Social Security Testimony

Subcommittee on Social Security
Committee on Ways and Means
United States House of Representatives

Mr. Chairman and members of the Subcommittee, I appreciate the opportunity to testify today on Chile’s private pension system, especially since it has become the model for countries around the world that have reformed their public pension systems or are considering doing so.1

In 1924 Chile was the first country in the hemisphere to implement a state-run retirement system. In 1981, Chile became the first country in the world to replace its bankrupt pay-as-you-go pension system with an investment-based privately managed system of individual retirement accounts. The problems that are currently putting pressure on workers and public retirement programs in so many countries also plagued Chile’s government-run system, ultimately making it fiscally unviable: payroll taxes were high and saw large increases, the implicit debt of the public system was over 100 percent of GDP, the ratio of workers to retirees saw a significant and continuous decline, and the government was contributing to more than a third of the public pension system’s revenues.2

Chile’s pioneering reform addressed the above problems by creating a fully funded system whose principal features are individual choice, clearly defined property rights, and the private administration of accounts. By linking effort and reward, the reform offers proper investment and work incentives, and has contributed to Chile’s impressive growth rates.

Since the private pension system was implemented, labor force participation, pension fund assets, and benefits have increased. Today, 95 percent of Chilean workers have joined the system; the pension funds have accumulated assets of some $58 billion, amounting to more than 75 percent of Chilean GDP; and the average real rate of return on the pension funds has been 10.24 percent.3

The Chilean Private Pension System

Every month workers deposit 10 percent of the first $22,000 of earned income in their own individual pension savings accounts, which are managed by the specialized pension fund administration company of their choice. (There are currently six competing pension fund companies in Chile.) Those companies invest workers’ savings in a portfolio of bonds and stocks, subject to government regulations on the specific types of instruments and the overall mix of the portfolio. Fund managers can invest up to 30 percent of the portfolio overseas, a measure that allows workers to hedge against currency fluctuations and country risk. At retirement, workers use the funds accumulated in their accounts to purchase annuities from insurance companies. Alternatively, workers make programmed withdrawals from their accounts (the amount of those withdrawals depends on the worker’s life expectancy and those of his dependents); or a worker can choose temporary programmed withdrawals with a deferred lifetime annuity.

The government provides a safety net for those workers who, at retirement, do not have enough funds in their accounts to provide a minimum pension. But because the new system is much more efficient than the old government-run system and because, to qualify for the minimum pension under the new system, a worker must have at least 20 years of contributions, the cost to the taxpayer of providing a minimum pension funded from general government revenues has so far been small-about 0.1 percent of GDP.4 (Of course, that cost is not new; the government also provided a safety net under the old program.) Those who have not contributed for 20 years and have not accumulated sufficient funds to meet the minimum pension can apply for a lower welfare-type pension.

When the reform began, workers already in the labor force were given a choice to join the new system or remain in the old. Those who chose to switch to the private system were given “recognition bonds” that reflected past contributions to the public pension program and that are paid by the government upon a worker’s reaching the legal retirement age. New entrants into the labor force were required to join the new pension system, thus eventually ending the unsustainable pay-as-you-go system. The benefits of those already retired and receiving a pension at the time of the reform were not affected.

The transition to the private system was financed in a number of ways. It should be noted that the net economic costs of moving from an unfunded pay-as-you-go system to a fully funded system are zero. That is to say, the total funded and unfunded debt of a country does not change by moving from an unfunded system to a funded one. There is, however, a cash flow problem when moving toward a fully funded retirement system. In the case of Chile, transition costs can be broken down into three different parts. First, there is the cost of paying for the retirement benefits of those workers who were already retired when the reform was implemented and of those workers who chose to remain in the old system. That makes up by far the largest share of the transition costs at present. These costs will decline as time goes by. Second, there is the cost of paying for the recognition bonds given to those workers who moved from the old system to the new in acknowledgement of the contributions they had already made to the old system. Since these bonds will be redeemed when the recipients retire, this cost to the government will gradually increase as transition workers retire (but will eventually disappear). It is worth stressing that these are new expenditures only if we assume that the government would renege on its past promises. The third cost to the government is that of providing a safety net to the system, a cost that is not new in the sense that the government also provided a safety net under the old pay-as-you-go system.

To finance the transition, Chile used five methods. First, it issued new government bonds to acknowledge part of the unfunded liability of the old pay-as-you-go system. Second, it sold state-owned enterprises. Third, a fraction of the old payroll tax was maintained as a temporary transition tax. That tax had a sunset clause and is zero now. Fourth, it cut government expenditures. And, fifth, pension privatization and other market reforms have contributed to high growth in Chile, which in turn has increased government revenues, especially those coming from the value added tax.

