In Chile, They Went Private 16 Years Ago

The United States is not the first, or the only, country to face a crisis in its government-run retirement system. All over the globe, old-fashioned pay-as-you-go social security and pension programs are going broke, facing the hard lessons of demographics.

Among the first countries to enact fundamental pension reform was my nation of Chile, the first country in the Western Hemisphere to adopt a social security system, in 1925, 10 years before the United States. But by 1980, when I was Chile’s secretary of labor and social security, its social security system faced the same financial problems as the U.S. system faces today.

Rather than make the usual short-term fixes of raising taxes or cutting benefits Chile (population, 14.5 million) decided on a revolutionary approach: a privately administered national system of individually owned, privately invested retirement accounts.

The success of Chile’s venture into privatization can provide a valuable example for the United States. After 16 years, Chile’s experiment has proven itself. Pension benefits in the private system already are 50 to 100 percent higher (adjusted for inflation) than they were in the state-run system. The resources administered by the private pension funds amount to $30 billion, or around 43 percent of GDP as of 1997. Because it has improved the functioning of both the capital and the labor markets, Social Security privatization has been one of the key reforms that has pushed the growth rate of the economy upward from the historical 3 percent a year to 7 percent on average during the last 12 years. The Chilean savings rate has increased to 25 percent of GDP, and the unemployment rate has decreased to around 5 percent since the reform was undertaken.

Under Chile’s privatized system, which is monitored and regulated by the government, neither the worker nor the employer pays a social security tax to the state. Nor does the worker collect a government-funded pension. Instead, during his working life, he has 10 percent of his wages automatically deposited by his employer each month in his own, individual account. The contribution is not taxed. His pension level is determined by the amount of money he accumulates during the number of years he is working.

A worker may contribute an additional 10 percent of his wages each month, which is also pre-tax, as a form of voluntary savings. Generally, a worker will contribute more than 10 percent of his salary if he wants to retire early or obtain a higher pension.

A worker chooses one of about 14 private Pension Fund Administration companies to manage his account. Each company operates the equivalent of a mutual fund that invests in stocks and bonds. Investment decisions are made by the managing company. Government regulation sets only maximum percentage limits both for specific types of investments and for the overall mix of the portfolio. In the spirit of the reform, those regulations are to he reduced with the passage of time and as the companies gain experience.

Workers are free to change from one investment company to another. For that reason, there is competition among the companies to provide a higher return on investment, better customer service or a lower commission. Each worker is given a passbook for his account; every three months he receives a statement informing him of how much money has accumulated and how his investment fund has performed. The account bears the worker’s name, is his property, and will be used to pay his old age pension (with a provision for survivors’ benefits).

Harvard economics professor Martin Feldstein estimates that “the combination of the improved labor market incentives and the higher real return on savings (of moving to a fully funded Social Security system) has a net present value gain of $10 trillion to $20 trillion, an amount equivalent to 5 percent of each future year’s GDP forever.”

The government retains some involvement in the system, via a safety net financed from general revenues for those who have not accumulated enough. A worker who has contributed for at least 20 years but whose pension fund, when he reaches retirement age, is below the legally defined “minimum pension,” receives a pension from the state once his account has been depleted.

What should be stressed here is that no one is defined as “poor” in advance. Only after his working life has ended, and his account has been depleted, does a poor pensioner receive a government subsidy. (Those without 20 years of contributions can apply for a welfare pension at a much lower level).

Upon retiring, a worker may choose one of two general payout options. Under one option, a retiree may use the capital in his account to purchase an annuity from any private life insurance company. Alternatively, a retiree may leave his funds in

the account and make pre-arranged withdrawals, subject to limits based on the life expectancy of the retiree and his dependents.

In the latter case, if he dies, the remaining funds in his account form a part of his estate. In both cases, he can withdraw as a lump sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages.

In moving to this new system, we set three basic rules. The government guaranteed people already receiving a pension that it would be unaffected by the reform. That was important because it would be unfair to the elderly to change their benefits or expectations.

Every worker already contributing to the pay-as-you-go system was given the choice of staying in that system or moving to the new system Those who left the old system were given recognition bonds that were deposited in their accounts. Those bonds reflected the rights the workers had already acquired in the pay-as-you-go system

All new entrants to the labor force were required to enter the new system. The door was dosed to the pay-as-you-go system because it was unsustainable. This requirement ensured the complete end of the old system once the last worker who remained in it reaches retirement age (from then on, and during a limited period of time, the government has only to pay pensions to retirees of the old system). That is important, because the most effective way to reduce the size of government is to end programs completely, not simply scale them back so that a new government may revive them at a later date.

Since the system began to operate on May, 1, 1981, the average real return on investment has been 12 percent per year (three times higher than the anticipated yield of 4 percent). Of couse, the annual yield has shown the oscillations that are intrinsic to the free market — ranging from minus 3 percent to plus 30 percent in real terms — but the important yield is the average one over the long term.

Pensions under the new system have been significantly higher than under the old, state-administered system, which required a total payroll tax of about 25 percent. The typical retiree is receiving a benefit equal to nearly 80 percent of his average annual income over the last 10 years of his working life — almost double the percentage available in the U.S. social security system. The law requires that the benefit represent at least 70 percent of the recipient’s last monthly salary.

The new pension system, therefore, has made a significant contribution to the reduction of poverty by increasing the size and certainty of old age, survivors and disability pensions and by the indirect, but very powerful, effect of promoting economic growth and employment.

What would happen if the United States followed Chile’s example? The benefits to the U.S. economy would he substantial. Harvard economics professor Martin Feldstein estimates that “the combination of the improved labor market incentives and the higher real return on savings (of moving to a fully funded Social Security system) has a net present value gain of $10 trillion to $20 trillion, an amount equivalent to 5 percent of each future year’s GDP forever.”

And, most important, today’s young workers would be assured that when they retire they will be able to do so with dignity and security.

Jose Pinera was Chile’s minister of labor and social security from 1980 until 1983. He is currently president of the International Center for Pension Reform and co-chairman of the Cato Institute Project on Social Security Privatization.