Empowering People: The Privatization of Social Security in Chile

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 Bunning for his invitation to me totestify. In keeping with the truth in testimony requirements, letme first note that neither the Cato Institute nor the InternationalCenter for Pension Reform receives any government money of anykind.

The Worldwide 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.

For example, the OECD projects that government retirementbenefits alone will exceed 16 percent of GDP annually in Germany,France, and Italy by 2030. According to the OECD, the currentunfunded liabilities of the public pension systems in France,Germany, and Japan are well over 100 percent of their respectiveGDPs. In the United States, your Social Security system will beginrunning a deficit in just 15 years.

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.

When I was secretary of labor and social security in Chile, wefaced similar problems with our social security system. In 1981, wedecided to replace our U.S.-style pay-as-you-go system with a newsystem based on individually-owned, privately invested accounts,details of which I will provide in a few minutes. This system hasbeen an overwhelming success for 16 years and is now being copiedthroughout the world.

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).

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.

The Chilean PSA System

Let me tell you a little more about the Chilean model. In 1980,Chile approved a law (D.L. 3500) to fully replace a government-runpension system with a privately administered, national system ofPension 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." He goes on to say that, "The pension reformhas also had an important effect on the functioning of the labormarket. First, by reducing the total rate of social securitycontributions it has reduced the cost of labor. Second, by relyingon a capitalization system it has eliminated the labor taxcomponent 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:

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 ataround 80 percent of GDP. (The value of that debt had been reducedby a reform of the old system in 1978, especially by therationalization of indexing, the elimination of special regimes,and the raising of the retirement age.) That study stated that"Chile shows that a country with a reasonably competitive bankingsystem, a well-functioning debt market, and a fair degree ofmacroeconomic stability can finance large transition deficitswithout large interest rate repercussions."

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

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.

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.

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.

Mr. Chairman, I will not try to spell out in detail exactly howa Chilean-style system can be established in the United States. Letme simply say that I believe it is possible for the United Statesto move to a social security system based on individual accountsand private investment. The transition to such a system will betechnically tricky but can be done. Several of your country's topexperts are now at work designing such transition proposals. I donot pretend that Chile's system can be imported to the UnitedStates without any changes. But, I do believe that you can learnfrom our successful experiment.

Thank you very much.