Empowering People: The Privatization of Social Security


Mr. Chairman, distinguished members of the subcommittee:

My name is José Piñera and I am a Chilean citizen.I spent several years of my life at Harvard University, earning aMaster in Arts and a Ph.D. in economics, and my eldest son was bornduring those years in Boston. Today, I am president of theInternational Center for Pension Reform in Santiago, Chile, andco‐​chairman of the Cato Institute’s Project on Social SecurityPrivatization. As Minister of Labor and Social Security from 1978to 1980, I was responsible for the privatization of the Chileanpension system.

I want to thank Chairman Gramm for his invitation to me totestify in the U.S. Senate. In keeping with the truth in testimonyrequirements, let me first note that neither the Cato Institute northe International Center for Pension Reform receives any governmentmoney of any kind.

Social Security in the United States

The Social Security system of the United States is facing aprofound crisis. [1] According to thelatest report of its Board of Trustees, the system will beinsolvent by 2029, back from 2030 in last year’s report. Thatrepresents the eighth time in the last 10 years that the insolvencydate has been lowered.

But even that fact does not provide the full story of SocialSecurity’s looming crisis. The important date is 2012. SocialSecurity taxes currently bring in more revenue than the system paysout in benefits. The surplus theoretically accumulates in theSocial Security Trust Fund. However, in 2012 the situation willreverse. Social Security will begin paying out more in benefitsthan what it collects in revenues. To continue meeting itsobligations, it will have to begin drawing on the Trust Fund. Thetrouble is that this Fund is really little more than a politefiction. For years the federal government has used the Trust Fund,borrowing money from it to pay current operating expenses andreplacing the money with government bonds.

Even if Congress can find a way to redeem the bonds, the TrustFund will be completely exhausted by 2029. At that point, SocialSecurity will have to rely solely on revenue from the payroll tax.But such revenues will not be sufficient to pay all promisedbenefits. Either payroll taxes will have to be increased – tobetween 28 percent and 40 percent, according to various estimatesby the trustees – or benefits will have to be reduced by as much asone‐​third.

Moreover, even if Social Security’s financial difficulties couldbe fixed, the system remains a bad deal for most Americans, asituation that is growing worse for today’s young workers. Payrolltaxes are already so high that even if today’s young workersreceive the promised benefits, such benefits will amount to a low,below-market return on those taxes. While today’s retirees willgenerally get back all they paid into Social Security (includingthe employer’s portion) plus a modest return on their investment,when today’s young workers retire, they will actually receive anegative rate of return – that is, less than what they paid in. Atypical young worker today would actually be better off stuffinghis Social Security taxes in a mattress than counting on benefitsfrom the program.

Almost 30 years ago, visionary people like Nobel laureate JamesBuchanan understood that radical reform of the U.S. Social Securitysystem would be needed. [2]

Also economic growth in the United States would be higher ifSocial Security were to be privatized. Of course, I am not talkingabout the government investing the Social Security Trust Fund inprivate capital markets, a proposal fraught with danger, asprofessor Krzysztof Ostaszewski has clearly shown. [3]

I believe that the benefits of privatization would besubstantial. Harvard Professor Martin Feldstein, for example,estimates that “the combination of the improved labor marketincentives and the higher real return on savings (of moving to afully funded Social Security system) has a net present value gainof more than $15 trillion, an amount equivalent to 3 percent ofeach future year’s GDP forever.” [4]

Some might believe that privatizing social security would notbenefit the poor, but the opposite is the case, according toMichael Tanner of the Cato Institute. [5]Moreover, as Boston University Professor Laurence Kotlikoff andothers have shown,

Privatizing social security can, intragenerationally speaking,be quite progressive notwithstanding the fact that such a policywould eliminate the ongoing use of highly progressive socialsecurity benefit schedule. Part of the reason for this outcome isthat being forced to contribute to and receive a less‐​than‐​marketrate of return from “pay‐​as‐​you‐​go” social security represents alarger implicit tax for the poor because of the ceiling on socialsecurity taxable earnings. The other part is that the growth in thetax base permits the government to cut general revenues in a waythat can differentially benefit the poor. [6]

And, most important, today’s young workers would be assured thatwhen they retired, they would be able to do so with dignity andsecurity.

