Mr. Chairman and members of the Subcommittee, I appreciate theopportunity to testify today on Chile’s private pension system,especially since it has become the model for countries around theworld that have reformed their public pension systems or areconsidering doing so.1
In 1924 Chile was the first country in the hemisphere toimplement a state‐run retirement system. In 1981, Chile became thefirst country in the world to replace its bankrupt pay‐as‐you‐gopension system with an investment‐based privately managed system ofindividual retirement accounts. The problems that are currentlyputting pressure on workers and public retirement programs in somany countries also plagued Chile’s government‐run system,ultimately making it fiscally unviable: payroll taxes were high andsaw large increases, the implicit debt of the public system wasover 100 percent of GDP, the ratio of workers to retirees saw asignificant and continuous decline, and the government wascontributing to more than a third of the public pension system’srevenues.2
Chile’s pioneering reform addressed the above problems bycreating a fully funded system whose principal features areindividual choice, clearly defined property rights, and the privateadministration of accounts. By linking effort and reward, thereform offers proper investment and work incentives, and hascontributed to Chile’s impressive growth rates.
Since the private pension system was implemented, labor forceparticipation, pension fund assets, and benefits have increased.Today, 95 percent of Chilean workers have joined the system; thepension funds have accumulated assets of some $58 billion,amounting to more than 75 percent of Chilean GDP; and the averagereal rate of return on the pension funds has been 10.24percent.3
The Chilean Private PensionSystem
Every month workers deposit 10 percent of the first $22,000 ofearned income in their own individual pension savings accounts,which are managed by the specialized pension fund administrationcompany of their choice. (There are currently six competing pensionfund companies in Chile.) Those companies invest workers’ savingsin a portfolio of bonds and stocks, subject to governmentregulations on the specific types of instruments and the overallmix of the portfolio. Fund managers can invest up to 30 percent ofthe portfolio overseas, a measure that allows workers to hedgeagainst currency fluctuations and country risk. At retirement,workers use the funds accumulated in their accounts to purchaseannuities from insurance companies. Alternatively, workers makeprogrammed withdrawals from their accounts (the amount of thosewithdrawals depends on the worker’s life expectancy and those ofhis dependents); or a worker can choose temporary programmedwithdrawals with a deferred lifetime annuity.
The government provides a safety net for those workers who, atretirement, do not have enough funds in their accounts to provide aminimum pension. But because the new system is much more efficientthan the old government‐run system and because, to qualify for theminimum pension under the new system, a worker must have at least20 years of contributions, the cost to the taxpayer of providing aminimum pension funded from general government revenues has so farbeen small‐about 0.1 percent of GDP.4 (Of course, that cost is not new; the governmentalso provided a safety net under the old program.) Those who havenot contributed for 20 years and have not accumulated sufficientfunds to meet the minimum pension can apply for a lowerwelfare‐type pension.
When the reform began, workers already in the labor force weregiven a choice to join the new system or remain in the old. Thosewho chose to switch to the private system were given “recognitionbonds” that reflected past contributions to the public pensionprogram and that are paid by the government upon a worker’sreaching the legal retirement age. New entrants into the laborforce were required to join the new pension system, thus eventuallyending the unsustainable pay‐as‐you‐go system. The benefits ofthose already retired and receiving a pension at the time of thereform were not affected.
The transition to the private system was financed in a number ofways. It should be noted that the net economic costs of moving froman unfunded pay‐as‐you‐go system to a fully funded system are zero.That is to say, the total funded and unfunded debt of a countrydoes not change by moving from an unfunded system to a funded one.There is, however, a cash flow problem when moving toward a fullyfunded retirement system. In the case of Chile, transition costscan be broken down into three different parts. First, there is thecost of paying for the retirement benefits of those workers whowere already retired when the reform was implemented and of thoseworkers who chose to remain in the old system. That makes up by farthe largest share of the transition costs at present. These costswill decline as time goes by. Second, there is the cost of payingfor the recognition bonds given to those workers who moved from theold system to the new in acknowledgement of the contributions theyhad already made to the old system. Since these bonds will beredeemed when the recipients retire, this cost to the governmentwill gradually increase as transition workers retire (but willeventually disappear). It is worth stressing that these are newexpenditures only if we assume that the government would renege onits past promises. The third cost to the government is that ofproviding a safety net to the system, a cost that is not new in thesense that the government also provided a safety net under the oldpay‐as‐you‐go system.
