Integrated Disability and Retirement Systems in Chile

Studies | International | Social Security | Welfare

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


Introduction

Twenty-five years ago, Chile replaced its traditional social security system with one in which workers make mandatory contributions to accounts they individually own.  Each worker contributes 10 percent of wages to his or her personal retirement account, plus another 2.4 percent to cover administrative expenses, and survivors' and disability insurance.  The money is invested by a pension fund, called an AFP (for Administradoras de Fondos de Pensiones), chosen by workers from among a number of competing, privately-owned firms. Thus the retirement benefits of workers are prefunded by their own savings.  [See the side bar “Personal Retirement Accounts in Chile.”]

Personal Retirement Accounts in Chile

In the early 1980s, Chile replaced its traditional social security system with a prefunded system in which workers make mandatory contributions to accounts they individually own. Each worker covered
by the system must contribute 10 percent of wages to his or her personal retirement account, plus another 2.4 percent to cover administrative expenses and survivors and disability insurance.

The money is invested by a pension fund, called an AFP (for Administradoras de Fondos de Pensiones), chosen by workers from among a number of competing, privately-owned firms. AFPs must invest according to strict guidelines. Over the past 25 years account investments have earned an average annual 10 percent rate of return, after adjusting for inflation. (The rate of return is expected to fall in the long run.)

Payouts are also tightly circumscribed: When they retire, workers can choose between annuities
and programmed withdrawals. For annuities, workers turn their accounts over to an insurance company and receive a guaranteed income for life, indexed for inflation, but forgo the right to leave a bequest to heirs. About two-thirds of retired workers annuitize. For programmed withdrawals, the account is left with a pension fund administrator and retirees annually withdraw an amount determined by a preset formula. Retirees who choose programmed withdrawals can bequeath any funds remaining
in their account at their death to their heirs, but they run the risk of exhausting their accounts before they die. Regardless of the option chosen, the government makes a minimum pension guarantee (MPG) to all workers who have contributed for 20 years. The MPG is about 25 percent of the average wage, rising to 27 percent at age 70 and 29 percent at 75.

Chile's pension system also provides insurance for widows financed by their husbands rather than by the public treasury. Married men who annuitize must buy joint annuities, which provide the surviving widow at least 60 percent of the husband's annuity (if there are surviving dependent children, the annuity provides 50 percent to the widow plus 15 percent to each child). The formula for programmed
withdrawals also includes these provisions for widows and survivors.

Also, workers have a choice of the age at which they begin to withdraw their money from the system. The normal retirement age is 65 for men, 60 for women. After this age, workers may begin withdrawing funds regardless of the amount accumulated. But workers are permitted to take early retirement
and make early withdrawals at any age once they have accumulated an account balance large enough to finance a pension that is 150 percent of the MPG and 70 percent of their own average wage. For these workers, further contributions are voluntary rather than mandatory.

It is important to note that “early retirement from the system” does not mean “retirement from the labor force.” It simply means workers start withdrawing from, and may stop contributing to, their retirement accounts. In fact, the elimination of the required contribution may have a positive impact on the labor supply of older workers. Preliminary evidence indicates that the labor force participation of older workers has been rising since the mid-1980s, very likely as a result of the pension reform.

See Alejandra Cox Edwards and Estelle James, “Pension Reform and Postponed Retirement: Evidence from Chile,” Michigan Retirement Research Center, Working Paper 2005-098.

The disability insurance system in Chile is much less well-known than its pioneering pension system, but it is equally innovative.  It differs from traditional public disability insurance in two important ways: 1) it is largely prefunded; and 2) the disability assessment procedure includes participation by private pension funds and insurance companies, which have a direct pecuniary interest in controlling costs.  This paper describes how Chile handles disability insurance, and draws lessons from that experience for other countries, including the United States.

“Workers in Chile can withdraw funds from their individually-owned retirement
accounts if they become disabled.”

The United States and many other countries have traditional pay-as-you-go (PAYGO) defined-benefit public pension systems.  In PAYGO systems, today's workers pay Social Security taxes to fund benefits for today's beneficiaries.  Due to falling birth rates and increasing longevity, the number of workers supporting each retiree is falling.  Thus, public retirement systems that transfer income from today's workers to today's retirees will require ever-higher taxes on current workers to pay benefits.  To avoid the problems inherent in PAYGO systems, many countries have followed Chile's lead and adopted retirement systems that include prefunded accounts.  The United States has also considered such a system.

Disability and survivors' benefits constitute the fastest growing portion of social security expenditures in the United States and many other countries. 2 It is particularly difficult to incorporate these programs into a system with personal retirement accounts.  Workers who contribute steadily to a funded account may be able to fund ample retirement benefits.  But those who become disabled when young have small individual account balances that could only replace a small percentage of their wages. Moreover, if the personal account is topped-up to provide a more generous defined disability benefit, workers may be encouraged to apply for disability rather than old age (retirement) benefits, thereby increasing system costs.  Chile's experience shows how a personal retirement account system can handle problems associated with disability insurance.


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