Let me, for the remainder of my time, bring you an idea, apowerful idea, that can save social security in the United Statesby privatizing its provision. That is exactly what we did in Chile16 years ago.

The Chilean PSA System [7]

In 1980, Chile approved a law (D.L. 3500) to fully replace agovernment‐​run pension system with a privately administered,national system of Pension Savings Accounts.

The new system began to operate on May 1, 1981 (Labor Day inChile). After 16 years of operation, the results speak forthemselves. Pensions in the new private system already are 50 to100 percent higher – depending on whether they are old-age,disability, or survivor pensions – than they were in thepay‐​as‐​you‐​go system. The resources administered by the privatepension funds amount to around 42 percent of Chile’s GNP. Byimproving the functioning of both the capital and the labormarkets, pension privatization has been one of the key initiativesthat, in conjunction with other free‐​market oriented structuralreforms, has pushed the growth rate of the economy upwards from thehistorical 3 percent a year to 7.0 percent on average during thelast 12 years.

In a recent work, UCLA Professor Sebastian Edwards has statedthat, “The [Chilean] pension reform has had important effects onthe overall functioning of the economy. Perhaps one of the mostimportant effects is that it has contributed to the phenomenalincrease in the country’s saving rate, from less than 10% in 1986to almost 29% in 1996.” [8] He goes on tosay that, “The pension reform has also had an important effect onthe functioning of the labor market. First, by reducing the totalrate of social security contributions it has reduced the cost oflabor. Second, by relying on a capitalization system it haseliminated the labor tax component of the retirement system.”

Under Chile’s Pension Savings Account (PSA) system, whatdetermines a worker’s pension level is the amount of money heaccumulates during his working years. Neither the worker nor theemployer pays a social security tax to the state. Nor does theworker collect a government‐​funded pension. Instead, during hisworking life, he automatically has 10 percent of his wagesdeposited by his employer each month in his own, individual PSA. Aworker may contribute an additional 10 percent of his wages eachmonth, which is also deductible from taxable income, as a form ofvoluntary savings.

A worker chooses one of the private Pension Fund Administrationcompanies (“Administradoras de Fondos de Pensiones,” AFPs) tomanage his PSA. These companies can engage in no other activitiesand are subject to government regulation intended to guarantee adiversified and low‐​risk portfolio and to prevent theft or fraud. Aseparate government entity, a highly technical “AFPSuperintendency,” provides oversight. Of course, there is freeentry to the AFP industry.

Each AFP operates the equivalent of a mutual fund that investsin stocks and bonds. Investment decisions are made by the AFP.Government regulation sets only maximum percentage limits both forspecific types of instruments and for the overall mix of theportfolio; and the spirit of the reform is that those regulationsshould be reduced constantly with the passage of time and as theAFP companies gain experience. There is no obligation whatsoever toinvest in government or any other type of bonds. Legally, the AFPcompany and the mutual fund that it administers are two separateentities. Thus, should an AFP go under, the assets of the mutualfund – that is, the workers’ investments – are not affected.

Workers are free to change from one AFP company to another. Forthis reason there is competition among the companies to provide ahigher return on investment, better customer service, or a lowercommission. Each worker is given a PSA passbook and every threemonths receives a regular statement informing him how much moneyhas been accumulated in his retirement account and how well hisinvestment fund has performed. The account bears the worker’s name,is his property, and will be used to pay his old age pension (witha provision for survivors’ benefits).

As should be expected, individual preferences about old agediffer as much as any other preferences. The old, pay‐​as‐​you‐​gosystem does not permit the satisfaction of such preferences, exceptthrough collective pressure to have, for example, an earlyretirement age for powerful political constituencies. It is aone‐​size‐​fits‐​all scheme that exacts a price in humanhappiness.

The PSA system, on the other hand, allows for individualpreferences to be translated into individual decisions that willproduce the desired outcome. In the branch offices of many AFPsthere are user‐​friendly computer terminals that permit the workerto calculate the expected value of his future pension, based on themoney in his account, and the year in which he wishes to retire.Alternatively, the worker can specify the pension amount he hopesto receive and ask the computer how much he must deposit each monthif he wants to retire at a given age. Once he gets the answer, hesimply asks his employer to withdraw that new percentage from hissalary. Of course, he can adjust that figure as time goes on,depending on the actual yield of his pension fund or the changes inthe life expectancy of his age group. The bottom line is that aworker can determine his desired pension and retirement age in thesame way one can order a tailor‐​made suit.

