(Reprinted from HKCER Letters, Vol. 11, November 1991) 


Can the Government Substitute the Family?
-The Social Loss of Mandatory Retirement
Insurance for the Elderly

Francis T. Lui



The issue of social security for the elderly has again become a central topic of discussion in Hong Kong lately. In the most recent debate on this issue in the Legislative Council in July 1991, the fourth in the past 25 years, the proposal for the establishment of a Central Provident Fund was rejected. However, four months later, the government surprisingly recommended regulations that demand that employers set up mandatory private provident funds. The government also plans to form a special working group to formulate a "comprehensive" social security program for the near future. In the private sector, various groups and individuals have openly voiced their opinions, mostly in favor of social security. It has been mentioned that most countries provide social security for their citizens after retirement, and Hong Kong should not fall behind in this respect.

With only a few exceptions, one important aspect has been missed in the discussion. Retirement insurance policies have been adopted by many Western countries and socialist countries for many years. These policies invariably create economic problems, the effects of which have become increasingly apparent. Despite the efforts of policymakers and some of the best economists in the academia, no satisfactory solutions to these problems are in sight. Given the seriousness of these problems, it may be unwarranted for Hong Kong to adopt a social security system at this time.

Economic Loss

Some time ago, the author, in collaboration with Professor Isaac Ehrlich, studied the retirement insurance policies of most of the countries in the world. Based on this research, the author comes up with some preliminary conclusions and conservative estimates. If Hong Kong should adopt a particular type of social security system, as suggested by certain groups, then in three to four decades, she could lose about 800 billion dollars of output (after adjustment for inflation), which is good enough for the construction of several Chek Lap Kok airports. This sum does not include the payment made to the elderly in their retirement. The social loss of the retirement insurance program will increase with time and with its scope, though not all programs are equally costly.

In order to analyze the economic consequences of various types of retirement insurance policies, one must first understand how an average citizen makes financial arrangements for his retirement years. In traditional societies, such a person is financially supported by his own savings and by contributions from his children. In modern societies, the sources of support can come from various social welfare programs, retirement funds administered by private enterprises, the "fully funded" social security system, which is sometimes known as the Central Provident Fund (CPF), and the so-called "pay-as-you-go" social security system (PYGSS). Many people in Hong Kong erroneously believe that most countries have established the CPF. In fact, it is the PYGSS system, which is distinctly different from the CPF, that is commonly adopted. The PYGSS system will lead to more serious economic consequences, which we will discuss later.

The Central Provident Fund

The CPF is a form of saving. A citizen contributes a mandatory sum with which the government makes investments, and is paid back during his retirement years. The amount he collects from the CPF depends entirely on the total contribution he has made in his working years and on the rates of return of the investments. Generally speaking, every dollar contributed to the CPF implies a dollar less in personal savings. Consequently, the total saving reserved for the retirement years does not change in any significant way. Apart from the necessary administration costs, the CPF does not have any significant positive or negative effects. Such kind of economic policy is essentially redundant.

Some in favor of the CPF argue that the low-income citizens in Hong Kong have a savings rate which is too low. This system will enable them to save at least some minimal amounts. It should first be pointed out that the savings rate in Hong Kong is already higher than that in the Western countries (probably because there is no retirement insurance in Hong Kong). Moreover, there are many forms of saving. For example, having more children and investing more in their education, are among the most important forms of saving. If one takes these implicit forms of saving into account, one will conclude that even the savings rate for the low-income citizens in Hong Kong is not low.

On the other hand, it is rather questionable whether the CPF can have the intended function of forced saving. A low-income citizen who wishes to put $100 in his personal saving may need to take a loan of $100 if the CPF requires him to contribute $200. Consequently, his actual savings rate is unaffected, but he will have to pay interest for the loan. Since poor people often have to pay a higher-than-average interest rate when they apply for loans, the CPF may end up having adverse effects on them.

It should further be pointed out that the present generation of elderly citizens, since it has not made any contribution in the past, will not benefit from a newly introduced CPF system. The program will start serving the purpose of retirement insurance only when the present young generation turns old. In other words, a CPF cannot alleviate the retirement problems of the current elderly population. Hence, it makes economic sense for the government to reject the CPF, which is no more than one form of interfering in people's private decisions on how to save.

Strictly speaking, retirement insurance schemes administered by private enterprises are fundamentally the same as the CPF. Hence, the above analysis applies similarly. However, should the government impose regulations on the private sector and make the schemes mandatory, new problems will arise. As pointed out by a legislative councillor, even small businesses like an herbal tea shop will be forced to establish retirement plans. This illustrates how such system can run into the extremes. But these problems can be solved relatively easily. In the U.S., many financial management firms have emerged to administer retirement plans on behalf of the employers and the employees. Employees can still hold on to their previous contributions even when they change jobs.

Another common misconception is that, since the employer is legally required to contribute to the employee's retirement fund, the latter will benefit from the plan. In fact such an argument is rather naive. In competitive markets, an employer would certainly make corresponding adjustments in the employee's salaries and other benefits after making mandatory contributions to his retirement funds.