To finance the transition, Chile used five methods. First, itissued new government bonds to acknowledge part of the unfundedliability of the old pay‐as‐you‐go system. Second, it soldstate‐owned enterprises. Third, a fraction of the old payroll taxwas maintained as a temporary transition tax. That tax had a sunsetclause and is zero now. Fourth, it cut government expenditures.And, fifth, pension privatization and other market reforms havecontributed to high growth in Chile, which in turn has increasedgovernment revenues, especially those coming from the value addedtax.
In sum, the transition to the new system has not been an addedburden on Chile because the country was already committed to payingretirement benefits. On the contrary, the transition has actuallyreduced the economic and fiscal burden of maintaining anunsustainable system.
In the new private system, workers have become owners of themeans of production, or “worker capitalists,” in the words ofJosé Piñera, Chile’s former minister of labor andsocial security who implemented the reform.5 This paradigm shift from a consumption toan investment‐based system has positively impacted the country’spolitical economy by reducing class conflict and depoliticizing alarge part of Chilean economy.
Commonly Heard Criticisms of the ChileanSystem
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. Some of those criticisms aremisinformed. For example, administrative costs are less than 1percent of assets under management, a more favorable figure thanmanagement costs in the U.S. mutual fund industry. Other criticismsare highly misleading. To the extent the criticisms are valid,shortcomings in the private system typically result from excessivegovernment 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 or 4 percentagepoints, depending on the type of fund, or 50 percent below theindustry’s average real return in the last 36 months). Thatregulation forces the funds to make similar investments and,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.
The following is a closer look at some of the more frequentlyheard criticisms of Chile’s private pension system.
“The Administrative Costs are Too High”
Critics often claim that the commissions that workers pay to thepension funds are exorbitant. The often‐cited figure of 18 – 20percent represents administrative costs as a percentage of currentcontributions, which is not how administrative costs are usuallymeasured. This figure is usually obtained by dividing thecommission fee, which is on average equivalent to 2.37 percent oftaxable wages, by the total contribution (10 percent plus thecommission). This calculation fails to take into account that the2.3 percent includes the life and disability insurance premiums(about 0.95 percent of taxable wages on average6) that workers pay, which are deductedfrom the variable commission, and thus overstates administrativecosts as a percentage of total contributions.
The proper way to measure administrative costs is as apercentage of assets under management. In Chile, the administrativecosts of the private pension system are 0.66 percent of assetsmanaged.7 The Chileanpension fund administrators’ association calculates that thecommissions the industry charges are 0.63 percent of assets undermanagement, far lower than such fees charged by other fund managersincluding U.S. mutual funds that charge about 1.38percent.8
Prior to the above findings, others have calculated similarlylow administrative costs. Chilean economist Salvador Valdésestimated the average annual cost of the AFP system to beequivalent to 0.84 percent of total assets under management overthe life cycle of the worker.9 The Congressional Budget Office estimated in 1999that the administrative costs of private retirement accounts inChile “can be equivalently expressed as 1 percent ofassets.“10 Whenadministrative costs are compared to the old government‐run system,the criticism is even less convincing. Chilean economistRaúl Bustos Castillo has estimated the costs of the newsystem to be 42 percent lower than the average costs of the oldsystem.11
To the extent that such administrative costs are stillconsidered too high, that is the result of government regulationson the commissions the AFPs can charge and on the investments thesecompanies can make. The existence of a “return band” preventsinvestment product differentiation among the different AFPs. As aresult, the way an individual AFP tries to differentiate itselffrom the competition is by offering better service to itscustomers. One way to provide better service would be to offer adiscount on the commission fee to workers who fit a certain profile– e.g., workers who have maintained their account for an extendedperiod of time or who contribute a certain amount of money to theiraccounts; however, government regulations do not allow that. Thoseregulations state that the AFPs may only charge a commission basedon the worker’s taxable income and expressed as a percentage ofthat income.