As noted above, worker contributions are deductible for incometax purposes. The return on the PSA is tax free. Upon retirement,when funds are withdrawn, taxes are paid according to the incometax bracket at that moment.

The Chilean PSA system includes both private and public sectoremployees. The only ones excluded are members of the police andarmed forces, whose pension systems, as in other countries, arebuilt into their pay and working conditions system. (In myopinion – but not theirs yet – they would also be better off with aPSA). All other employed workers must have a PSA. Self‐​employedworkers may enter the system, if they wish, thus creating anincentive for informal workers to join the formal economy.

A worker who has contributed for at least 20 years but whosepension fund, upon reaching retirement age, is below the legallydefined “minimum pension” receives that pension from the state oncehis PSA has been depleted. What should be stressed here is that noone is defined as “poor” a priori. Only a posteriori, after hisworking life has ended and his PSA has been depleted, does a poorpensioner receive a government subsidy. (Those without 20 years ofcontributions can apply for a welfare‐​type pension at a lowerlevel).

The PSA system also includes insurance against premature deathand disability. Each AFP provides this service to its clients bytaking out group life and disability coverage from private lifeinsurance companies. This coverage is paid for by an additionalworker contribution of around 2.9 percent of salary, which includesthe commission to the AFP.

The mandatory minimum savings level of 10 percent was calculatedon the assumption of a 4 percent average net yield during the wholeworking life, so that the typical worker would have sufficientmoney in his PSA to fund a pension equal to 70 percent of his finalsalary.

Upon retiring, a worker may choose from two general payoutoptions. In one case, a retiree may use the capital in his PSA topurchase an annuity from any private life insurance company. Theannuity guarantees a constant monthly income for life, indexed toinflation (there are indexed bonds available in the Chilean capitalmarket so that companies can invest accordingly), plus survivors’benefits for the worker’s dependents. Alternatively, a retiree mayleave his funds in the PSA and make programmed withdrawals, subjectto limits based on the life expectancy of the retiree and hisdependents. In the latter case, if he dies, the remaining funds inhis account form a part of his estate. In both cases, he canwithdraw as a lump sum the capital in excess of that needed toobtain an annuity or programmed withdrawal equal to 70 percent ofhis last wages.

The PSA system solves the typical problem of pay‐​as‐​you‐​gosystems with respect to labor demographics: in an aging populationthe number of workers per retiree decreases. Under the PSA system,the working population does not pay for the retired population.Thus, in contrast with the pay‐​as‐​you‐​go system, the potential forinter‐​generational conflict and eventual bankruptcy is avoided. Theproblem that many countries face – unfunded pensionliabilities – does not exist under the PSA system.

In contrast to company‐​based private pension systems thatgenerally impose costs on workers who leave before a given numberof years and that sometimes result in bankruptcy of the workers’pension funds – thus depriving workers of both their jobs and theirpension rights – the PSA system is completely independent of thecompany employing the worker. Since the PSA is tied to the worker,not the company, the account is fully portable. Given that thepension funds must be invested in tradable securities, the PSA hasa daily value and therefore is easy to transfer from one AFP toanother. The problem of “job lock” is entirely avoided. By notimpinging on labor mobility, both inside a country andinternationally, the PSA system helps create labor marketflexibility and neither subsidizes nor penalizes immigrants.

A PSA system is also much more efficient in promoting a flexiblelabor market. In fact, people are increasingly deciding to workonly a few hours a day or to interrupt their workinglives – especially women and young people. In pay‐​as‐​you‐​go systems,those flexible working styles generally create the problem offilling the gaps in contributions. Not so in a PSA scheme wherestop‐​and‐​go contributions are no problem whatsoever.

The Transition

One challenge is to define the permanent PSA system. Another, incountries that already have a pay‐​as‐​you‐​go system, is to managethe transition to a PSA system. Of course, the transition has totake into account the particular characteristics of each country,especially constraints posed by the budget situation.

