Is defined contribution a panacea for defined benefit social security funding problems? Lessons from two countries

Abstract

Many countries are changing their social security retirement program from defined benefit
(DB) to a defined contribution (DC) basis. Other countries such as the United States are
discussing the introduction of a defined contribution 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 defined benefit 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 labour 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 paygo 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 that are 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 trying to identify 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 realworld
plans, Chilean and Swedish. It then uses the theoretical considerations and the experience
of those plans to draw conclusions about reform proposals in the U.S., particularly the President’s
Commission to Strengthen Social Security Model 2.

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