Integrated Disability and Retirement Systems in Chile

Policy Reports | International | Social Security | Welfare

No. 302
Saturday, September 01, 2007
by Estelle James and Augusto Iglesias

Executive Summary

People are living longer and healthier lives, yet disability benefits are the fastest growing portion of social security expenditures in the United States and many other countries.  What can be done to restrain the rising cost of disability?  Chile may have found a partial answer. 

Chile once had a pay-as-you-go (PAYGO) public pension system similar to Social Security in the United States.  In PAYGO systems, the taxes of today's workers fund the benefits of today's retirees.  Chile was experiencing problems that are unavoidable in PAYGO systems, including the United States today:  Due to decreasing birth rates and increasing longevity, the number of workers supporting each retiree was falling, so the government could not finance all the promised benefits without ever-higher taxes.

Chile 's System of Private Insurance and Private Accounts.  Twenty-five years ago, Chile replaced its traditional old age security system with one in which workers contribute to accounts they individually own.  The money is invested by a pension fund chosen by each worker from among a number of competing, privately-owned firms.  Thus the retirement benefits of workers are largely prefunded by their own savings, rather than passing the burden on to others.  Many countries have followed Chile's lead and adopted retirement systems that include prefunded accounts.

At the same time, Chile reformed its disability insurance system. The new disability system is less well-known than its pension scheme, but it is equally innovative. First, like the old age system, it is prefunded, so each generation covers its own disability costs. Second, private pension funds and insurance companies participate in the process of assessing workers' disabilities, and financially benefit from controlling costs. Disability rates and costs in the new system are lower than in the old system and lower than in most other countries.

Features of the Chilean System.  Specifically, disabled workers who qualify are guaranteed a defined benefit for the balance of their lives:  70 percent of their average wage (if totally disabled) and 50 percent (if partially disabled).  The benefit is funded in two ways.  First, the money in the worker's retirement account is available in case of a disability.  Second, if the amount in the account is insufficient to pay for a lifetime annuity at the specified level, the balance is funded by a group disability insurance policy purchased by each pension fund and paid for by its affiliated workers.  Survivors' benefits for the spouse and minor children of a deceased worker are covered by the same group disability and survivors (D&S) insurance contract.  Thus, at the point when a worker has been certified as permanently disabled, his entire lifetime defined benefit has been funded by a combination of his own retirement account and a top-up from the D&S insurance.  This means that costs are not passed on to future generations. (If the 70 percent or 50 percent wage replacement rate for a disabled worker is less than the minimum pension guaranteed by the government, the worker's benefit is augmented by the public treasury.)

Modeling the Chilean System.  A model was developed to compare the disability insurance fee in Chile with the annual costs of covering disability benefits in a PAYGO system, assuming the same incidence of disability and levels of benefits.  The model predicts that annual costs will be higher in Chile for the first 14 years of the new system, compared to a PAYGO system, because individual accounts are small and the insurance fees have to finance reserves for a lifetime of annuity payouts.  But over time the insurance fee is expected to fall dramatically, as an increasing percentage of disability costs are funded by workers' accounts.  In the long run, fees in a Chilean-type system are predicted to be much less than annual costs in a PAYGO system. The model also showed that fees in a Chilean system would be very sensitive to the interest rate, rising as the rate of return on investments falls, but less sensitive to population aging than a PAYGO system. 

Indeed, actual combined fees for disability and survivors insurance in Chile fell until 1998 as accounts built up, then rose slightly due to falling interest rates.  As of 2005 the combined insurance fee was less than 1 percent of wages, much less than the tax that would be required to finance annual payouts to the disabled and survivors in a PAYGO system.  Annual fees are lower in Chile because disability benefits are financed partly by money in the workers' retirement accounts and partly by investment earnings on the annuity purchased by the worker, reducing the cost of the insurance top-up. 

Controlling Costs.  Total disability expenditures are also controlled through the participation of pension fund managers in determining disability criteria and administering disability benefits.  Unlike government bureaucrats, they have a financial interest in limiting the number of beneficiaries.  Independent medical boards determine the degree of a worker's disability based on medical criteria, but a nonvoting representative of the pension funds is usually present and may ask questions.  Pension funds are allowed to appeal disability determinations, in contrast to traditional public systems in which the worker is often the only party who may appeal.  Pension funds help set the medical criteria for full versus partial disability and keep the contribution records that determine whether or not a worker is eligible for the insurance top-up.  This system has reduced age-specific disability rates and therefore total disability costs. 

International Comparisons.  Although many other factors are undoubtedly involved, the incidence and costs of disability are much lower in Chile than in countries with traditional PAYGO systems:

  • In 1999, for example, among middle-aged (45-to-54) insured workers, 2.9 per 1,000 were newly classified as disabled in Chile, less than half the rate in the United States (7.8 per 1,000) and less than one-third the rate in European (OECD) countries (8.6 per 1,000).
  • The D&S fee in Chile is only 1 percent of wages, of which about two-thirds is for disability and one-third is for survivors.
  • In other Latin American countries that have adopted the Chilean model — such as Argentina and Colombia — D&S fees are 0.9 percent to 1.7 percent of wages. 
  • By contrast, PAYGO disability benefits in the United States are 1.8 percent of wages (and cover the disabled only until normal retirement age). 
  • They are over 3 percent of wages in most other OECD countries and up to 10 percent in some European countries.

Retaining Work Incentives.  Having a disability does not mean a worker is unable to work; rather, it is a medically-determined physical or mental impairment that can reduce a worker's earning capacity.  In most countries workers are not allowed to work while they receive disability benefits.  Very few beneficiaries return to work and relinquish their benefits.  In Chile, workers who are granted permanent disability status are allowed to continue working while retaining their annuity.  In this way, the Chilean disability system encourages work, benefiting the individual, the system and the economy.

Opportunities for Reform.   Countries around the world are faced with rising costs of social security programs.  In many countries, such as the United States, disability expenditures have been rising even faster than old age expenditures.  The experience of Chile suggests that these costs can be contained in the long run by prefunding and by private participation in the assessment procedure.  Publicly managed PAYGO systems might consider adopting processes that mimic these characteristics.

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