In Chile we set three basic rules for the transition:

1. The government guaranteed those already receiving a pensionthat their pensions would be unaffected by the reform. This rulewas important because the social security authority would obviouslycease to receive the contributions from the workers who moved tothe new system. Therefore the authority would be unable to continuepaying pensioners with its own resources. Moreover, it would beunfair to the elderly to change their benefits or expectations atthis point in their lives.

2. Every worker already contributing to the pay‐​as‐​you‐ gosystem was given the choice of staying in that system or moving tothe new PSA system. Those who left the old system were given a“recognition bond” that was deposited in their new PSAs. (The bondwas indexed and carried a 4 percent real interest rate). Thegovernment pays the bond only when the worker reaches the legalretirement age. The bonds are traded in secondary markets, so as toallow them to be used for early retirement. This bond reflected therights the worker had already acquired in the pay‐​as‐​you‐​go system.Thus, a worker who had made pension contributions for years did nothave to start at zero when he entered the new system.

3. All new entrants to the labor force were required to enterthe PSA system. The door was closed to the pay‐​as‐​you‐ go systembecause it was unsustainable. This requirement assured the completeend of the old system once the last worker who remained in itreaches retirement age (from then on, and during a limited periodof time, the government has only to pay pensions to retirees of theold system).

After several months of national debate on the proposed reforms,and a communication and education effort to explain the reform tothe people, the pension reform law was approved on November 4,1980.

Together with the creation of the new system, all gross wageswere redefined to include most of the employer’s contribution tothe old pension system. (The rest of the employer’s contributionwas turned into a transitory tax on the use of labor to help thefinancing of the transition; once that tax was completely phasedout, as established in the pension reform law, the cost to theemployer of hiring workers decreased). The worker’s contributionwas deducted from the increased gross wage. Because the totalcontribution was lower in the new system than in the old, netsalaries for those who moved to the new system increased by around5 percent.

In that way, we ended the illusion that both the employer andthe worker contribute to social security, a device that allowspolitical manipulation of those rates. From an economic standpoint,all the contributions are ultimately paid from the worker’smarginal productivity, because employers take into account alllabor costs – whether termed salary or social securitycontributions – in making their hiring and pay decisions. Byrenaming the employer’s contribution, the system makes it evidentthat workers make all contributions. In this scenario, of course,the final wage level is determined by the interplay of marketforces.

The financing of the transition is a complex technical issue andeach country must address this problem according to its owncircumstances. The implicit pay‐​as‐​you‐​go debt of the Chileansystem in 1980 has been estimated by a recent World Bank study[9] at around 80 percent of GDP. (Thevalue of that debt had been reduced by a reform of the old systemin 1978, especially by the rationalization of indexing, theelimination of special regimes, and the raising of the retirementage.) That study stated that “Chile shows that a country with areasonably competitive banking system, a well‐​functioning debtmarket, and a fair degree of macroeconomic stability can financelarge transition deficits without large interest raterepercussions.”

Chile used five methods to finance the transition to a PSAsystem:

1. Since the contribution needed in a capitalization system tofinance adequate pension levels is generally lower than the currentpayroll taxes, a fraction of the difference between them was usedas a temporary transition payroll tax without reducing net wages orincreasing the cost of labor to the employer (the gradualelimination of that tax was considered in the original law and, infact, that happened, so that today it does not exist).

2. Using debt, the transition cost was shared by futuregenerations. In Chile roughly 40 percent of the cost has beenfinanced issuing government bonds at market rates of interest.These bonds have been bought mainly by the AFPs as part of theirinvestment portfolios and that “bridge debt” should be completelyredeemed when the pensioners of the old system are no longer withus.

3. The need to finance the transition was a powerful incentiveto reduce wasteful government spending. For years, the budgetdirector has been able to use this argument to kill unjustified newspending or to reduce wasteful government programs, thereby makinga crucial contribution to the increase in the national savingsrate.

4. The increased economic growth that the PSA system promotedsubstantially increased tax revenues. Only 15 years after thepension reform, Chile is running fiscal budget surpluses of around2 percent of GNP.

5. In a theoretical state’s balance sheet (where each governmentshould show its assets and liabilities), state pension obligationsmay be offset to some extent by the value of state‐​ownedenterprises and other types of assets. Privatizations in Chile werenot only one way to contribute, although marginally, to finance thetransition, but had several additional benefits such as increasingefficiency, spreading ownership, and depoliticizing theeconomy.