The Pay-as-You-Go System

The pay-as-you-go social security system is by far the most important proposal recently and should therefore be discussed in more detail. This system is intrinsically different from the systems discussed above and it can have negative effects on the long-run growth rate of the economy. The characteristics of the PYGSS system are as follows. The government collects social security taxes from the citizens in the work force, which are immediately used to support the existing elderly in retirement instead of invested in a fund. The financial support for a retired citizen depends mainly on the amount of total social security taxes collected at the time and is basically independent of the tax history of the recipient in his working years.

It may seem, then, the PYGSS system is superior to the CPF, especially in the initial stage, since the present elderly can also benefit. As such, the PYGSS system can have significant political support from the recipients who make up a part of the voting population. For these reasons, most countries in the world adopted the PYGSS system. Some current proposals in Hong Kong are nothing but variations on this theme.

It should be realized that the PYGSS system has serious setbacks. Once it is established, politically it would be very difficult to abolish later. Since it is not funded, should the system be discontinued somehow, there is nothing to pay back those who have previously contributed but are not old enough to reap the return. Of course, there is no need to worry about its abolishment -- if the system does no harm to society. The problem is, it is very likely to bring about tremendous social losses, and it is thus necessary to be aware of the high political costs of termination well before its inception.

What are the possible economic losses due to the PYGSS system? From quantitative analyses of the social security systems of various countries, we find that for the developing countries, such a system may have positive or negative effects on the long-term growth rate. For the high-income countries, and Hong Kong is now ranked as such, the PYGSS system leads to significant decreases in the growth rate. The effect depends on the scope of the social security system: The higher the social security tax rate, the larger the decrease in the growth rate.

Assuming that the social security tax rate in Hong Kong is as low as that of the U.S. in the 1950s, then even by conservative estimation, the growth rate will be lowered by about 0.1 percent per annum. The higher the tax rate, the greater the drop in the growth rate. It is worth noting that once the PYGSS system has been introduced, there will be pressure to raise the tax rate over time due to changes in the socioeconomic and demographic environment.

A 0.1 percent drop in the growth rate may not seem that much, but the cumulative effect of such decreases can be very substantial. If we assume that the average real growth rate in Hong Kong over the next three to four decades will only be 4 percent (instead of 6.5 percent as in the past), then the social security system will reduce it to about 3.9 percent. In 30 years, the cumulative loss will reach 800 billion Hong Kong dollars (after inflation has been accounted for). If the future growth rate of Hong Kong is going to be higher than 4 percent, then the income loss will even be greater. These are of course crude estimates. Further studies are needed to come up with a fuller account of the negative impacts of the social security system.

Education, the Family, and Growth

Why, then, would the PYGSS system lead to a drop in the growth rate? Many economic studies have repeatedly demonstrated the crucial contribution of education to economic growth. Any factor which reduces investment in education is unfavorable to the growth rate. In a country without any social security system, the care and material support from the children constitute important contributions toward the livelihood of the elderly. Hence, the number of children and their education level (and hence their income) are decisive factors which determine the benefits in the retirement years. On the other hand, with a PYGSS system, the financial support depends on the taxes collected by the government and is independent of the number of one's own children and their income. Hence, in such a system, there are incentives for the citizens to depend entirely on their government and "eat from the big rice bowl" or behave as free riders. Consequently, parents?investments in their children will become less important. In developing countries, the social security system may give incentives for parents to have smaller families, which may be good for economic growth. In the high-income countries, where the birth rates are already at very low levels, however, the main effect of the social security system is to reduce investment in the education of the offsprings. This, in turn, will have negative effects on the economic growth rate. No doubt, parents care for their children and spend on their education, despite the social security system. The point is that some parents would naturally do less of it because of the system.

Certain economic phenomena are consistent with the above analysis. In the U.S., the social security system was established in 1934. Before this, most of the elderly people lived with their children. After the social security system was introduced, the percentage of the elderly living with their children decreased considerably. At present, it is below 10 percent. Also, recent studies show that the academic standard of students in the U.S. and certain European countries has deteriorated steadily, despite the increase in government expenditures on their school systems. This can possibly reflect the lesser amount of time parents are spending on the education of their children at home.


For thousands of years, the family has functioned as the institution which provides care and support for the elderly. Once the social security system is established, this traditional role of the family will be partially eliminated. Can the government be a better substitute for the family? In general, the answer is in the negative. When the role of the government becomes more important, the "eat from the big rice bowl" behavior will be more common. This will lead to economic losses. For some special cases, such as the unmarried or handicapped elderly, the family may not be a good solution to their living problem, and government support would be an appropriate supplement. However, if the aim of social security is to provide welfare to the poor, there are certainly alternatives with much lower social costs than a mandatory retirement insurance scheme. Perhaps granting tax exemptions as a means to encourage personal saving (like the Individual Retirement Annuity system in the U.S.) will be superior to either the CPF or any kind of social security system.

Dr. Francis T. Lui is a senior lecturer in the Department of Finance and Economics at The Hong Kong University of Science and Technology.


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