A specter is haunting the world. It is the specter of bankrupt
government-run Social Security systems. The pay-as-you-go system
that reigned supreme through most of the 20th century has a funda-
mental flaw, one rooted in a false conception of how human beings
behave: it destroys, at the individual level, the link between contribu-
tions and benefits—in other words, between effort and reward.
Whenever that happens on a massive scale and for a long period of
time, the final result is disaster.

Two exogenous factors aggravate the consequences of that flaw:
the global demographic trend toward decreasing fertility rates and
medical advances that are lengthening life. As a result, fewer workers
have to support more and more retirees. Since increasing payroll
taxes generates unemployment, sooner or later promised benefits
have to be reduced, a telltale sign of a bankrupt system. Whether
benefits are reduced through inflation, as in most developing coun-
tries, or through legislation, the result is the same: anguish about
old age is created, paradoxically, by the inherent insecurity of an
unfunded “Social Security” system.

In Chile, the Pension Reform law of 1980 introduced a revolution-
ary innovation. The law gave every worker the choice of opting out
fully from the government-run pension system and instead putting
the former payroll tax in a privately managed personal retirement
account (PRA). Since 95 percent of the workers chose the PRA sys-
tem, the end result was a “privatization from below” of Chile's
Social Security system.

Originally published as Cato's Letters no. 10, 1996.

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