AS POPULATIONS IN RICH COUNTRIES grow older, the cost of paying for public pensions has risen,
boosting tax burdens and placing increased pressure on government budgets. Only one of the
seven largest industrial countries, the United Kingdom, has overhauled its public pensions in a
way that is likely to hold down future pension spending so that it does not increase sharply
relative to national income. The favorable outlook for public spending on British pensions is the
result of policies that tightly restrain the growth of basic government pensions and encourage
active workers to abandon the second-tier, earnings-related public program in favor of private
pensions. Future retirees are expected to derive much more of their retirement income from
privately managed and invested pension accounts than from publicly financed, pay-as-you-go
pensions. Other leading industrial countries still face major challenges in paying for or
fundamentally reforming their main public pension programs (Bosworth and Burtless, 1998).
Policymakers in several rich countries show interest in following the British example and
replacing part of their public systems with private pensions organized around individual
retirement accounts. In May 2001 the German government revised Germany’s national pension
system to curtail the future growth of publicly provided pensions and to subsidize the creation of
new defined-contribution pensions based upon individual accounts. In June 2001 the upper
house of the Japanese legislature gave final approval to the government’s plan to offer workers
tax-favored retirement saving plans modeled closely on 401(k) retirement accounts now
available in the United States. The new retirement plan, like the one in Germany, is intended to
supplement pensions provided by the main public system. In both Germany and Japan, benefits
under the main public system will be scaled back for workers retiring over the next several
decades. The United States has long used tax incentives to promote private retirement systems,
which now cover about half of the workforce. Many critics of traditional public pensions would
like to go much further. A presidential commission recently outlined three reform plans to
reduce benefits under the existing U.S. social security system and replace them with annuities
financed out of voluntary retirement savings accounts (President’s Commission to Strengthen
Social Security, 2002).
This paper examines evidence on the likely success of individual retirement accounts in
providing retirement incomes to typical workers. Historical and simulated data on financial
market performance are used to evaluate the market risks facing contributors to a private system
based on individual retirement accounts. The paper provides evidence on these risks by
considering the hypothetical pensions that workers in five industrialized countries would have
received based on financial market performance between 1927 and 2002 if they had accumulated
retirement savings in individual accounts. The contributors to individual retirement accounts are
assumed to have identical careers and to contribute a fixed percentage of their wages to private
investment funds. When contributors reach retirement age, they convert their retirement savings
into a level annuity. To make the calculations comparable across countries and across time, all
contributors are assumed to have an identical career path of earnings and to face the same
mortality risks after reaching retirement. Contributors differ only with respect to the level and
timing of stock and bond returns, bond yields when they reach retirement, and price inflation.
These differences occur because of the differing start and end dates of the workers’ careers and
because workers reside in different countries and are assumed to restrict their investments to the
stocks and bonds of their own countries.
The analysis demonstrates that the financial market risks of a funded private retirement
system are empirically large in all of the industrialized countries. Although some of these risks
are also present in a public retirement system, a public system, backed by the taxing and
borrowing authority of the state, can spread risks over a much larger population of potential
contributors and beneficiaries. This makes the risks more manageable for individual workers,
many of whom have little ability to insure themselves privately against financial market risk.
