6 percent of GDP. The pl?nsion fund reform should provide half of that requirement, which is a 1 ery significant contribution indeed. References Diamond, Peter. 1995. "Economic Support in Old Age" Annual Bank Conference on Development Economics, The World Bank. May. Feldstein, Martin. 1974. "Social Security-Induced Retirement and Aggregate Capital Accu- mulation." ]oilriznl o f Political Ecoiloiiry, vol. 24, pp. 935-20. Martinez, Gabriel. 1996. "Ahorro y Seguridad Social er Mexico." Paper presented at the International Seminar on Social Security for the 21s' Century, Mexico City, March. Noriega, Carlos C. 1997. "Domestic Savings and Per sion Reform in Me;ico." Paper presented at the International Seminar on Pension Re forms and Transition Fiscal Costs, Cancun, April. Sales, Carlos, Fernando Solis-Soberon, and Alejandro V.llag6mez. 1996. "Pension System Reform: The Mexican Case." NBER Working Paper KO. 5780. September. Solis-Soberbn, Fernando. 1995. "Description del Sistema de Ahorro para el Retiro." CONSAR, Docuriwrrto de Trnbajo hro. 3, September. Richard Disney* The United Kingdom, c does not appear to have a f i ~ has accomplished a substantial without apparent political contrc of social security without vocife achieved, and what have been provides a brief exposition of 1 future financial projections, and saving and on retirement behavi It is important first to note privatization of social security in Chile. I have argued elsewhere Johnson 1997) that the history of mid 1980s in fact involved a arrangements: for example, the ( ance organized by workers into Insurance and, much more rec provided pension plans througl lished in the 1975 Social Securit 1986 saw an abortive experinr following the introduction of the (SERPS), and it was not until tl- from public to private pension F A second preliminary point i 'Professor of Economics, Queen hl i and Research Fellow, Institute for Fiscz!