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

The Chilean System versus PAYGO

In addition to the cost reductions stemming from incentives faced by AFPs, further long-run economies are achieved by prefunding in Chile. Some of the prefunding takes place through the retirement accounts, which are used to pay part of the disability benefit.  In effect, the account does double duty, covering disability as well as retirement at no additional cost.  Prefunding also takes place when a top-up is added to the account of a disabled worker, so that the account is sufficient to finance a lifetime annuity.  In the long run, the Chilean approach results in lower annual fees than a PAYGO system would, for equivalent benefits. Insurance Fees versus Payouts in Chile

“Insurance costs fell below benefit payouts as workers' accounts grew.”

Evolution of Costs in Chile over Time.   Figure II compares total disability benefits paid out in Chile with insurance fees for the top-up from 1990 to 2004.  Both numbers are given as a percentage of the total wages covered.  Total disability benefits reveal what the cost to workers would have been if the system were PAYGO. When the prefunded Chilean retirement and disability system was young, annual insurance fees were much higher than benefits paid out because individual accounts were small and the insurance fee had to finance reserves for a lifetime of annuity payouts. 22 Today, insurance fees are much smaller than payouts to current beneficiaries.  Payouts have gone up due to the growth in the number of individuals receiving disability benefits, but insurance costs have gone down because an increasing share of benefits are funded from workers' retirement accounts.

“In the long run, insurance fees in a PAYGO system will be four times as much as fees under the prefunded Chilean system.”

Simulated Costs in a Chilean-Type System versus a PAYGO System.    Paying benefits on a PAYGO basis requires annual contributions equal to the total annual benefit payout.  Furthermore, as a PAYGO system matures, the stock of beneficiaries increases relative to the flow of newly disabled workers.  As a result, system costs rise and a higher contribution rate is required.  This contrasts with a Chilean-type system in which annual insurance costs must only cover the top-up for newly disabled workers and will fall as the system matures and the personal accounts grow in size.  A simulation of these contrasting patterns of costs is shown in Figure III.  The model (summarized in the Appendix) shows that for two systems with the same benefits, workers and wages: 23

  • In the first year of a Chilean-type system, insurance costs amount to 1.35 percent of wages, compared to costs of only 0.08 percent of wages in a PAYGO system.
  • In year 14 these annual costs are both about 1.1 percent.
  • But in the long run (steady state), total costs in a Chilean-type system fall to 0.67 percent of wages, whereas total costs for a PAYGO system would be four times as much, or 2.73 percent of wages.

Simulated Disability Insurance Fees in a Chilean-Type System versus a PAYGO* System Part of the reason for this dramatic fall in costs in a Chilean-type scheme is that accounts grow and cover a larger share of the total disability annuity costs as the system matures.  Figure IV shows that:

  • In the first year, employee accounts cover just 1 percent of the system's disability annuity costs.
  • By the 14th year, employee accounts cover 15 percent of the system's disability annuity costs.
  • In the very long-run, employee accounts cover more than half of the system's disability annuity costs.

“Personal retirement accounts will eventually cover half the cost of disability annuities.”

Projected investment earnings by AFPs or insurance companies during the payout stage will cover another quarter of the cost.  Thus the annual cost of disability insurance in a Chilean-type scheme is only 25 percent of what it would be in a PAYGO system with the same benefits, in the long run.

Since the incidence of disability is higher for older workers, population aging will lead to higher disability rates and costs in both a Chilean and a PAYGO system.  However, the costs in a Chilean scheme will be partially offset by the increasing size of the workers' accounts as they age.  Thus, as workers live longer, costs will not rise as much as they will in a PAYGO system. Simulated Percentage of System

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