Economist Estelle James Examines Chile’s Pension System

February 25, 2005 • Commentary
This article appeared on Cato​.org on February 25, 2005.

Responding to recent criticisms of the Chilean private pension system, economist Estelle James penned an in‐​depth commentary in the Washington Post on the pros and cons of the Chilean system and what we can learn from their experience. James gives a detailed explanation of how the system functions and how it has fared thus far. From her explanation:

“Has it been a good deal? Yes. The annual rate of return excluding fees (more on that shortly) during the first 22 years was an astonishing 10 percent above inflation — fortunate for the new system but far above the rate that any country can maintain in the long run. However, even lower returns can ensure comfortable retirements. If the rate of return falls to 4.9 percent above inflation (a figure the U.S. Social Security Administration uses as the expected return of a mixed portfolio of stocks and bonds) while wages grow at 2 percent above inflation, the average Chilean worker who contributes until he retires at 65 would get 60 percent of his final wage plus a survivor’s pension for his spouse. (Under Social Security, a middle‐​income U.S. worker currently gets about 42 percent of his pre‐​retirement earnings.)

“Of course, it’s not that simple. Higher returns entail higher risks. Financial market swings pose some dangers for retirees who rely on personal accounts. But Chile has reduced risk in several ways. Most important, it established a minimum pension guarantee, financed out of general tax revenues, for any worker who contributes to a personal account for 20 years. Every year the government has raised the pension minimum, roughly in line with wage growth. This keeps the pension floor around 25 percent of the average wage, almost double the poverty line, for retirees who earned little or use up the money in their accounts. (A lower means‐​tested pension exists for those who contribute for less than 20 years.) Only 4 percent of all beneficiaries collect the pension subsidy so far, but the numbers are bound to grow, and Chile hasn’t figured out the ultimate costs, or how to pay for them.”

James goes on to list several lessons that reform advocates in the United States should heed in creating a similar system. The following excerpt discusses those lessons.

“What are the downsides to Chile’s scheme? What should we do differently here?

“First, workers in Chile had practically no investment choice for 20 years. Each asset manager could offer only one portfolio and portfolios were all similar. A young worker might have wanted to make riskier investments than an older worker, but that wasn’t an option. Chile recently modified its rules to enable each asset manager to offer five portfolios, with different degrees of risk. But now some low earners game the system and choose the riskiest investments, hoping for big gains while knowing that the government will give them the minimum pension if the risk does not pay off.

“If we create personal accounts in the United States, we should also make portfolio choices simple, limited and diversified — including international securities — to protect inexperienced investors from themselves.

“Second, Chile’s system initially had very high administrative costs, in part because fund managers had to invest in new information technologies and marketing tools. As assets grew, costs fell dramatically and are now about 1 percent of assets, lower than in the average U.S. mutual fund. Over a lifetime, costs in Chile are projected to reduce a worker’s final pension by 15 percent. In the United States, we can do better. We can enjoy economies of scale and the bargaining power obtained from aggregating many small accounts into enormous sums. For example, we could auction off the rights to run the funds to a limited number of asset managers, which would push down their fees. We could require the use of index funds and collect contributions through the existing tax collection system. The experience of the retirement plan for federal civil servants suggests that these techniques would cut our costs to about one‐​third of those in Chile.

“Third, Chile allows workers to stop contributing and start withdrawing once they meet a certain threshold. Most workers qualify before age 60, some even before 50 —and they have taken their annuities as soon as they can. Eventually many retirees will qualify for subsidies when the government’s minimum guarantee overtakes their annuities. (Taking the pension does not mean you must stop working. In fact, Chile encourages pensioners to continue working by exempting them from the payroll tax. This is good for their incomes and the economy.)

“Fourth, Chile’s minimum pension is good, but could be even better. On the plus side: It keeps low‐​income pensioners from falling way below the average standard of living. On the negative side: It offers no extra safety net for more than 20 years of work. Some low earners avoid contributing beyond 20 years because their additional contributions would simply replace subsidies they would get otherwise. In the United States, we could avoid creating such perverse incentives.”

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