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

How Adverse Selection Is Reduced

In PAYGO systems, workers often have an incentive to claim disability because their disability benefits start earlier than or exceed their normal retirement benefits.  In Chile, prefunding through account ownership reduces this incentive because workers eventually get their own money regardless of their disability status.  Although other features of the Chilean system encourage some workers to seek disability instead of retirement benefits, or to qualify for insured status by timing their participation in the system to increase their net benefits, the system contains safeguards against such costly behavior.

“Workers with a high risk of disability and small accounts have an incentive to enter the system and claim the higher disability benefits.”

Adverse Selection Based on the Risk of Disability.   Adverse selection results when workers with a higher risk of disability become insured and file claims while healthy workers avoid paying into the system. This could potentially be a big problem in Chile. On average, Chilean workers contribute for about 60 percent of their potential working lives; the rest of the time they are out of the labor force, self-employed or in the informal sector. 19 Participation in the system by the self-employed and independent contractors is voluntary.  Healthy workers can avoid contributing by working in the self-employed or informal sector, and move to the formal employment sector if a disability claim seems likely.  This could raise insurance costs substantially.

Adverse Selection by Workers with Small Account Balances and Large Top-Up.  Workers approaching old age who have contributed only a few years, who therefore have only small retirement accounts, also have a strong incentive to re-enter the contributory system and apply for disability benefits.  They may not have enough savings to get a 70 percent wage replacement rate on the basis of normal retirement.  However, if they qualify for disability insurance because they are currently contributing, they could receive the 70 percent wage replacement rate guaranteed to disabled workers, which is much more than their own account balances would support: 

  • To fund retirement benefits equal to the 70 percent replacement rate offered by the disability system, an individual who has contributed for the last 20 years and wishes to retire at age 60 would need an annual rate of return of more than 11 percent.
  • A person who has contributed only for the last 10 years would need a 23 percent rate of return.

Neither of these rates of return are likely, and they exceed the average annual 10 percent rate of return above inflation that the AFPs have earned to date.  Thus, many individuals who have not contributed throughout their adult lives will fare better by contributing and applying for disability benefits.  In contrast, workers with large accounts don't gain from disability benefits, and may try to stop contributing as soon as possible. This is a kind of adverse selection, since it leaves a disproportionate number of individuals in the system who will require a large top-up, if they should become disabled.

“Chile holds these incentives in check by monitoring and enforcing rules.”

AFPs and Adverse Selection.  In traditional systems it is sometimes difficult to avoid strategic behavior by high-risk individuals or by individuals with only a few years of contributions.  Eligibility conditions for insurance were not well enforced in the past in Latin America and many other countries due to poor record-keeping and incentives facing public agencies.  In Chile, AFPs combat adverse selection by monitoring and enforcing insurance eligibility rules.  They keep the contribution records of affiliated workers and thus can ensure that they have contributed long enough to be eligible for disability insurance.

“Workers must contribute regularly for 10 years to receive disability benefits equal to 70 percent of their full, average wage.”

How the Reference Wage Discourages Strategic Behavior.  Another way the Chilean system discourages strategic behavior by workers with irregular contribution histories is by setting a low reference wage.  The reference wage is used to determine a worker's wage that benefits will replace.  It is based on a worker's average wage during the last 10 years.  For each of the last 10 years a worker has not contributed to the system, a zero is averaged in, lowering his reference wage and benefit, even if he is eligible for disability insurance.  For example: 

  • The wage replacement rate for a steady worker who becomes disabled is 70 percent, but a worker who contributed only 60 percent of the last 10 years would receive only 42 percent of his working wage (60 percent of 70 percent). 20
  • The widow of an average disabled beneficiary would get 60 percent of his benefit, or 25 percent of the wage he got when working (60 percent of 42 percent).

AFPs use their records to ensure that the rules defining the reference wage are strictly applied, making it less advantageous for a worker who has not contributed for all of the preceding 10 years to apply for disability insurance.  Thus adverse selection is diminished.  Even if a worker successfully applies, the lower reference wage saves the system money.  Of course, this also means many individuals get low benefits, which the government may end up subsidizing through the minimum pension guarantee.

Positive Selection by AFPs.  One way AFPs keep disability costs down, according to industry representatives, is by attracting and retaining workers with low disability risks while avoiding high-risk ones—replacing adverse selection by positive selection.  AFPs are not permitted to exclude workers who want to affiliate but they can encourage or discourage certain workers from affiliating by their choice of location, sales efforts and fee structure. 21   This selection process reduces an AFP's cost.  It does not reduce costs for the system as a whole — it simply shifts costs from one AFP to another — if it does not change total system membership.  However, it will reduce system costs if these efforts increase coverage of low-risk workers.  Also, if different AFPs follow different strategies, or are more effective than others, this can make it difficult for some workers to get into the AFP of their choice.  High-risk workers may end up pooled together in AFPs with high fees, low service or low profits — thereby re-introducing differentiated fees.  These are likely to be the older, larger AFPs, which are left with their old clientele through inertia.  In contrast, the newer AFPs try to cream the better risks, using data that were not originally available.  Data on AFP behavior suggest that they are also the AFPs most likely to keep system costs down by fighting false claims efficiently.

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