In sum, the transition to the new system has not been an added burden on Chile because the country was already committed to paying retirement benefits. On the contrary, the transition has actually reduced the economic and fiscal burden of maintaining an unsustainable system.

In the new private system, workers have become owners of the means of production, or “worker capitalists,” in the words of José Piñera, Chile’s former minister of labor and social security who implemented the reform.5 This paradigm shift from a consumption to an investment-based system has positively impacted the country’s political economy by reducing class conflict and depoliticizing a large part of Chilean economy.

Commonly Heard Criticisms of the Chilean System

Critics of the Chilean system, however, often point to high administrative costs, lack of portfolio choice, and the high number of transfers from one fund to another as evidence that the system is inherently flawed and inappropriate for other countries, including the United States. Some of those criticisms are misinformed. For example, administrative costs are less than 1 percent of assets under management, a more favorable figure than management costs in the U.S. mutual fund industry. Other criticisms are highly misleading. To the extent the criticisms are valid, shortcomings in the private system typically result from excessive government regulation.

In Chile pension fund managers compete with each other for workers’ savings by offering lower prices, products of a higher quality, better service or a combination of the three. The prices or commissions workers pay the managers are heavily regulated by the government. For example, commissions must be a certain percentage of contributions regardless of a worker’s income. As a result, fund managers are prevented from adjusting the quality of their service to the ability (or willingness) of each segment of the population to pay for that service. That rigidity also explains why the fund managers have an incentive to capture the accounts of high-income workers, since the profit margins on those accounts are much higher than on the accounts of low-income workers.

The product that the managers provide — that is, return on investment — is subject to a government-mandated minimum return guarantee (a fund’s return cannot be more than 2 or 4 percentage points, depending on the type of fund, or 50 percent below the industry’s average real return in the last 36 months). That regulation forces the funds to make similar investments and, consequently, have very similar portfolios and returns.

Thus, the easiest way for a pension fund company to differentiate itself from the competition is by offering better customer service, which explains why marketing costs and sales representatives are such an integral part of the fund managers’ overall strategy and why workers often switch from one company to another.

The following is a closer look at some of the more frequently heard criticisms of Chile’s private pension system.

“The Administrative Costs are Too High”

Critics often claim that the commissions that workers pay to the pension funds are exorbitant. The often-cited figure of 18-20 percent represents administrative costs as a percentage of current contributions, which is not how administrative costs are usually measured. This figure is usually obtained by dividing the commission fee, which is on average equivalent to 2.37 percent of taxable wages, by the total contribution (10 percent plus the commission). This calculation fails to take into account that the 2.3 percent includes the life and disability insurance premiums (about 0.95 percent of taxable wages on average6) that workers pay, which are deducted from the variable commission, and thus overstates administrative costs as a percentage of total contributions.

The proper way to measure administrative costs is as a percentage of assets under management. In Chile, the administrative costs of the private pension system are 0.66 percent of assets managed.7 The Chilean pension fund administrators’ association calculates that the commissions the industry charges are 0.63 percent of assets under management, far lower than such fees charged by other fund managers including U.S. mutual funds that charge about 1.38 percent.8

Prior to the above findings, others have calculated similarly low administrative costs. Chilean economist Salvador Valdés estimated the average annual cost of the AFP system to be equivalent to 0.84 percent of total assets under management over the life cycle of the worker.9 The Congressional Budget Office estimated in 1999 that the administrative costs of private retirement accounts in Chile “can be equivalently expressed as 1 percent of assets.”10 When administrative costs are compared to the old government-run system, the criticism is even less convincing. Chilean economist Raúl Bustos Castillo has estimated the costs of the new system to be 42 percent lower than the average costs of the old system.11

To the extent that such administrative costs are still considered too high, that is the result of government regulations on the commissions the AFPs can charge and on the investments these companies can make. The existence of a “return band” prevents investment product differentiation among the different AFPs. As a result, the way an individual AFP tries to differentiate itself from the competition is by offering better service to its customers. One way to provide better service would be to offer a discount on the commission fee to workers who fit a certain profile — e.g., workers who have maintained their account for an extended period of time or who contribute a certain amount of money to their accounts; however, government regulations do not allow that. Those regulations state that the AFPs may only charge a commission based on the worker’s taxable income and expressed as a percentage of that income.

