April 1999 - Among three options for constructing funded social security pillars, one system - individual accounts invested in the institutional market, with constrained choice among investment companies - appears to offer reduced administrative and marketing costs, significant worker choice, and more insulation from political interference than a single centralized fund or individual investments in the retail market would offer. One of the main criticisms of the defined-contribution, individual-account components of social security systems is that they are too expensive. James, Ferrier, Smalhout, and Vittas investigate the cost-effectiveness of three options for constructing funded social security pillars: Individual accounts invested in the retail market with relatively open choice; Individual accounts invested in the institutional market with constrained choice among investment companies; A centralized fund without individual accounts or differentiated investments across individuals. The authors asked several questions: What is the most cost-effective way to organize a system with mandatory individual accounts? How does the cost of an efficient individual account system compare with that of a single centralized fund? And are the cost differentials great enough to outweigh other important considerations? The authors concentrate on countries with well-functioning financial markets, such as the United States, but make comparative references to developing countries. Based on empirical evidence about U.S. mutual and institutional funds, the authors found that the retail market (option 1) allows individual investors to benefit from scale economies in asset management-but at the cost of the high marketing expenses needed to attract large pools of small investments. By contrast, a centralized fund (option 3) can be much cheaper because it achieves scale economies without high marketing costs. But it gives workers no choice and is subject to political manipulation and misallocation of capital. The system of constrained choice (option 2) is much cheaper than the retail option and only slightly more expensive than a single centralized fund. It allows scale economies in asset management and record-keeping while incurring low marketing costs and allowing significant worker choice. It is also more effectively insulated from political interference than a single centralized fund. The authors estimate that option 2 would cost only 0.14 percent-0.18 percent of assets annually. Such large administrative cost savings imply a Pareto improvement-so long as choice is not constrained too much. This paper-a product of Poverty and Human Resources and Finance, Development Research Group-was prepared for a National Bureau of Economic Research Conference on Social Security held on December 4, 1998. The authors may be contacted at ejames3@worldbank.org or dvittas@worldbank.org.