Chile’s Pension Reform: An Inspiration to Others
Chile’s pension system, based on obligatory individual accounts and private administration, is once again a focus of attention, now that U.S. President George W. Bush has presented it as a model for modernizing his country’s Social Security system.
As early as April 2001, when Chilean president Ricardo Lagos visited the White House, Bush revealed his admiration for the performance of Chile’s system. Bush focused on the year 2042 when, forecasters say, the U.S. Social Security system will collapse. “Our Social Security system must be modernized and I hope, Mister President, to receive some suggestions about how to do that, because you have done so well in that regard,” Bush told Lagos, according to the official transcription of their meeting.
All this scrutiny has exposed the weaknesses of the Chilean pension reforms, introduced 24 years ago when General Augusto Pinochet led the country. In Chile itself, the debate has focused on the people who remain outside the system – a problem that the Chilean government says it will fix problem by broadening Social Security coverage. Overall, the consensus is that the system of so-called “Pension Fund Administrators” has more strengths than weaknesses. That explains why, from Central and South America to Eastern Europe, the Chilean system has served as the inspiration for 17 countries that have decided to get rid of their underfinanced systems of distribution.
What is the main attraction of the Chilean pension system? Olivia Mitchell, executive director of Wharton’s Pension Research Council, suggests “four powerful reasons” for its popularity. First, the Chilean system was created at the beginning of the 1980s as the successor to the old state-run system, which went bankrupt. “Like Chile, many countries, including the United States, are facing the insolvency of their Social Security system. That’s because their populations are aging, and their systems must pay a high level of benefits compared with a low level of revenues.” Chile’s experience is relevant for every country that is trying to make its system solvent again.
A second factor, says Mitchell, is that the Chilean reform includes the concept of individual capital accounts. “This feature appeals to many people who believe that governments are often unable to maintain sufficient assets to finance a retirement system.” Individual accounts, argues Mitchell, can be better protected against political risks. Mitchell explains another relevant feature of Chile’s approach: Its system incorporates a “security network” in the form of minimum pensions and old-age benefits guaranteed by the government. Mitchell agrees with those experts who applaud the multifaceted nature of the Chilean system and the way risks are shared in it. “Ultimately, the Chilean model has existed for more than 20 years, and its survival tends to inspire confidence,” Mitchell says.
This feature has been recognized by such institutions as the World Bank, which is promoting the development of pension systems that have more than just one foundation or ‘pillar.’ Multi-pillar systems must distribute the responsibility of optimizing saving, redistribution and insurance for retirees among several bases of support. According to a study by the AFP Association (which comprises Chile’s seven private-sector pension administrators), the first foundation of the Chilean model is the country’s government. In its subsidiary role, the government finances a portion of the minimum pensions and all of the public-assistance pensions provided for the aged poor. The second foundation consists of the private-sector pension administrators who administer the obligatory Social Security savings. They help to relieve the burden on the government. The third pillar is Chile’s workforce, which voluntarily saves, either to increase its pensions or in order to take early retirement. The mechanism for doing this is called ‘voluntary provisional savings.’
Augusto Iglesias, a consultant at PrimAmerica, which does forecasting for foreign governments, shares Mitchell’s view of the Chilean system. Individual accounts, says Iglesias, “permit the establishment of a direct link between those contributions that people make to the system and the benefits they derive from it. This creates incentives for people to assume responsibility for their own pensions” and can lead to a range of positive results for savings, the development of capital markets, and higher worker productivity. These factors, in turn, stimulate economic growth.
Its impact on economic growth is a key “virtue” of the Chilean model. According to Roberto Fuentes, research director at the association of private-sector administrators, the system acts like “a virtuous circle that generates wealth.” All participants benefit. “The accumulation of savings in individual accounts generates fresh long-term resources for the economy. It lowers the cost of capital, generates investments, and leads to new jobs with higher salaries.”
Fuentes estimates that total Social Security savings of Chilean workers has reached about $60 billion, the equivalent of 60% of the country’s entire GDP. Over the last 24 years, the overall return on investment for funds has been 10.3% higher than the average annual inflation rate. “As a result, 60% of old-age pensions are taken ahead of schedule. Men take early retirement nine years in advance and women take it seven years in advance.”