“The Coverage Under the New System is Low”
Critics also say that some 30 – 40 percent of Chilean workers arenot participating in the private system. Although the number ofChileans participating in the private system is actually greaterthan the work force (some Chileans affiliated to the private systemhave left the work force), only about 61 percent of thoseparticipating in the employed work force regularly contribute totheir private accounts. According to the Chilean pension fundregulatory agency, that method of calculation underestimates realcoverage because it counts only workers who have contributed in aparticular month even though other workers who made contributionsin previous months will also receive benefits from the system.Including workers who have contributed within the past year,coverage in the private system amounted to 69.7 percent of the workforce, which is greater than that of the previous public system inthe four years prior to the reform. From 1976 – 1980, coverage underthe old system “averaged 67 percent of the workforce, with a cleardownward trend.“12
Others have also found that coverage in the private system isgreater than that of the old system. Measuring coverage as thosewho contribute on a regular monthly basis, the percentage of theemployed work force covered in the private system (more than 60percent) is superior to the coverage of the old system beforereform (54 percent in 1980) and it has been increasing. See graphbelow.13
Several factors explain why coverage is not higher in Chile. Theself‐employed, who represent about 30 percent of the work force,are not required to participate in the private system. Only about 6percent of the self‐employed contribute on a regular basis. Workerswho are unemployed also do not contribute to the system (theunemployment rate has been between 8 – 10 percent in Chile in thepast five years.) Moreover, of the 3.4 million people affiliatedwith the private pension system, 1.44 million‐including students orwomen who have stopped working to care for children, forexample‐are not currently in the work force.14 There is also a large informaleconomy, which is typical of developing countries. Lastly, theevidence suggests a strong relationship between economicdevelopment and the level of coverage around the world (higher percapita incomes correlate with higher coverage). 15
In short, the level of coverage under the system does notreflect negatively on the private pension system itself. To theextent that coverage could improve, factors not inherent to theprivate system, such as rigidities in the labor market and the sizeof the informal economy, would have to be addressed by other publicpolicies. In addition, only beginning around the year 2025, whenthe first generation of workers who have contributed during theirentire working lives begins to retire, will it be fair to comparethe private system with the old system.
“Too Many Workers Will Depend on the Minimum Pension andthe System Will Impose Large Costs”
The Chilean finance ministry estimates that the average numberof minimum pensions that it will be supplementing per month in 2005will be 65,000. The costs of doing so are minimal and currentlystand at 0.1 percent of GDP. Part of the reason that the cost islow is that the government does not provide the full amount of theminimum pension since a worker has some assets in his/her account.On average, the government provides 20 – 30 percent of the capitalneeded to finance the minimum pension. Indeed, the public cost offinancing pensions, most of which is made up of meeting theobligations of the old system, is projected to continue falling(see Table 1).16
|Table 1: Civil SocialSecurity Deficit Forecast|
|Year||Public Pensions||Recognition Bonds||Welfare Pensions||Minimum AFP Pensions||Total|
|2002||3% GDP||1.2% GDP||0.4% GDP||0.1% GDP||4.7% GDP|
|2012||2% GDP||1.2% GDP||0.4% GDP||0.27% GDP||3.87% GDP|
|Difference||-1% GDP||0% GDP||0.4% GDP||0.17% GDP||-0.83% GDP|
|REDUCTION OF FISCAL SPENDINGON PENSIONS: ‑0.83% OF GDP
(Source: Ministry of Finance Budget Department, MacroeconomicAspects of the Draft Law for the Public Sector, 2002; andAsociación AFP)
It is estimated that the percentage of members affiliated to theprivate pension system that will receive government supplements forthe minimum pension (only those who have contributed 20 years areeligible) will vary between 1.9 and 10.5 percent depending on therates of return.17
“Workers Change Pension Fund Administration CompaniesToo Frequently”
Because of investment regulations and rules on fees andcommissions, product differentiation is low. Thus companies competeby offering gifts or other incentives for workers to switch totheir companies. Switchovers increased dramatically from 1988, theyear when the requirement to request in person the change from oneAFP to another was eliminated, until 1997, when the governmentreintroduced some restrictions to make it more difficult forworkers to transfer from one AFP to another. The number oftransfers in 1998 – 2000 decreased to less than 700,000, less than500,000, and slightly more than 250,000, respectively, from anall‐time high of almost 1.6 million in 1997. Transfers have sincefallen to about 228,000 per year.
Liberalizing the Chile’s Private PensionSystem
It is clear that some of the regulations mentioned above havebecome outdated and may negatively affect the future performance ofthe system. Fortunately, Chilean authorities have taken someimportant steps in addressing the challenges of a more maturesystem.
The most important structural reform in recent years is theintroduction of multiple investment funds. Up until 2000, thepension fund management companies could only manage one fund. Thatyear, the regulatory framework was changed to allow the AFPs tooffer a second fund, invested only in fixed income instruments.That reform proved to be insufficient, as very few workers decidedto switch their savings from the diversified fund to thefixed‐income one. Indeed, consumer demand for the fixed‐income fundwas negligible. What was needed was to let pension fund managementcompanies manage more than one variable‐income fund.
