Green paper on social security ignores reality of retirement system

If government policies were judged by their intentions rather than their outcomes, SA would be a paradise. However, good intentions rarely guarantee good outcomes. The green paper on social security reform gazetted recently by social development minister Lindiwe Zulu was a case in point. 

The paper proposed an almost complete redesign of SA’s retirement system for those earning less than about R260,000 a year, which is to say most of the working population.

Instead of relying on employer-based retirement plans that hold real assets to meet their liabilities to members, workers would now be enrolled in a single government-sponsored defined benefit fund, pay an extra tax of 8%-12% of earnings (though International Labour Organization modelling suggests this would need to increase) and in return receive government promises of a retirement income and other benefits. 

The minister should not allow herself to be persuaded that the outcry that greeted her paper — and led to its retraction — is the result of strong but malign vested interests or skulduggery, or simply a failure to follow due process. Rather, objections reflect genuine and well-founded concerns based on decades of international experience with pension systems and a hard-headed assessment of what SA needs and can afford.

The most important objection to the department’s proposal was that it ignored the reality of SA’s retirement system. Over the past 30 years our country has made substantial investment in creating a largely defined contribution system that enjoys — with reservations — the trust of the population, and in which a large fraction of our workforce already participates.

Another well-founded concern relates to the defined benefit nature of the proposed fund, especially the retirement benefits: members of the fund were promised a retirement benefit defined in law as an income from a given age. The primary advantage of this design is that it provides certainty to members. But wherever it has been tried it has proven extraordinarily difficult to reconcile this certainty for members with the huge uncertainties in the future economic and demographic conditions that underlie the promise.

No guarantee

In Europe and the US, retirement ages have increased far more slowly than life expectancy. Combined with falls in fertility rates, this has meant the social security tax rates required to balance their systems are far higher now than would have been acceptable to the people who implemented them decades ago, resulting in profound generational inequalities. High tax rates have also created a disincentive for work and lower personal savings — and hence lower national wealth — than might otherwise have been achieved. 

The green paper at least recognised this issue. As a solution it proposed “automatic stabilisers” — system parameters that automatically adjust to changes in financial and demographic circumstances. But automatic stabilisers destroy the primary advantage of the defined benefit design because they replace known benefits for members with fuzzy automatically stabilised ones. And even then, they provide no guarantee they will function as intended: stabilisers may well turn out to be “automatic” when they advantage current members or serve the political interests of the day, but very “manual” when they do not.

Another reasonable concern with the department’s proposal was that it relied too heavily on a public sector that, with the best of intentions, often struggles to provide even basic services, let alone implement a system that needs uninterrupted good governance and effective administration over generations to succeed.

Here, the experience of Latin America is instructive. In the years after World War 1  many Latin American countries implemented similar defined benefit retirement systems. While they could easily create institutions that looked on paper like the European ones they were trying to emulate (sound familiar?), as contribution rates rose, reflecting system maturity and other changes, many Latin Americans simply opted out by choosing to work informally. A greater proportion of the SA workforce contributes to the voluntary retirement system than the Mexican workforce contributes to their supposedly compulsory one.

Small changes

A third well-founded concern with the defined benefit nature of the proposed design concerns administrative complexity. Writing down rules that determine benefits in a fair way that encompasses all possible lived experiences has proven exceptionally difficult.

Larry Kotlikoff, a professor of economics at Boston University and expert in the US social security system, claims it now has 2,728 rules. Many deal with the complexities of allocating spousal benefits on divorce, but there are others too, for instance those related to early and late retirement and adjustment of benefits for incomplete working lives.

Most of the hullabaloo about the department of social development’s paper was unnecessary; the minister could achieve most of her social development goals at far lower cost and a fraction of the risk by making a few small but important changes.

The proposed defined benefit fund should be replaced with a notional defined contribution benefit — cash lump sums that depend on past contributions and some growth rate (such as the growth in per capita GDP or the growth in wages).

The lump sum is exchanged for income at retirement on terms determined then, rather than 50 or more years before as in the green paper’s proposal. This makes administration far easier: early and late retirement become a non-issue, and contributions can be divided between spouses at the time they are made rather than when the benefits become payable, making adjustments for divorce, remarriage and complex families unnecessary. 

The notional defined contribution benefit should be provided within the existing private system, obviating the need for further public investment and risky big-bang reform. Private sector funds could simply pay over a portion of contributions to the government in exchange for units in a notional fund they include on their platforms in the same way as they invest in other funds.

The fund’s unit price could grow at a rate set by the government, in line with social insurance principles. And the government could subsidise the contributions of low-income workers if necessary, provided such subsidies are invested in the notional fund.

Retirement and life insurance benefits could be paid regarding notional fund balances in line with social insurance principles, as determined by age and need. By blending the system in this way lower-income workers could be given greater certainty of benefits but also enjoy the returns generated by the formal economy.  (None other than Thomas Piketty bemoans the fact that the French retirement system reserves this opportunity only for the rich).

The minister has said she will use the forced retraction of the green paper as an opportunity to reconsider. I hope she does: progress towards the goal of providing a more secure retirement to South Africans and their families will be enhanced rather than diminished if it includes broader input and builds on, rather than undermines, the substantial strengths our economy already possesses.

• Dr McCarthy advised the National Treasury on retirement and social security reform between 2011 and 2016. He teaches at the University of Georgia in the US, but writes in his personal capacity.