The Criticism: Low Coverage and Administrative Costs
Critics argue that the Chilean system leaves defenseless those independent workers who do not achieve the 20 years of payments required to gain access to a minimum pension, should their funds run out. This is not a small problem. According to research by Isabel Márquez, research director at the Institute of Pension Fund Normalization, [Chile’s state-run pension system], in a study of 540 people registered in the system, 60.6% will not accumulate sufficient capital to get the minimum self-financed pension. Of those, 86% will also be unable to achieve the 240 contributions required to obtain a government guarantee. The country’s income levels make this situation worse. According to Marquez, 50.8% of all workers who belong to the system have incomes below 200,000 Chilean pesos a month (about $340.)
What can be done? Iglesias says there is no effective way to impose Social Security contributions on independent workers. As a result, they can easily evade any possible obligation that they contribute. “If we want to increase coverage rates in this group, we have to create tax incentives for voluntary saving for Social Security, mainly by lowering taxes and by giving subsidies.” Nevertheless, Iglesias warns that even this approach has limited potential. Saving for Social Security will always have a disadvantage compared with other, more liquid forms of savings, which can be used, if necessary, to finance other goals.”
The problem should be tackled from another angle, says Iglesias. For many workers, housing is the main asset they can dispose of when they retire. “Nevertheless, there are no financial instruments in today’s market that enable them to make this form of savings ‘liquid’ without losing their right to use the actual real estate -- at least, not until their death.” In his view, “reverse mortgages” could help solve this problem.
Fuentes argues that Chile’s pension system is in transition. “Most people who are now eligible for a pension contributed to the old system for a significant period of time. They are not merely getting pensions from the new system.” According to studies conducted by trade unions, the new system will deliver pensions of between 70% and 105% of an average worker’s income. “From the point of view of social security, that is a very good rate of return,” Fuentes says.
According to Iglesias, some participants in the new system have low pensions because they did not make any contributions for long periods of time. “Nevertheless, this is not because of the Social Security system itself. It stems from that person’s working career. In fact, every [Social Security] system that pays out pensions in return for worker contributions links a worker’s total benefits to the contributions that he or she makes over his or her active years.”
Early on, Chilean industry saw the need to increase its return on investment, improve the diversification of its portfolio and yield higher returns. This happened, largely as a result of investing in overseas markets, which now attract 30% of all Chilean funds.
People also complain about the cost of the system. Often, they are concerned about the portion of their taxable salary that is used to finance it. These funds go to managing the pension plan’s savings and financing the disability and survival benefits that all Chilean firms must provide for their employees. The system also sets fixed commissions as well as variable fees that the seven public administrators use to gain a competitive edge. Mitchell admits that the system has suffered from high administrative costs and a lack of alternative investments. However, she notes, “both defects have been dramatically improved.” The average commission paid by participants in Chile is 2.31% of taxable income, quite a good rate compared with the Latin American norm. According to a recent report by the World Bank, the cost of administering social security in Chile is the lowest in the region. The average participant in Chile pays 27% less than the Latin American average, and 48% less than in Mexico, where costs are highest.
Differences between Chileand the U.S.
Is the United States prepared to bear the significant initial costs involved in transforming a public system into a private one, given the large U.S. budget deficit? Although the U.S. does not enjoy the fiscal surplus that Chile enjoyed when it changed its system, Mitchell believes that this should not become an obstacle on the road to urgently needed reform.
Over the years, politicians in the U.S. and many other countries have promised Social Security benefits to workers, but they have never explained how these benefits will be paid for. “A large number of honest officials need precise data, and a debate about this is taking place in the Congress,” says Mitchell. “We have to reach some sort of agreement about what portion of the GDP can – and must – be used for dealing with the problem that retirees are living longer. This is especially so when governments have a lot of other national objectives, including education, health, regulation and defense. Every country will find its own balance. Chile shows us one way to do it.”
Putting things in perspective, Mitchell recalls that the insolvent liabilities of the U.S. Social Security system are as large as the country’s GDP (in current value). Add to that commitments for medical care for retirees, and the total cost rises to seven times the GDP. As a result, insists Mitchell, the U.S. must reform its system. A member of the presidential commission for strengthening Social Security, Mitchell believes that the investment needed for establishing the new system is affordable – less than 1% of GDP, assuming the highest level of spending. “In the final analysis, reform cannot be avoided, and the faster we act, the less painful it will be.”