Chilean authorities finally adopted this reform in early 2002when they instituted a rule that mandated AFPs to offer 5 differentfunds that range from very low risk to high risk. One advantage ofhaving several funds administered by the same company is that thatcould reduce administrative costs if workers were allowed to investin more than one fund within the same company. This adjustment alsoallows workers to make prudent changes to the risk profile of theirportfolios as they get older. For instance, they could invest allthe mandatory savings in a low‐risk fund and any voluntary savingsin a riskier fund. Or they could invest in higher risk funds intheir early working years and then transfer their savings to a moreconservative fund as they approached retirement. Table 2 shows themaximum percentages of equity investment allowed in each fund:
|Maximum Percentage Allowed||Mandatory Minimum Percentage|
|Fund E||Not Allowed||Not Allowed|
The introduction of a family of funds is an important step andconsumers are behaving as one would expect — that is, bydiversifying their investments across the menu of funds. Othersteps that have been taken in the recent past include:
The lengthening of the investment period over which the minimumreturn guarantee is computed to 36 months from 12 months and thewidening of the band from 2 to 4 percentage points for some type offunds;
The further liberalization of the investment rules, so thatworkers with different tolerances for risk can choose funds thatare optimal for them; and
The expansion of consumer choice with the signature of abilateral accord with Peru that allows workers from those twocountries to choose the pension system with which they want to beaffiliated.
Other specific steps that Chilean regulators should take toensure the continuing success of the private pension systeminclude: Liberalizing the commission structure to allow fundmanagers to offer discounts and different combinations of price andquality of service (which would introduce greater price competitionand possibly reduce administrative costs to the benefit of allworkers); letting other financial institutions, such as banks orregular mutual funds, enter the industry;18 giving workers the option of personallymanaging their accounts through the world wide web; and reducingthe moral hazard created by the government safety net by linkingthe minimum pension to the number of years (or months) workerscontribute.
Those adjustments would be consistent with the spirit of thereform, which has been to adapt the regulatory structure as thesystem has matured and as the fund managers have gained experience.In summary, the Chilean private pension system, despite minorshortcomings, is a success story by any measure and deservedlycontinues to be the model for rich and poor countries around theworld that are considering reforming their retirement systems.
1I thank JacoboRodríguez from whose work I have borrowed liberally and withpermission.
2Jacobo Rodríguez,“Chile’s Private Pension System at 18: Its Current and FutureChallenges,” Cato Institute Social Security paper no. 17, 1999, p.3.
3For detailed statistics ofthe Chilean pension system, see the website of the Superintendenciade AFPs, the Chilean government regulator of the private pensionsystem, www.safp.cl
4Ministry of Finance,Chile.
5See JoséPiñera, “Liberating Workers: The World Pension Revolution,“Cato’s Letter no. 15, 2001.
6Rubén Castro, “Segurode Invalidez y Sobrevivencia: Qué Es y Qué LeEstá Pasando,” Documento de Trabajo no. 5, Superintendenciade AFP, May 2005, p.12.
7Superintendencia de AFP, TheChilean Pension System (Santiago: Superintendencia de AFP, 2003),p. 154.
8Asociacion AFP, “The AFPsCharge Lower Commissions Than Other Institutions, Both Local andForeign,” Research Series paper no. 42, June 2004, available atwww.afp-ag.cl.
9Salvador Valdés, “LasComisiones de las AFPs ¿Caras o Baratas?” EstudiosPúblicos, Vol. 73 (Verano 1999): 255 – 91.
10Congressional BudgetOffice, Social Security Privatization: Experiences Abroad, sec. 2,p. 7 (January 1999).
11Raúl BustosCastillo, “Reforma a los Sistemas de Pensiones: Peligros de losProgramas Opcionales en América Latina.” In Sergio Baeza andFrancisco Margozzini, eds., Quince Años Después: UnaMirada al Sistema Privado de Pensiones (Santiago, Chile: Centro deEstudios Públicos, 1995), pp. 230 – 1. However, comparing theadministrative costs of the old system with those of the new one isinappropriate, because the underlying assumption when making thatcomparison is that the quality of the product (or the productitself) being provided is similar under both systems, which iscertainly not the case in Chile.
12The Chilean PensionSystem, pp. 120 – 23.
15Robert Holzmann, TrumanPackard, and Jose Cuesta, “Extending Coverage in MultipillarPension Systems: Constraints and Hypotheses, Preliminary Evidenceand Future Research Agenda,” in Robert Holzmann and Joseph E.Stiglitz, eds. New Ideas About Old Age Security (Washington: WorldBank, 2001), p. 454; and Asociación AFP.
16Ministry of Finance andAsociación AFP, “The AFP System: Myths and Realities,“August 2004, available at www.afp-ag.cl.
17Asociación AFP;the rates of return assumed are 3 percent, 5 percent, and 7percent.
18 If financialinstitutions were allowed to establish one‐stop financialsupermarkets, where consumers could obtain all their financialservices if they so chose, the duplication of commercial andoperational infrastructure could be eliminated and administrativecosts could be reduced.