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 be blushing from the accolades it has received. Since 1993 seven other Latin American nations have implemented pension reforms modeled after Chile’s. In March Poland became the first country in Eastern Europe to implement a partial privatization reform based on the Chilean model. In short, the Chilean system has clearly become the point of reference for countries interested in finding an enduring solution to the problem of paying for the retirement benefits of aging populations.
Critics of the Chilean system 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 and those in continental Europe. Some of those criticisms are misinformed. For example, administrative costs are about 1 percent of assets under management, a figure similar to management costs in the U.S. mutual fund industry. To the extent the criticisms are valid, they result from the same problem: excessive government regulation.
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, the return on investments made–is subject to a government‐mandated minimum return guarantee (a fund’s return cannot be more than 2 percentage points below the industry’s average real return in the last 12 months). That regulation forces the funds to make very similar investments and, consequently, have very similar 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 existence of government restrictions on fees and returns has probably created distortions in the optimal mix of price, quality and service each individual fund manager would offer to his customers under a more liberalized regime. As a result of those restrictions, most of the emphasis is placed on the one variable over which the manager has the most discretionary power: quality of the service.
Although, in the eyes of the Chilean reformers, those restrictions made sense at the beginning of the system in a country with little experience in the private management of long‐term savings, it is clear that such regulations have become outdated and may negatively affect the future performance of the system. Thus, in addressing the challenges of the system as it reaches adulthood, Chilean authorities should act with the same boldness and vision they exhibited 18 years ago. They should take specific steps:
- Liberalize the commission structure to allow the 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.
- Let other financial institutions, such as banks or regular mutual funds, enter the industry. That would result in lower prices for the services provided.
- Eliminate the minimum return guarantee, or, at the very least, lengthen the investment period over which it is computed.
- Further liberalize the investment rules, so that workers with different tolerances for risk can choose funds that are optimal according to their preferences.
- Let pension fund management companies manage more than one fund. One simple way to do this would be to allow those companies to offer a short menu of funds that range from very low risk to high risk. That could reduce administrative costs if workers were allowed to invest in more than one fund within the same company. This adjustment would also allow 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.
- As Latin American markets become more integrated, expand consumer sovereignty by allowing workers to choose among the systems in Latin America that 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, which has been to relax regulations as the system has matured and as the fund managers have gained experience. All the ingredients for the system’s success–individual choice, clearly defined property rights in contributions and private administration of accounts–have been present since 1981. If Chilean authorities address some of the remaining shortcomings with boldness, then we should expect Chile’s private pension system to be even more successful in its adulthood than it has been during its first 18 years.