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2tional saving will increase as atial part of a privatization is the:fits, saving during the transition[changed, the transition involveswhich private saving is reduced2onse to any other tax increase.strained may choose to smoo.th2ars and therefore save less thanalready liquidity-constrained will

that are saving primarily forheir behavior at all. The impact of,1 therefore be on the order ofnposed.nsition that achieves a bit more inilling to give up a bit of national2stigated the possibility of makingystem voluntary in a way that isg-out" in the United Kingdomon to be voluntary, we can be sureo make households that do enter

of that work thus far is that theing is critical to the success of anygoals of high voluntary participa-saving rate will in general requires of an optimal income tax.lesson to emerge from the work by2conomy such as the United States,velfare, not saving. When discuss-stem, the two concepts are simplymprove welfare is to remove then ot Social Security from futureltbout 18 percent of covered payrollest for future generations. Whenurity that might achieve that end, itimportant element of reform is the

rl otherwise be incurred. The savingstraightfoward. When the reformtion but a change in the promised'ecome more ambiguous.

1997. The Economics of Prefunding Socialling in 8 Bernanke and J Rotemberg, eds.,1 4: National Bureau of Economic Research.'eterogeneity and Social Security Reform.

Agust in G Carstens

Mex~co, ike many other countries in Latin America, has recentlyembarked on a major reform of its social security system. The mainelement of this reform is a transition from a pay-as-you-go pensionsystem to a fully funded system with individual accounts and a mini-mum pewion guarantee. In more general terms, this is basically atransition 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 governmentemployees. The IMSS pension system, which covers over 70 percent of theformal sector work force, was the focus of the recent reform. The mostimmediate 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 todomestic 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 completedissociation between contributions and benefits. In a pay-as-you-gosystem, one can expect that contributions will not have a rigid relation-ship to benefits, particularly in extreme cases, that is, those of thelowest-pad or the highest-paid workers. Such a system often has someredistributive aspects. In Mexico, however, the imbalance between con-tributions paid in and benefits received became excessive. For example, aworker might contribute for only 10 years and thereby obtain theminimum pension of minimum wage for his life plus the life of his

'Director General, Dep artm ent of Economic Research, Banco de Mexico.

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154 gustin G arstens THE REFORM OF SOCIAL SECURITY IN hdependents. This is equivalent to the Mex~cangovernment issuinginternal debt at a real rate of return of more than 50 percent. No doubt thsis an extreme example. Nevertheless, for the vast majority of cases, theparticipation of workers in the previous pension fund system wasequivalent to their investing in government debt that paid a multiple ofthe market's real rate of interest.

A second major problem the pension systcam faced was that reservesthat should have been accumulated u nder the pay-as-you-go system hadbeen depleted to subsidize deficits in other programs in the social securitysystem, such as health and maternity benefits. A third problem was therelatively high contribution rates required by he social security system,31.5 percent of nominal salary, which generafed incentives for massiveunder-invoicing and outright evasion. (This 31.5 percent accounted fordisability, housing, and health insurance in addition to retirement insur-ance.) As a result, enrollment in the system was less than what wasprojected by pure demographics. This history tf low enrollment, togetherwith the aging of the Mexican population, imvlied a rapid deteriorationof the elderly dependency ratio, compounding the system's financialdifficulties.

In my view, these three factors alone justified the reform of Mexico'spension system. The actuarial deficit of tht. previous IMSS pensionsystem was estimated to be more than 100 percent of GDP. Had thereform not been implemented, contributions M-ould ave had to increaseby more than four times by the year 2020 to avoid a cash flow deficit.Clearly, such an enormous increase in contrib~ltions o the pension fundsystem would have generated unacceptable distortions in the labormarket.

What then are the major features of our pf.nsion fund reform, whichwill 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 acomplement to the IMSS system. The former 8.5 percent of salarycontribution to the previous IMSS pension sy5tem (which included bothdisability and life insurance) is now divided into two parts: 4.5 percent tobe accumulated in individual accounts and 4 percent to go directly to theIMSS for the provision of life, health, an d disability insurance for retirees.In addition, contributions to individual accounts will include the 2percent contributions to the SAR system along with a new "socialcontribution" by the government, which will be a fixed amount equiva-lent to 5.5 percent of the minimum wage as of January 1997, indexed toinflation. 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 to8.5 percent of salary. The new regulations also allow for voluntarycontributions to the individual accounts.

