On paper, the Chilean system has worked very well. Assets under management have increased from $300 million in 1981 to $35 billion today. That equals almost 50 percent of Chile’s gross domestic product. In a population of 15 million, more than 95 percent of the labor force has chosen to leave the old government-run pay-as-you-go system and join the private system. Average real rates of return have been 11 percent per year since 1981, which has allowed workers to retire with larger and more secure pensions.
One of the greatest objections to a privatized system has been that poorer workers lack the knowledge and skills to invest wisely and that, as a result, the system will benefit only those already well off. The Chilean experience refutes that objection. The advantage of the free-enterprise system is that workers do not have to be financial experts to benefit from investing in financial markets. Indeed, workers can hire firms that have expertise in managing portfolios. So the claim that one has to be a financial expert to profit from a system of individual retirement accounts is as far-fetched as saying that one has to be a gourmet cook to enjoy a good meal.
Furthermore, anecdotal evidence from my visit to Santiago reveals that low-income workers are not as ignorant as some pundits make them out to be. I asked several Chilean citizens about their celebrated private pension system. Their responses revealed a degree of sophistication about financial markets not usually associated with the “common man” of a developing country. Three examples will suffice.
A taxicab driver praised the system because it gives workers property rights in their contributions and greater freedom in deciding when to retire. The driver rightly complained, however, about the high price of annuities that workers can purchase at retirement. This is one of the problems of the Chilean system. Because the private pension system has been in use for a relatively short time (20 years) and few people have retired so far, there is not enough information for the insurers to fully evaluate and estimate annuity prices based on the aging population. As time passes and more Chileans retire under the system, more competitive annuity rates will become available. The taxi driver understood this, albeit in simpler terms.
A barber did not participate in the system because he was self-employed (the self-employed are not required to participate in the private system, as they were not required to participate in the government system). He was familiar, however, with the main features of the private system and the fact that the Chilean model has been imitated in several other Latin American countries.
A recent college graduate also liked the system but complained about not being able to invest more abroad or in a riskier portfolio. The minimum return guarantee in the Chilean system encourages portfolio managers to invest all workers’ savings in pretty much the same way. But the risk and return preferences of all workers are not the same. And the risk and return preferences of an individual worker are unlikely to be the same at all times of his professional career. Younger workers are more likely to prefer riskier portfolios than workers close to retirement. Greater flexibility in the investment rules would allow workers to make prudent changes in the risk profiles of their portfolios as they got older.
The issues I discussed with many Chileans were not simple. Yet they knew what they were doing within a set of financial incentives and structural constraints. In truth, “nanny state” pundits and policymakers are the ones likely to exaggerate the common man’s ignorance.
If trusting people and expanding opportunities for all Americans are important to President Bush, he should move ahead with his plans to allow all American workers to invest part of their payroll taxes in financial markets. If given that choice, American workers, like their Chilean counterparts, will know what is best for them.