In 1981 Chile replaced its bankrupt pay-as-you-go retirement system with a fully funded system of individual retirement accounts managed by the private sector.[1] That revolutionary reform defused the fiscal time bomb that is ticking for countries with pay-as-you-go systems under which fewer and fewer workers have to pay for the retirement benefits of more and more retirees. More important, Chile created a retirement system that, by giving workers clearly defined property rights in their pension contributions, offers proper work and investment incentives; acts as an engine of, not an impediment to, economic growth; and enhances personal freedom and dignity.
Since the Chilean system was implemented, labor force participation, pension fund assets, and benefits have all grown. Today, more than 95 percent of Chilean workers have joined the system; the pension funds have accumulated $36 billion in assets; and the average real rate of return has been 10.9 percent per year.[2]
If imitation is the sincerest form of flattery, the Chilean system should be blushing from the accolades it has received. Since 1993 eight other Latin American nations have implemented pension reforms modeled after Chile’s. In March of 1999 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.
Although the basic story is well known, it is worth recapping briefly. Every month workers deposit 10 percent of the first $22,000 of earned income in their own individual pension savings accounts, which are managed by the specialized pension fund administration company of their choice. Those companies invest workers’ savings in a portfolio of bonds and stocks, subject to government regulations on the specific types of instruments and the overall mix of the portfolio. Contrary to a common misconception, fund managers are under no obligation to buy government securities, a requirement that would not be consistent with the notion of pension privatization. At retirement, workers use the funds accumulated in their accounts to purchase annuities from insurance companies. Alternatively, workers make programmed withdrawals from their accounts; the amount of those withdrawals depends on the worker’s life expectancy and those of his dependents. The government provides a safety net for those workers who, at retirement, do not have enough funds in their accounts to provide a minimum pension. But because the new system is much more efficient than the old government-run system and because, to qualify for the minimum pension under the new system, a worker must have at least 20 years of contributions, the cost to the taxpayer of providing a minimum pension funded from general government revenues has so far been very close to zero. (Of course, that cost is not new; the government also provided a safety net under the old program.)
The bottom line is that workers are retiring with better, more secure pensions and, increasingly, at an early age. For instance, since the early-retirement option was introduced in 1988, the average monthly pensions for workers retiring early have ranged from $258 (in 1989) to $318 (in 1994). By comparison, the representative worker in the United States retiring at age 62 is getting monthly benefits that range from $506 to $780 under Social Security.[3] That is an indication of the efficiency of the private system in Chile, not just in comparison with the old Chilean government-run social security system, but also in comparison with the government-run system in the United States, a country where per capita income is more than five times higher than in Chile. Chilean workers who retire at 65 are also getting benefits that are higher relative to per capita income than the benefits U.S. workers get under Social Security.
Through their pension accounts, Chilean workers have become owners of the means of production in Chile and, consequently, have grown much more attached to the free market and to a free society. This has had the effect of reducing class conflicts, which in turn has promoted political stability and helped to depoliticize the Chilean economy. Pensions today do not depend on the government’s ability to tax future generations of workers, nor are they a source of election-time demagoguery. To the contrary, pensions depend on a worker’s own efforts and thereby afford workers satisfaction and dignity.
Critics of the Chilean system, however, 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 European countries. 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 a single problem: excessive government regulation.
In Chile 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, return on investment–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 portfolios and 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.
Government restrictions on fees and returns have probably created distortions in the optimal mix of price, quality and service each fund manager would offer his customers under a more liberalized regime. As a result of those restrictions, fund managers emphasize the one variable over which they have the most discretionary power: quality of the service. (Before the airline industry was deregulated in the United States, airlines competed on service, rather than on price. That service might be thought of as the equivalent of “wasteful administration costs” in the absence of price competition. Similarly, banks in the United States competed on service before deregulation of the banking industry allowed them to engage in other forms of competition, such as offering better interest rates or lower fees.)
Although, in the eyes of the Chilean reformers, 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 21 years ago. They should take specific steps:
- Liberalize the commission structure to allow 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. If financial institutions were allowed to establish one-stop financial supermarkets, where consumers could obtain all their financial services if they so chose, the duplication of commercial and operational infrastructure could 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 with different tolerances for risk can choose funds that are optimal for them.
- Let pension fund management companies manage more than one variable-income fund. (At present, and since the spring of 2000, AFPs have been able to manage a second fund made up completely of fixed-income instruments. Consumer demand for that type of fund has been to date negligible.) 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.
- Give workers the option of personally managing their accounts. Thanks to the emergence of the World Wide Web as an investment tool, individuals could gain greater control over their retirement savings if they decided to administer their accounts themselves.
- Reduce the moral hazard created by the government safety net by linking the minimum pension to the number of years (or months) workers contribute.
- Adjust contribution rates in such a way that workers have to contribute only that percentage of their income that will allow them to purchase an annuity equal to the minimum pension. In other words, if a high-income worker can obtain an annuity equal to the minimum pension by contributing only 1 percent of his income, he should be able to do so and decide for himself how to allocate the rest of his income between present and future consumption.
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 infancy and adolescence. And unlike a pay-as-you-go system, a fully funded individual capitalization system can anticipate fewer problems as it matures.
Notes
[1] A lengthier treatment of the Chilean reform can be found in L. Jacobo Rodríguez “Chile’s Private Pension System at 18: Its Current State and Future Challenges.” Cato Institute Social Security Paper no. 17, July 30, 1999.
[2] For more statistical information on the Chilean system, see the official website of the Superintendencia de AFPs, the Chilean government regulator of the private pension system, at http://www.safp.cl.
[3] Information taken from the Office of the Chief Actuary, Social Security Administration, http://www.ssa.gov/OACT/COLA/IllusAvg.html.
