In May 1981 Chile adopted a revolutionary reform by replacing its bankrupt pay-as-you-go retirement system with a fully funded system of individual retirement accounts managed by the private sector. The new system is based on three important pillars: freedom of choice, private-sector management and property rights in the retirement accounts. In its 18 years, the private retirement system has been an enormous success: more than 95 percent of Chilean workers have joined the system; the pension funds have accumulated over $34 billion in assets; and the average real rate of return has been 11.3 percent per year.
If imitation is the sincerest form of flattery, the Chilean system should beblushing from the accolades it has received. Since 1993 seven other LatinAmerican nations have implemented pension reforms modeled after Chile's. InMarch Poland became the first country in Eastern Europe to implement apartial privatization reform based on the Chilean model. In short, theChilean system has clearly become the point of reference for countriesinterested in finding an enduring solution to the problem of paying for theretirement benefits of aging populations.
Critics of the Chilean system often point to high administrative costs, lackof portfolio choice and the high number of transfers from one fund toanother as evidence that the system is inherently flawed and inappropriatefor other countries, including the United States and those in continentalEurope. Some of those criticisms are misinformed. For example,administrative costs are about 1 percent of assets under management, afigure similar to management costs in the U.S. mutual fund industry. To theextent the criticisms are valid, they result from the same problem:excessive government regulation.
Pension fund managers compete with each other for workers' savings byoffering lower prices, products of a higher quality, better service or acombination of the three. The prices or commissions workers pay themanagers are heavily regulated by the government. For example, commissionsmust be a certain percentage of contributions regardless of a worker'sincome. As a result, fund managers are prevented from adjusting the qualityof their service to the ability (or willingness) of each segment of thepopulation to pay for that service. That rigidity also explains why thefund managers have an incentive to capture the accounts of high-incomeworkers, since the profit margins on those accounts are much higher than onthe accounts of low-income workers.
The product that the managers provide--that is, the return on investmentsmade--is subject to a government-mandated minimum return guarantee (a fund'sreturn cannot be more than 2 percentage points below the industry's averagereal return in the last 12 months). That regulation forces the funds tomake very similar investments and, consequently, have very similar returns.Thus, the easiest way for a pension fund company to differentiate itselffrom the competition is by offering better customer service, which explainswhy marketing costs and sales representatives are such an integral part ofthe fund managers' overall strategy and why workers often switch from onecompany to another.
The existence of government restrictions on fees and returns has probablycreated distortions in the optimal mix of price, quality and service eachindividual fund manager would offer to his customers under a moreliberalized regime. As a result of those restrictions, most of the emphasisis placed on the one variable over which the manager has the mostdiscretionary power: quality of the service.
Although, in the eyes of the Chilean reformers, those restrictions madesense at the beginning of the system in a country with little experience inthe private management of long-term savings, it is clear that suchregulations have become outdated and may negatively affect the futureperformance of the system. Thus, in addressing the challenges of the systemas it reaches adulthood, Chilean authorities should act with the sameboldness and vision they exhibited 18 years ago. They should take specificsteps:
- Liberalize the commission structure to allow the fund managers to offerdiscounts and different combinations of price and quality of service, whichwould introduce greater price competition and possibly reduce administrativecosts to the benefit of all workers.
- Let other financial institutions, such as banks or regular mutual funds,enter the industry. That would result in lower prices for the servicesprovided.
- Eliminate the minimum return guarantee, or, at the very least, lengthenthe investment period over which it is computed.
- Further liberalize the investment rules, so that workers with differenttolerances for risk can choose funds that are optimal according to theirpreferences.
- Let pension fund management companies manage more than one fund. Onesimple way to do this would be to allow those companies to offer a shortmenu of funds that range from very low risk to high risk. That could reduceadministrative costs if workers were allowed to invest in more than one fundwithin the same company. This adjustment would also allow workers to makeprudent 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 fundand any voluntary savings in a riskier fund. Or they could invest in higherrisk funds in their early working years and then transfer their savings to amore conservative fund as they approached retirement.
- As Latin American markets become more integrated, expand consumersovereignty by allowing workers to choose among the systems in Latin Americathat have been privatized, which would put an immediate (and very effective)check on excessive regulations.
Those adjustments would be consistent with the spirit of the reform, whichhas been to relax regulations as the system has matured and as the fundmanagers have gained experience. All the ingredients for the system'ssuccess--individual choice, clearly defined property rights in contributionsand private administration of accounts--have been present since 1981. IfChilean authorities address some of the remaining shortcomings withboldness, then we should expect Chile's private pension system to be evenmore successful in its adulthood than it has been during its first 18 years.