The Results

The PSAs have already accumulated an investment fund of $30billion, an unusually large pool of internally generated capitalfor a developing country of 14 million people and a GDP of $70billion.

This long‐​term investment capital has not only helped fundeconomic growth but has spurred the development of efficientfinancial markets and institutions. The decision to create the PSAsystem first, and then privatize the large state‐​owned companiessecond, resulted in a “virtuous sequence.” It gave workers thepossibility of benefiting handsomely from the enormous increase inproductivity of the privatized companies by allowing workers,through higher stock prices that increased the yield of their PSAs,to capture a large share of the wealth created by the privatizationprocess.

One of the key results of the new system has been to increasethe productivity of capital and thus the rate of economic growth inthe Chilean economy. The PSA system has made the capital marketmore efficient and influenced its growth over the last 15 years.The vast resources administered by the AFPs have encouraged thecreation of new kinds of financial instruments while enhancingothers already in existence, but not fully developed. Another ofChile’s pension reform contributions to the sound operation andtransparency of the capital market has been the creation of adomestic risk‐​rating industry and the improvement of corporategovernance. (The AFPs appoint outside directors in the companies inwhich they own shares, thus shattering complacency at boardmeetings.)

Since the system began to operate on May 1, 1981, the averagereal return on investment has been 12 percent per year (more thanthree times higher than the anticipated yield of 4 percent). Ofcourse, the annual yield has shown the oscillations that areintrinsic to the free market – ranging from minus 3 percent to plus30 percent in real terms – but the important yield is the averageone over the long term.

Pensions under the new system have been significantly higherthan under the old, state‐​administered system, which required atotal payroll tax of around 25 percent. According to a recentstudy, the average AFP retiree is receiving a pension equal to 78percent of his mean annual income over the previous 10 years of hisworking life. As mentioned, upon retirement workers may withdraw ina lump sum their “excess savings” (above the 70 percent of salarythreshold). If that money were included in calculating the value ofthe pension, the total value would come close to 84 percent ofworking income. Recipients of disability pensions also receive, onaverage, 70 percent of their working income.

The new pension system, therefore, has made a significantcontribution to the reduction of poverty by increasing the size andcertainty of old‐​age, survivors, and disability pensions, and bythe indirect but very powerful effect of promoting economic growthand employment.

When the PSA was inaugurated in Chile in 1981, workers weregiven the choice of entering the new system or remaining in the oldone. One fourth of the eligible workforce chose the new system byjoining in the first month of operation alone. Today, more than 93percent of Chilean workers are in the new system.

As the state pension system disappears, politicians will nolonger decide whether pension checks need to be increased and inwhat amount or for which groups. Thus, pensions are no longer a keysource of political conflict. A person’s retirement income willdepend on his own work and on the success of the economy, not onthe government or on the pressures brought by special interestgroups.

For Chileans, pension savings accounts now represent real andvisible property rights – they are the primary sources of securityfor retirement. After 16 years of operation of the new system, infact, the typical Chilean worker’s main asset is not his used caror even his small house (probably still mortgaged), but the capitalin his PSA.

Finally, the private pension system has had a very importantpolitical and cultural consequence. Indeed, the new pension systemgives Chileans a personal stake in the economy. A typical Chileanworker is not indifferent to the behavior of the stock market orinterest rates. Intuitively he knows that his old age securitydepends on the wellbeing of the companies that represent thebackbone of the economy.

The Global Pension Crisis

The real specter haunting the world these days is the specter ofbankrupt state‐​run pension systems. The pay‐​as‐​you‐​go pensionsystem that has reigned supreme through most of this century has afundamental flaw, one rooted in a false conception of how humanbeings behave: it destroys, at the individual level, the essentiallink between effort and reward – in other words, between personalresponsibilities and personal rights. Whenever that happens on amassive scale and for a long period of time, the result isdisaster.

Two exogenous factors aggravate the results of that flaw: (1)the global demographic trend toward decreasing fertility rates;and, (2) medical advances that are lengthening life. As a result,fewer and fewer workers are supporting more and more retirees.Since the raising of both the retirement age and payroll taxes hasan upper limit, sooner or later the system has to reduce thepromised benefits, a telltale sign of a bankrupt system.

