Pay‐as‐you‐go social security systems destroy the link between contributions and benefits, between effort and reward. Everyone tries to minimize what he puts into the system while trying to maximize through political pressure what he can get out of it. That’s why pay‐as‐you‐go plans are going bankrupt all over the world.
Chile faced that problem in the late ‘70s. As secretary of labor and social security, I could have postponed the crisis by playing at the edges, increasing payroll taxes a little and slashing benefits a little. But instead of making some cosmetic adjustments, I decided to undertake a structural reform that would solve the problem once and for all.
We decided to save the idea of a retirement plan by basing it on a completely different concept — one that links benefits and contributions.
Chile allowed every worker to choose whether to stay in the state‐run, pay‐as‐you‐go social security system or to put the whole payroll tax into an individual retirement account. For the first time in history we have allowed the common worker to benefit from one of the most powerful forces on earth: compound interest.
Some 93% of Chilean workers chose the new system. They trust the private sector and prefer market risk to political risk. If you invest money in the market, it could go up or down. Over a 40‐year period, though, a diversified portfolio will have very low risk and provide a positive rate of real return. But when the government runs the pension system, it can slash benefits at any time.
The Chilean system is run completely by private companies. We now have 15 mutual funds competing for workers’ savings.