To be eligible for a pension, aThe tax-free benefits depend on thevidual's working life, that is, theearned on his account. And the mirto qualify for a minimum pension h;

The management of pensionpension fund administrators calledvised by a special government agenAFORE of their choice. As of thisalready have affiliated. Workers taccount to another AFORE once peroperate several pension funds, soresources in one or several of thAFORE.

AFOREs will be allowed to ckfees as a percentage of the conindividual account balance, or an.responsible for the collection of coiwhy commissions in Mexico are cOne drawback in the current regul;is the imposition of a maximumindividual AFORE, starting in 19years. Until July 1997, this restricti

A crucial determinant of thethe nature of the transition from acapitalizatio~~cheme. This processredistributive effects, with long-tethe reform, the government n0.cpensions of current retirees and ocontributed to the previous pensicment expenditures in the future, 14reductions in other governmentdebt.

How these fiscal requiremenfcrucially influence the net impaDebt-financing implies that in t'rcapital stock will be only margintudes that depend on the net effilwell as on voluntary saving. Ondeficits are financed through tzpension reform with tighter fiscztransfer of resources from currenhigher rate of saving and, thus, cfollow a combination of both optici reform to have a positive impact

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[exican government issuing Ihan 50 percent. No doubt thisle vast majority of cases, the

pension fund system wast debt that paid a multiple ofy'stem faced was that reserveshe pay-as-you-go system hadxograms in the social securityfits. A third problem was theby the social security system,erated incentives for massivelis 31.5 percent accounted for

addition to retirement insur-tem was less than what was)ry of low enrollment, togetherimplied a rapid deterioration

~nd ing he system's financialustified the reform of Mexico'sf the previous IMSS pension100 percent of GDP. Had the,ns would have had to increase1 to avoid a cash flow deficit.~tributionso the pension fundtable distortions in the labor)ur pension fund reform, which'orm basically involves improv-lorro para el Retiro, the "SARthat was initiated in 1992 as aformer 8.5 percent of salary

In system (which included bothled into two parts: 4.5 percent told 4 percent to go directly to thedisability insurance for retirees.1 accounts will include the 22m along with a new "socialwill be a fixed amount equiva-as of January 1997, indexed to

inimum wage, total contri-3unt to 12 percent of h s salary.-a1contributions will amount toons also alIow for voluntary

THE R :FORM OF SOCIA L SECURITY IN MEXICO 55TI) e eligible for a pension, a worker must be at least 6 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 returnsearned on his account. And the minimum number of contributing yearsto qualify for a minimum pension has been increased from 10 to 25 years.

The management of pension funds will be entrusted to privatepension fund administrators called AFOREs, to be regulated and super-vised b? a special government agency. Participants may affiliate with theAFORE of their choice. As of this writing, more than 8 million workersalready have affiliated. Workers will have the right to transfer theiraccount to another AFORE once per year. Each AFORE will be allowed tooperate several pension funds, so workers will be able to invest theirresources in one or several of the pension funds managed by theirAFORE.

AFC)REs will be allowed to charge freely determined managementfees as a percentage of the contribution flows or the outstandingindividu.tl account balance, or any combination thereof. IMSS will beresponsible for the collection of contributions. This is one of the reasonswhy commissions in Mexico are currently the low st in Latin America.One draw-back n the current regulations on the operation of the AFOREsis the imuosition of a maximum market share of 17 percent for anyindividua AFORE, starting in 1997 and continuing for the next fouryears. Until July 1997, this restriction had not been binding, however.

A crucial determinant of the pension reform's long-term success isthe nature of the transition from a pay-as-you-go system to a fully fundedcapitalization scheme. This process will have important fiscal and incomeredistribut:ve effects, with long-term implications. As a consequence ofthe reforrr, the govemment now faces the problem of paying thepensions O current retirees and of honoring the claims of workers whocontributed 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 newdebt.

