On Social Security and Pension Reform: Lessons from Other Countries
The Current State of Chile’s Private Pension System

In 1981 Chile replaced its bankrupt pay-as-you-go retirementsystem with a fully funded system of individual retirement accountsmanaged by the private sector.[1] Thatrevolutionary reform defused the fiscal time bomb that is tickingfor countries with pay-as-you-go systems under which fewer andfewer workers have to pay for the retirement benefits of more andmore retirees. More important, Chile created a retirement systemthat, by giving workers clearly defined property rights in theirpension contributions, offers proper work and investmentincentives; acts as an engine of, not an impediment to, economicgrowth; and enhances personal freedom and dignity.

Since the Chilean system was implemented, labor forceparticipation, pension fund assets, and benefits have all grown.Today, more than 95 percent of Chilean workers have joined thesystem; the pension funds have accumulated $36 billion in assets;and the average real rate of return has been 10.9 percent peryear.[2]

If imitation is the sincerest form of flattery, the Chileansystem should be blushing from the accolades it has received. Since1993 eight other Latin American nations have implemented pensionreforms modeled after Chile's. In March of 1999 Poland became thefirst country in Eastern Europe to implement a partialprivatization reform based on the Chilean model. In short, theChilean system has clearly become the point of reference forcountries interested in finding an enduring solution to the problemof paying for the retirement benefits of aging populations.

Although the basic story is well known, it is worth recappingbriefly. Every month workers deposit 10 percent of the first$22,000 of earned income in their own individual pension savingsaccounts, which are managed by the specialized pension fundadministration company of their choice. Those companies investworkers' savings in a portfolio of bonds and stocks, subject togovernment regulations on the specific types of instruments and theoverall mix of the portfolio. Contrary to a common misconception,fund managers are under no obligation to buy governmentsecurities, a requirement that would not be consistent with thenotion of pension privatization. At retirement, workers use thefunds accumulated in their accounts to purchase annuities frominsurance companies. Alternatively, workers make programmedwithdrawals from their accounts; the amount of those withdrawalsdepends on the worker's life expectancy and those of hisdependents. The government provides a safety net for those workerswho, at retirement, do not have enough funds in their accounts toprovide a minimum pension. But because the new system is much moreefficient than the old government-run system and because, toqualify for the minimum pension under the new system, a worker musthave at least 20 years of contributions, the cost to the taxpayerof providing a minimum pension funded from general governmentrevenues has so far been very close to zero. (Of course, that costis not new; the government also provided a safety net under the oldprogram.)

The bottom line is that workers are retiring with better, moresecure pensions and, increasingly, at an early age. For instance,since the early-retirement option was introduced in 1988, theaverage monthly pensions for workers retiring early have rangedfrom $258 (in 1989) to $318 (in 1994). By comparison, therepresentative worker in the United States retiring at age 62 isgetting monthly benefits that range from $506 to $780 under SocialSecurity.[3] That is an indication of theefficiency of the private system in Chile, not just in comparisonwith the old Chilean government-run social security system, butalso in comparison with the government-run system in the UnitedStates, a country where per capita income is more than five timeshigher than in Chile. Chilean workers who retire at 65 are alsogetting benefits that are higher relative to per capita income thanthe benefits U.S. workers get under Social Security.

Through their pension accounts, Chilean workers have becomeowners of the means of production in Chile and, consequently, havegrown much more attached to the free market and to a free society.This has had the effect of reducing class conflicts, which in turnhas promoted political stability and helped to depoliticize theChilean economy. Pensions today do not depend on the government'sability to tax future generations of workers, nor are they a sourceof election-time demagoguery. To the contrary, pensions depend on aworker's own efforts and thereby afford workers satisfaction anddignity.

Critics of the Chilean system, however, often point to highadministrative costs, lack of portfolio choice and the high numberof transfers from one fund to another as evidence that the systemis inherently flawed and inappropriate for other countries,including the United States and European countries. Some of thosecriticisms are misinformed. For example, administrative costs areabout 1 percent of assets under management, a figure similar tomanagement costs in the U.S. mutual fund industry. To the extentthe criticisms are valid, they result from a single problem:excessive government regulation.

In Chile pension fund managers compete with each other forworkers' savings by offering lower prices, products of a higherquality, better service or a combination of the three. The pricesor commissions workers pay the managers are heavily regulated bythe government. For example, commissions must be a certainpercentage of contributions regardless of a worker's income. As aresult, fund managers are prevented from adjusting the quality oftheir service to the ability (or willingness) of each segment ofthe population to pay for that service. That rigidity also explainswhy the fund managers have an incentive to capture the accounts ofhigh-income workers, since the profit margins on those accounts aremuch higher than on the accounts of low-income workers.

