CHILE RETIREMENT ACCOUNTS On Social Security and Pension Reform: Lessons from Other Countries

STATEMENT of L. Jacobo Rodríguez Assistant Director, Project on Global Economic Liberty The Cato Institute

Subcommittee on Social Security of the Committee on Ways and Means United States House of Representatives

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My name is L. Jacobo Rodríguez and I am the assistant director the Project on Global Economic Liberty at the Cato Institute. I would like to thank Chairman Shaw for inviting me to testify. In the interest of transparency, let me point out that neither the Cato Institute nor I receive government money of any kind.

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.

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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.

I recently submitted the papers needed to start my own private pension scheme, now at the age of 23. It is in compliance with my obliged union(s) (sadly) deal with the employer, and with the support of the government, that I now pay around 3% of my income additionally to the around 10% I pay to my joint union/employer pension fund (collectively owned) to an individual fund that the union pension fund manages. As in the collective fund the employer eqauls what I put into the system, but I would like to increase the share my private fund has over the collective one.

Later I maybe will, although the current system gives me a lot of security, but I can choose into what collective fund I pay (there are many, many in the country, most of wich jointly run by the unions and the employer alliance), so if some financial company or bank starts a collective fund (the minimal number of participants is 100 persons) that will essentially keep my money in a lock box I will prefer that one. The possibility is there. I am now going to post a part of a speach by Icelands minister of finance, taken from here:

http://eng.fjarmalaraduneyti.is/Minister/speechesGHH/nr/578

"The Icelandic pension system can now almost be viewed as a model for other countries, and I believe that we have been able to manage things in such a way that we can look to the future without much worry.

Pension reforms in Iceland

Most countries today face challenges in the years ahead as a result of demographic changes where the proportion of older people will increase. I think everyone agrees that this calls for action and reforms. Furthermore, since reforms take time, the sooner reforms are implemented the better. This will serve the dual purpose of, firstly, to give the people affected, i.e. those retiring, more time to prepare and adjust while they are still of working age. Secondly, if reforms are delayed they will have to be all the more severe and may lead to distortions in the economy and adversely affect the fiscal balance.

As I said earlier, in many ways the situation as regards the pension system in Iceland seems to be better than in most other countries. Already, in the beginning of the 1970s we established a private pension fund scheme and it is now becoming more or less fully funded. Two years ago, similar changes were made to the public pension fund system and as a result of these reforms, this system will in due course be fully funded. Finally, at the beginning of this year important changes were implemented in order to strengthen the financial position of the funds and ensure similar pension rights for all pensioners. Increased freedom of choice, i.e. greater emphasis on voluntary pension savings, is also an important element.

As a result of these changes, the pension system in Iceland will gradually move from being essentially based on two pillars, i.e. a public pension scheme and a compulsory occupational pension fund scheme, to a three-pillar system with the addition of a voluntary private pension scheme. In this context, it is worth noting that this three-pillar approach is in close conformity with the recommendations of both the OECD and the World Bank.

The first pillar is publicly managed providing a tax-financed means-tested basic pension from the age of 67 and a means-tested supplementary pension from the age of retirement, usually at 65-70 years. The public pension scheme guarantees a minimum pension of about 44 per cent of the average before-tax salary of a male industrial worker.

The second pillar is a mandatory, more or less fully funded occupational scheme. According to present rules, a typical pension fund may pay a pension amounting to 45-58 per cent of average earnings in the age group 40-60 years with the first pillar adding another 11 per cent which brings the total replacement ratio to 60-70 per cent.

The third pillar, a fully funded voluntary savings plan, is still relatively small in Iceland. But the recent reforms, including a special tax incentive to pay into a private savings scheme of up to 4 per cent of the total income, will serve to gradually increase their role in the overall pension system in the coming years.

The Icelandic case is in many ways special. For instance, as regards the retirement age, there has never been a serious discussion about whether it should be lowered. If anything, many older people have felt that they should be allowed to work as long as they are fit and there is a demand for their services. As a result, we have one of the highest retirement age in Europe, in effect at 70, even though the official retirement age is 67. This is very important in order to prepare for future demographic changes.

Furthermore, there is a built-in disincentive for early retirement in the pension system where the level of pension payment is reduced if you retire early and the recent reforms go even further in this direction.

Thirdly, high employment has always been one of the main policy issues in Iceland and, as a result, there have only been brief spells of serious unemployment problems in Iceland. Therefore, we have not been forced to introduce widespread labour policy measures, many of which are now felt to provide strong disincentives to work in other countries. Finally, as I mentioned earlier, we had the good fortune to introduce a funded pension system in the early 1970s. All these factors have helped us be better prepared for meeting the demographic challenges ahead."

Maybe the US system should go into similar direction as ours has been. I beliewe though you have allready some kind of private pension scheme called by some three letter number and a k???? I like the idea of the author of the article of creating a private accounts with the surplus money, it will at least help in allowing that money to be invested in something else than government bonds, wich the government will just have to pay back some day.

The (collectively owned) Icelandic pension funds are by far the biggest owners of stock and bonds and all kinds of investmenst here and abroad in Iceland, actually it was in the news recently that when compared to population, the Icelandic funds were bigger than the oil induced Norweegian funds.

I like the Chilean pension system very much, and hopefully the role of the individual pension accounts will continu to increase in my country, the possibility for that is there at least in our current system, that has served us well, although it should be liberalized more. In fact some of the recommendation the Cato institute we could use here, some of them we are already doing.

The basic thing for the US I beliewe is to create the means of starting a private fund, however small it will initially be. Then little by little the pressure on increasing their role will grow stronger, as they accumulate more wealth by using other means of growth than government bonds over time. You should of course think longtime in these things, and by little by little replacing the current system with individual accounts, the old system can be phased out.

It will not be able to answer its committments in a near future, so just let it only answer those it can answer, not increas its role with added money inducement, or for it to have bigger role (like prescription drugs) so like our system will hopefully gradually be replaced with individual accounts, as the collective fund does not have to pay you as much if you have another source of income (like private accounts you get payments from) it can focus on helping those that need help, whose number will decrease with more and more people paying into their own personal accounts, more and more of their own money.

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