“The Coverage Under the New System is Low”

Critics also say that some 30-40 percent of Chilean workers are not participating in the private system. Although the number of Chileans participating in the private system is actually greater than the work force (some Chileans affiliated to the private system have left the work force), only about 61 percent of those participating in the employed work force regularly contribute to their private accounts. According to the Chilean pension fund regulatory agency, that method of calculation underestimates real coverage because it counts only workers who have contributed in a particular month even though other workers who made contributions in previous months will also receive benefits from the system. Including workers who have contributed within the past year, coverage in the private system amounted to 69.7 percent of the work force, which is greater than that of the previous public system in the four years prior to the reform. From 1976-1980, coverage under the old system “averaged 67 percent of the workforce, with a clear downward trend.”12

Others have also found that coverage in the private system is greater than that of the old system. Measuring coverage as those who contribute on a regular monthly basis, the percentage of the employed work force covered in the private system (more than 60 percent) is superior to the coverage of the old system before reform (54 percent in 1980) and it has been increasing. See graph below.13

Several factors explain why coverage is not higher in Chile. The self-employed, who represent about 30 percent of the work force, are not required to participate in the private system. Only about 6 percent of the self-employed contribute on a regular basis. Workers who are unemployed also do not contribute to the system (the unemployment rate has been between 8-10 percent in Chile in the past five years.) Moreover, of the 3.4 million people affiliated with the private pension system, 1.44 million-including students or women who have stopped working to care for children, for example-are not currently in the work force.14 There is also a large informal economy, which is typical of developing countries. Lastly, the evidence suggests a strong relationship between economic development and the level of coverage around the world (higher per capita incomes correlate with higher coverage). 15


In short, the level of coverage under the system does not reflect negatively on the private pension system itself. To the extent that coverage could improve, factors not inherent to the private system, such as rigidities in the labor market and the size of the informal economy, would have to be addressed by other public policies. In addition, only beginning around the year 2025, when the first generation of workers who have contributed during their entire working lives begins to retire, will it be fair to compare the private system with the old system.

“Too Many Workers Will Depend on the Minimum Pension and the System Will Impose Large Costs”

The Chilean finance ministry estimates that the average number of minimum pensions that it will be supplementing per month in 2005 will be 65,000. The costs of doing so are minimal and currently stand at 0.1 percent of GDP. Part of the reason that the cost is low is that the government does not provide the full amount of the minimum pension since a worker has some assets in his/her account. On average, the government provides 20-30 percent of the capital needed to finance the minimum pension. Indeed, the public cost of financing pensions, most of which is made up of meeting the obligations of the old system, is projected to continue falling (see Table 1).16

Table 1: Civil Social Security Deficit Forecast
Year Public Pensions Recognition Bonds Welfare Pensions Minimum AFP Pensions Total
2002 3% GDP 1.2% GDP 0.4% GDP 0.1% GDP 4.7% GDP
2012 2% GDP 1.2% GDP 0.4% GDP 0.27% GDP 3.87% GDP
Difference -1% GDP 0% GDP 0.4% GDP 0.17% GDP -0.83% GDP
(Source: Ministry of Finance Budget Department, Macroeconomic Aspects of the Draft Law for the Public Sector, 2002; and Asociación AFP)

It is estimated that the percentage of members affiliated to the private pension system that will receive government supplements for the minimum pension (only those who have contributed 20 years are eligible) will vary between 1.9 and 10.5 percent depending on the rates of return.17

“Workers Change Pension Fund Administration Companies Too Frequently”

Because of investment regulations and rules on fees and commissions, product differentiation is low. Thus companies compete by offering gifts or other incentives for workers to switch to their companies. Switchovers increased dramatically from 1988, the year when the requirement to request in person the change from one AFP to another was eliminated, until 1997, when the government reintroduced some restrictions to make it more difficult for workers to transfer from one AFP to another. The number of transfers in 1998-2000 decreased to less than 700,000, less than 500,000, and slightly more than 250,000, respectively, from an all-time high of almost 1.6 million in 1997. Transfers have since fallen to about 228,000 per year.

Liberalizing the Chile’s Private Pension System

It is clear that some of the regulations mentioned above have become outdated and may negatively affect the future performance of the system. Fortunately, Chilean authorities have taken some important steps in addressing the challenges of a more mature system.

The most important structural reform in recent years is the introduction of multiple investment funds. Up until 2000, the pension fund management companies could only manage one fund. That year, the regulatory framework was changed to allow the AFPs to offer a second fund, invested only in fixed income instruments. That reform proved to be insufficient, as very few workers decided to switch their savings from the diversified fund to the fixed-income one. Indeed, consumer demand for the fixed-income fund was negligible. What was needed was to let pension fund management companies manage more than one variable-income fund.

