The rise and fall of the World Bank’s global pension model

The global economic crisis has prompted the rapid demise of a treasured neoliberal pet project

Heneghan-100In many ways neoliberalism still seems an unshakeable paradigm.  However, in the pension reform arena governments across the world are abandoning pension privatisation in favour of a return to a primary role for the state.  This post charts the rise and fall of pension privatisation at the global level and offers an explanation for why the belief that the market could replace the state in the realm of pensions was a misguided one.

The story of pension privatisation begins in the 1970s when a team of Chilean economists trained under the tutelage of the monetarist Milton Friedman at the University of Chicago.  Upon their return to Chile, they rose to prominence under the authoritarian rule of Augusto Pinochet.  Nicknamed the ‘Chicago Boys’, they were given licence to begin experimenting with neoliberal economic reforms, of which perhaps the most radical was the complete privatisation of the public pension system in 1981.  This entailed switching from a system where pensioners received their income from central taxation, to one where individuals were made responsible for their own income in retirement and had accordingly to invest in a private pension plan.  By any standards, this represented a radical redrawing of the social contract – from the state to market and from the collective to the individual.

The subsequent performance of the Chilean economy, following these various neoliberal reforms, generated the sustained interest of right-leaning policy entrepreneurs.  It was argued that the privatisation of the pension system had helped to develop the country’s capital markets and consequently contributed to its impressive economic growth.  However, since the reforms had been undertaken by a dictatorship, it was feared that they were too radical for a democratically elected government to pursue.

In 1994 the World Bank came on board with the project.  Recognising that complete privatisation may not be possible in a democracy, it advocated a partial privatisation whereby a portion of contributions into the public pension system should be mandated to a private pension plan.  This would be done through a multi-pillar pension model that contained both public and private elements.  Its seminal publication, Averting the old age crisis: policies to protect the old and promote growth, argued that, because of population ageing, public pension systems were unsustainable in the long run.  Furthermore, pension privatisation had significant economic benefits in its own right.  At the macro level, it was argued that such a model would help to develop capital markets and increase investment.  At the micro level, it was suggested that private pension plans did not distort labour market incentives, as taxes did.  On these bases the World Bank set about promoting its prescribed model through seminars and conferences.  It also used its substantial resources to assist countries interested in the reforms, providing technical support and loans.

The reforms spread rapidly.  First was Latin America, with Peru, Argentina and Ecuador enacting multi-pillar pension models around the time of the original World Bank publication.  A policy transfer later occurred from South to East as the World Bank’s pension model spread across Central and Eastern Europe following the region’s transition from state socialist to market-based economies.  In total, 28 countries privatised part of their pension system following the publication of Averting.

However, after 2004 there was a lull in countries privatising their pension systems. President George W. Bush failed to get a multi-pillar pension reform through the US Congress and the World Bank itself began to take a more critical approach to the question of pension reforms.  In an evaluation of the project in Latin America, it was concluded that all the promises of the reforms had not been met.  The coverage of the pension system was disappointing in most of the region, whilst the high administrative costs of managing individual pension funds (in comparison to public systems) had reduced the generosity of the returns.  This dovetailed with criticism from within and outside of the World Bank on the perceived benefits of privatisation from eminent economists like Joseph Stiglitz and Nicholas Barr.

In 2008, at the onset of the global economic crisis, Argentina completely renationalised its private pension pillar, bringing the private resources into the state coffers.  The same move was later made by Hungary in 2010.  On the surface, this appeared to be the isolated actions of two populist governments keen to court favour with their electorates by displaying their radical credentials.  However, the trend began to spread.  In Latin America, Chile scaled back its private pension pillar, whilst Ecuador renationalised its system.  Meanwhile, in Central and Eastern Europe, Latvia, Estonia, Russia and Lithuania suspended contributions to the private pillar and Slovakia, Kazakhstan and Poland renationalised all or part of their private pension pillars. The planned privatisation of the Ukrainian pension system was similarly suspended and the more recent privatisation of the Czech Republic’s pension system has also been reversed.   All these developments raise substantial questions about the desirability and sustainability of a mandatory private pension system going forward.

The flaws in the model are two-fold: first, there is the market failure of a mandatory private system.  Managing private accounts requires sufficient resources.  An individual fund manager must allocate investments for each individual pension pot. This contrasts greatly with the administrative efficiency of a public pension system calculated from a basic formula.  During an economic downturn, pension fund holders inevitably experience market volatility, which can significantly reduce the value of a pension.

Second, there is the issue of the ‘double payment problem’.  Since those already retired, or close to it, cannot set aside resources for retirement, their pensions must be funded by the current workforce.  However, following a privatisation, the current workforce must also save for its own retirement.  This effectively doubles the cost of pension provision during the transition from a public to private system.  The World Bank recommended that public sector borrowing should fund the transition.  But this was particularly problematic in Central and Eastern Europe.  The universal nature of the communist welfare system meant that the transition costs were relatively higher than in other regions.  Furthermore, accession to the European Union stipulated that countries could not run a budget deficit greater than 3% of GDP.  Given that transition costs were as high as 1.8% of GDP in Poland, renationalising the private system and instantly reducing the deficit proved to be too tempting for governments to resist.  In addition, the significant migration of parts of the working-age population from the East to the West of Europe increased the dependency ratio of the pension system, making the problem more acute.

In sum, whilst the spread of pension privatisation was quick, its reversal has been even more rapid and dramatic.  Within just a few years of the onset of the global economic crisis, most countries have either completely reversed their reforms or reduced the importance of private provision in the mix of pension pillars.  This suggests that, in respect of providing income in retirement, the state still has a major role to play in the future.   The whole experience represents the rapid demise of a treasured neoliberal pet project.