How these fiscal requirements are financed over the transition willcrucially intluence the net impact of the reform on national saving.Debt-financing implies that in the short run, national saving and thecapital stock will be only marginally affected, and primarily by magni-tudes that depend on the net efficiency gains of the financial system aswell as on .ioluntary saving. On the other hand, if these future fiscaldeficits are financed through taxation, this will essentially combinepension reform with tighter fiscal policy. This strategy would imply atransfer of re3ources from current to future generations, encouraging ahigher rate 1 saving and, thus, capital stock formation. Mexico plans tofollow a combination of both options, which in principle should allow thereform to have a positive impact on national saving.

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The fiscal costs of the reform in net pr-esent value are estimated atroughly 80 percent of GDP. The incidence 0;' this cost ~7 ill e between 0.8and 1.0 percent of GDP per year in the comng years, but it will increasethrough time, reaching a peak of about 3.C percent of GDP in approxi-mately 35 years. Several studies have anal j zed the transition under theassumption that it will be partly d ebt -fin .~hced. he results obtainedpredict increases in net saving of between 2 to 3 percent of GDP in thenear future, independent of the impact of voluntary saving. The lattercould make a sigruficant contribution to sal ing, given the fact that withthe reform a large portion of the populatioll will for the first time haveaccess to saving services in the formal financial system, whichshouldtranslate into more efficient intermediation of saving in the economy as awhole.

In addition, the pension reform will prcduce a significant long-termincrease in the availability of financial r escu ce s to the economy. T h sshould promote further financial specialization and the creation of newfinancial instruments, in particular, mediun- and long-term securities.These are urgently needed in Mexico, give11 that most lending is nowconcentrated in loans tied to short-term interest rates, with maturities ofless than a year in most cases. The pension fund reform should alsopromote the development of the stock market in Mexico.

Estimates indicate that within 25 year;, the reform could doublefinancial savings in Mexico. The availabil-ty of these resources willpromote financial deepening and long-term investment, which shouldhave a significant impact on growth. For the Mexican economy to growat a minimum of 5 percent annually, it requi-es an investment rate of 25percent of GDP. For this to be possible wi thout excessive reliance onforeign saving, domestic saving ~7i ll eed to :ncrease in the coming yearsby between 5 and 6 percent of GDP. The pl?nsion fund reform shouldprovide half of that requirement, which is a ery significant contributionindeed.

eferencesDiamond, Peter. 1995. "Economic Support in Old Age" Annual Bank Conference onDevelopment Economics, The World Bank. May.Feldstein, Martin. 1974. "Social Security-Induced Retirement and Aggregate Capital Accu-mulation." ]oilriznl o Political Ecoiloiiry vol. 24 pp. 935 20.Martinez, Gabriel. 1996. "Ahorro y Seguridad Social er Mexico." Paper presented at theInternational Seminar on Social Security for the 21s' Century, Mexico City, March.Noriega, Carlos C. 1997. "Domestic Savings and Per sion Reform in Me;ico." Paperpresented at the International Seminar on Pension e forms and Transition Fiscal Costs,Cancun, April.Sales, Carlos, Fernando Solis-Soberon, and Alejandro V.llag6mez. 1996. "Pension SystemReform: 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.

ichard Disney

The United Kingdom,does not appear to have a f i ~has accomplished a substantialwithout apparent political contrcof social security without vocifeachieved, and what have beenprovides a brief exposition offuture financial projections, andsaving and on retirement behavi

It is important first to noteprivatization of social security inChile. I have argued elsewhereJohnson 1997) that the history ofmid 1980s in fact involved aarrangements: for example, theance organized by workers intoInsurance and, much more recprovided pension plans througllished in the 1975 Social Securit1986 saw an abortive experinrfollowing the introduction of the(SERPS), and it was not until tlfrom public to private pension

A second preliminary point i

'Professor of Economics, Queen l iand Research Fellow, Institute for Fiscz