The product that the managers provide--that is, return oninvestment--is subject to a government-mandated minimum returnguarantee (a fund's return cannot be more than 2 percentage pointsbelow the industry's average real return in the last 12 months).That regulation forces the funds to make very similar investmentsand, consequently, have very similar portfolios and returns.

Thus, the easiest way for a pension fund company todifferentiate itself from the competition is by offering bettercustomer service, which explains why marketing costs and salesrepresentatives are such an integral part of the fund managers'overall strategy and why workers often switch from one company toanother.

Government restrictions on fees and returns have probablycreated distortions in the optimal mix of price, quality andservice each fund manager would offer his customers under a moreliberalized regime. As a result of those restrictions, fundmanagers emphasize the one variable over which they have the mostdiscretionary power: quality of the service. (Before the airlineindustry was deregulated in the United States, airlines competed onservice, rather than on price. That service might be thought of asthe equivalent of "wasteful administration costs" in the absence ofprice competition. Similarly, banks in the United States competedon service before deregulation of the banking industry allowed themto engage in other forms of competition, such as offering betterinterest rates or lower fees.)

Although, in the eyes of the Chilean reformers, restrictionsmade sense at the beginning of the system in a country with littleexperience in the private management of long-term savings, it isclear that such regulations have become outdated and may negativelyaffect the future performance of the system. Thus, in addressingthe challenges of the system as it reaches adulthood, Chileanauthorities should act with the same boldness and vision theyexhibited 21 years ago. They should take specific steps:

• Liberalize the commission structure to allow fund managers tooffer discounts and different combinations of price and quality ofservice, which would introduce greater price competition andpossibly reduce administrative costs to the benefit of allworkers.
• Let other financial institutions, such as banks or regularmutual funds, enter the industry. If financial institutions wereallowed to establish one-stop financial supermarkets, whereconsumers could obtain all their financial services if they sochose, the duplication of commercial and operational infrastructurecould be eliminated and administrative costs could be reduced.
• 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 withdifferent tolerances for risk can choose funds that are optimal forthem.
• Let pension fund management companies manage more than onevariable-income fund. (At present, and since the spring of 2000,AFPs have been able to manage a second fund made up completely offixed-income instruments. Consumer demand for that type of fund hasbeen to date negligible.) One simple way to do this would be toallow those companies to offer a short menu of funds that rangefrom very low risk to high risk. That could reduce administrativecosts if workers were allowed to invest in more than one fundwithin the same company. This adjustment would also allow workersto make prudent changes to the risk profile of their portfolios asthey get older. For instance, they could invest all the mandatorysavings in a low-risk fund and any voluntary savings in a riskierfund. Or they could invest in higher risk funds in their earlyworking years and then transfer their savings to a moreconservative fund as they approached retirement.
• As Latin American markets become more integrated, expandconsumer sovereignty by allowing workers to choose among thesystems in Latin America that have been privatized, which would putan immediate (and very effective) check on excessiveregulations.
• Give workers the option of personally managing their accounts.Thanks to the emergence of the World Wide Web as an investmenttool, individuals could gain greater control over their retirementsavings if they decided to administer their accountsthemselves.
• Reduce the moral hazard created by the government safety net bylinking the minimum pension to the number of years (or months)workers contribute.
• Adjust contribution rates in such a way that workers have tocontribute only that percentage of their income that will allowthem to purchase an annuity equal to the minimum pension. In otherwords, if a high-income worker can obtain an annuity equal to theminimum pension by contributing only 1 percent of his income, heshould be able to do so and decide for himself how to allocate therest of his income between present and future consumption.

Those adjustments would be consistent with the spirit of thereform, which has been to relax regulations as the system hasmatured and as the fund managers have gained experience. All theingredients for the system's success--individual choice, clearlydefined property rights in contributions, and privateadministration 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 tobe even more successful in its adulthood than it has been duringits infancy and adolescence. And unlike a pay-as-you-go system, afully funded individual capitalization system can anticipatefewer problems as it matures.

Notes

[1] A lengthier treatment of the Chilean reformcan be found in L. Jacobo Rodríguez "Chile'sPrivate Pension System at 18: Its Current State and FutureChallenges." Cato Institute Social Security Paper no. 17, July30, 1999.

[2] For more statistical information on theChilean system, see the official website of the Superintendencia deAFPs, the Chilean government regulator of the private pensionsystem, at http://www.safp.cl.

[3] Information taken from the Office of theChief Actuary, Social Security Administration, http://www.ssa.gov/OACT/COLA/IllusAvg.html.