Whether this reduction of benefits is done through inflation, asin most developing countries, or through legislation, the finalresult for the retired worker is the same: anguish in old agecreated, paradoxically, by the inherent insecurity of the “socialsecurity” system.

The success of the Chilean private pension system has led threeother South American countries to follow suit. In recent years,Argentina (1994), Peru (1993), and Colombia (1994) undertook asimilar reform. Mexico, Bolivia, and El Salvador have alreadyapproved laws that will reform their state‐​run pension systemsfollowing the Chilean model. The new system in those countries willbegin operation in the next few months (for example, July 1 inMexico).

The Chilean experience can also be instructive to countriesaround the world, including the United States. In a report toCongress released earlier this year, five members of the AdvisoryCouncil on Social Security, led by Ms. Carolyn Weaver, an earlyadvocate of this line of reform, recommended the transformation ofthe current pay‐​as‐​you‐​go system into a two‐​tier system that wouldinclude privately‐​held individual accounts. Already, economistshave begun to write alternative plans to finance the transition inthe United States. [10] (Withoutendorsing any specific proposal, the Cato Project on SocialSecurity Privatization will present a number of possible transitionscenarios.)

As an indication of the power of ideas, even officials from thePeople’s Republic of China have come to Chile to study the privatepension system. Indeed, I have just returned from a conference inShanghai, where I met with top government officials whodemonstrated a clear interest in Chilean‐​style pension reform. Itis possible that before entering the new millennium, several othercountries, including all those in the Americas, will haveprivatized their pension system along the Chilean model. This wouldmean a massive redistribution of power from the state toindividuals, thus enhancing personal freedom, promoting fastereconomic growth, and alleviating poverty, especially in oldage.

Mr. Chairman, let me conclude with a warning about the damagingmoral effects of social security and other social insuranceprograms issued at the dawn of the New Deal:

The lessons of history, confirmed by evidence immediately beforeme, show conclusively that continued dependence on relief induces aspiritual and moral disintegration fundamentally destructive to thenational fiber. To dole out relief in this way is to administer anarcotic, a subtle destroyer of the human spirit. It is inimical tothe dictates of sound policy. It is a violation of the traditionsof America. [11]

That warning was issued by President Franklin Delano Rooseveltin his 1935 State of the Union address.

Thank you very much.


[1] For anoverview of the social security crisis, see Peter G. Peterson,Will America Grow Up Before It Grows Old?,Random House, 1996.

[2] JamesM. Buchanan, “Social Insurance in a Growing Economy: A Proposal forRadical Reform.” National Tax Journal,Vol. 21 (December 1968): 386 – 95.

[3]Krzysztof Ostaszewski, “Privatizing the Social Security TrustFund? Don’t Let the Government Invest.” CatoInstitute Social Security Paper No.6 (January 14, 1997).

[4] MartinFeldstein, “The Missing Piece in the Policy Analysis: SocialSecurity Reform.” American EconomicReview, Vol. 86, No. 2 (May 1996).

[5]Michael Tanner, “Privatizing Social Security: A Big Boost forthe Poor.” CatoInstitute Social Security Paper No. 4 (July 26,1996).

[6]Laurence Kotlikoff et al., “Privitazing U.S. Social Security‐​ASimulation Study.” Paper presented at the World Bank Conference on“Pension Systems: From Crisis to Reform,” November 1996.

[7] Thissection follows José Piñera, “Empowering Workers: ThePrivatization of Social Security in Chile.” Cato’s LetterNo. 10, Cato Institute (1996).

[8]Sebastian Edwards, “The Chilean Pension Reform: A PioneeringProgram.” Paper presented at the NBER Conference, “PrivatizingSocial Security,” August 1 – 2, 1996.

[9] WorldBank, Averting the Old Age Crisis(1994).

[10]See, for instance, Peter Ferrara, “A Plan for PrivatizingSocial Security.” CatoInstitute Social Security Paper No. 8 (April 30,1997).

[11]Franklin D. Roosevelt, The Public Papers andAddresses of Franklin D. Roosevelt, Vol. 4,The Court Disapproves: 1935, Random House,1938.

José Piñera

Subcommittee on Securities
Committee on Banking, Housing and Urban Affairs
The United States Senate