Integrated Disability and Retirement Systems in Chile

Studies | International | Social Security | Welfare

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

Lessons for Other Countries

This paper has focused on the impact of private incentives and prefunding on disability insurance costs in Chile.  Disability claims and costs seem to be relatively low compared with other countries.  Further research is needed to determine whether this process results in more accurate medical evaluations and whether Chile has chosen the right trade-off between benefits and costs.

Following are three ways that prefunded disability benefits can be integrated into individual retirement account systems, while overcoming some of the problems mentioned above.

Model 1:  Prefunding and Private Insurance with Risk-Pooling and Competitive Bidding. Countries with individual accounts could get the benefits of prefunding and private participation while reducing the risk of creaming and the interest-rate sensitivity mentioned above. They could place workers in one large risk pool and auction off the provision of disability term insurance to a private firm every 3 to 5 years in a competitive bidding process.  The entire contract would then go to one company (or a small number of companies to which workers are randomly assigned), instead of the decentralized provision in Chile.  The company winning the auction would have the task of topping up disabled workers' account balances to finance the defined disability benefit.

Both publicly-appointed experts and insurance company representatives would participate in the assessment process, similar to the procedure in Chile.  But, since everyone would be in the same pool, this company would not be able to select workers and, since the contract would be long-term, fee fluctuations tied to the interest rate would be smoothed.  In the long run, annual fees would continue to be kept low by investment returns on the funds, private monitoring of the assessment process, and the economies of scale and bargaining power stemming from the competitive bidding process. 30

However, a monopoly insurance company chosen by AFPs might have little incentive to monitor costs carefully, hoping to cover them by higher fees in the next round of bidding.  AFPs would also have less incentive to control costs, since any savings would be shared among the entire AFP and/or insurance industry.  Thus, some of the savings due to the incentives of AFPs to control costs would be lost.  Additionally, since they would not be able to change their fees each year, insurance companies might charge a high-risk premium to compensate for interest-rate smoothing over the contract period.  In that case, the shift toward a single pool and long term contract might reduce selection by AFPs but might also reduce oversight and raise costs overall. Notably, the Chilean government is currently proposing the adoption of such a system, apparently trading off cost minimization under the current system for other goals, such as uniform prices across individuals and through time.

“Option 2: Insurance could cover the disabled only up to the normal retirement age.”

Model 2: Prefunding with Private Provision, Only Until Normal Retirement Age.  As a variation on this model, insurance companies might finance the disability pension only for a fixed term, until the normal retirement age (say, age 65), at which point the old age benefit would take over.  This switch to normal retirement age is roughly consistent with current practice in the United States.  In this case, the individual's money would remain in his account, collecting interest, until age 65.  At that point, the disability annuity would cease and he would be treated similarly to normal retirement pensioners.

This variation would imply less uncertainty for the insurance company and less incentive for older workers to apply for disability benefits, because the disability annuity would cover a shorter time period.  Both of these would reduce disability costs.  But some workers would see their benefits fall substantially when they reach normal retirement age, if the old age pension is lower than the disability pension.  If part of the normal retirement pension is PAYGO, this variation would also imply a smaller shift to prefunding, therefore smaller short-run transition costs.  However, in the long-run annual cost saving would be lower, because prefunding and investment earnings are lower for the system as a whole.

“Option 3: Disability benefits paid by a government agency on a PAYGO basis, cost more in the long- run.”

Model 3: Public Provision, Largely PAYGO. The third option is to use a government agency, rather than private companies, to provide disability benefits — even though a country has a system of individual retirement accounts.  A government agency would take the money in the retirement accounts of disabled workers and pay them a defined benefit.  This system would be partially prefunded by the money in the accounts, but the rest of the benefit would be financed on a PAYGO basis.  Because of the smaller amount of prefunding, short-run costs would be lower and long-run costs higher than in a Chilean-type scheme.  Costs would be less sensitive to interest rate variations, but more sensitive to population aging, than a fully funded scheme.  Among countries with individual account systems, this method was used in Hungary and Croatia to avoid transition costs.  Latvia, Estonia and Sweden use this method only until normal retirement age, at which point disabled workers are treated like normal retirees.

The reliance on public management does not provide the cost controls that come from private participation in the assessment procedure.  Nevertheless, it might be possible to adapt some elements of the Chilean assessment process.  For example, the public agency responsible for the program could be given the right to appeal approved cases, or to oppose claimants' appeals, represented by lawyers who have incentives to win cases.  This should increase the probability that both sides would be presented — the argument for paying the benefit and, in questionable cases, the argument for denial — while leaving the final decision to an impartial court or body of experts. 31

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