Chilean authorities finally adopted this reform in early 2002 when they instituted a rule that mandated AFPs to offer 5 different funds that range from very low risk to high risk. One advantage of having several funds administered by the same company is that that could reduce administrative costs if workers were allowed to invest in more than one fund within the same company. This adjustment also allows workers to make prudent changes to the risk profile of their portfolios as they get older. For instance, they could invest all the mandatory savings in a low-risk fund and any voluntary savings in a riskier fund. Or they could invest in higher risk funds in their early working years and then transfer their savings to a more conservative fund as they approached retirement. Table 2 shows the maximum percentages of equity investment allowed in each fund:

Table 2:
Maximum Percentage Allowed Mandatory Minimum Percentage
Fund A 80% 40%
Fund B 60% 25%
Fund C 40% 15%
Fund D 20% 5%
Fund E Not Allowed Not Allowed

The introduction of a family of funds is an important step and consumers are behaving as one would expect — that is, by diversifying their investments across the menu of funds. Other steps that have been taken in the recent past include:

  • The lengthening of the investment period over which the minimum return guarantee is computed to 36 months from 12 months and the widening of the band from 2 to 4 percentage points for some type of funds;

  • The further liberalization of the investment rules, so that workers with different tolerances for risk can choose funds that are optimal for them; and

  • The expansion of consumer choice with the signature of a bilateral accord with Peru that allows workers from those two countries to choose the pension system with which they want to be affiliated.

Other specific steps that Chilean regulators should take to ensure the continuing success of the private pension system include: Liberalizing the commission structure to allow fund managers to offer discounts and different combinations of price and quality of service (which would introduce greater price competition and possibly reduce administrative costs to the benefit of all workers); letting other financial institutions, such as banks or regular mutual funds, enter the industry;18 giving workers the option of personally managing their accounts through the world wide web; and reducing the moral hazard created by the government safety net by linking the minimum pension to the number of years (or months) workers contribute.

Those adjustments would be consistent with the spirit of the reform, which has been to adapt the regulatory structure as the system has matured and as the fund managers have gained experience. In summary, the Chilean private pension system, despite minor shortcomings, is a success story by any measure and deservedly continues to be the model for rich and poor countries around the world that are considering reforming their retirement systems.

1I thank Jacobo Rodríguez from whose work I have borrowed liberally and with permission.
2Jacobo Rodríguez, “Chile’s Private Pension System at 18: Its Current and Future Challenges,” Cato Institute Social Security paper no. 17, 1999, p. 3.
3For detailed statistics of the Chilean pension system, see the website of the Superintendencia de AFPs, the Chilean government regulator of the private pension system, www.safp.cl
4Ministry of Finance, Chile.
5See José Piñera, “Liberating Workers: The World Pension Revolution,” Cato’s Letter no. 15, 2001.
6Rubén Castro, “Seguro de Invalidez y Sobrevivencia: Qué Es y Qué Le Está Pasando,” Documento de Trabajo no. 5, Superintendencia de AFP, May 2005, p.12.
7Superintendencia de AFP, The Chilean Pension System (Santiago: Superintendencia de AFP, 2003), p. 154.
8Asociacion AFP, “The AFPs Charge Lower Commissions Than Other Institutions, Both Local and Foreign,” Research Series paper no. 42, June 2004, available at www.afp-ag.cl.
9Salvador Valdés, “Las Comisiones de las AFPs ¿Caras o Baratas?” Estudios Públicos, Vol. 73 (Verano 1999): 255-91.
10Congressional Budget Office, Social Security Privatization: Experiences Abroad, sec. 2, p. 7 (January 1999).
11Raúl Bustos Castillo, “Reforma a los Sistemas de Pensiones: Peligros de los Programas Opcionales en América Latina.” In Sergio Baeza and Francisco Margozzini, eds., Quince Años Después: Una Mirada al Sistema Privado de Pensiones (Santiago, Chile: Centro de Estudios Públicos, 1995), pp. 230-1. However, comparing the administrative costs of the old system with those of the new one is inappropriate, because the underlying assumption when making that comparison is that the quality of the product (or the product itself) being provided is similar under both systems, which is certainly not the case in Chile.
12The Chilean Pension System, pp. 120-23.
13Asociación AFP.
15Robert Holzmann, Truman Packard, and Jose Cuesta, “Extending Coverage in Multipillar Pension Systems: Constraints and Hypotheses, Preliminary Evidence and Future Research Agenda,” in Robert Holzmann and Joseph E. Stiglitz, eds. New Ideas About Old Age Security (Washington: World Bank, 2001), p. 454; and Asociación AFP.
16Ministry of Finance and Asociación AFP, “The AFP System: Myths and Realities,” August 2004, available at www.afp-ag.cl.
17Asociación AFP; the rates of return assumed are 3 percent, 5 percent, and 7 percent.
18 If financial institutions were allowed to establish one-stop financial supermarkets, where consumers could obtain all their financial services if they so chose, the duplication of commercial and operational infrastructure could be eliminated and administrative costs could be reduced.