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Privatizing Social Security in Latin America
January 1999
Introduction
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"Seven other Latin American countries have followed Chile's example to some degree." "Features of reform very from one country to another, but private administration, individual accounts and investment in real assets are fundamental elements."
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Almost 18 years ago, Chile privatized its pension system, a move that eventually led to one of its most important cultural and economic transformations of the latter part of this century. Seven other Latin American countries have followed the Chilean example to some degree, and several others are considering such a move. [See Figure I.]
All of the Latin American social security reforms share three fundamental elements: (1) private administration, (2) individual accounts and (3) investment in real assets. Other features vary from one country to another. For example, some countries guarantee a minimum pension on retirement while others do not. Several allow new workers to join either the old state-run system or the new private system. Required contributions from workers vary among countries, and in some employers are required to contribute while in others they are not. [See Table I.] The pressure of an aging population and a shrinking pool of active workers to support the system - a prominent problem in the U.S. social security system - has been secondary in Latin America, where most populations are younger. Instead, their primary motivation has been to boost savings rates and develop financial markets.
This study looks first at the principles of pension reform in Chile, the pioneer in privatizing social security, and then at the reforms in other countries, describing the differences as well as the problems. Some of the analysis is subjective, reflecting the experience the author gained from helping to design the Chilean system in 1980 as a member of the Technical Committee that advised former Minister Jose Piñera.
The Chilean Model
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"In 1981 Chile replaced the public system with a private system in which benefits were directly related to worker contributions." "The new private system was based on capital accumulation rather than insurance." "Pension Fund Administrators (AFPs) manage and administer individual accounts, but don't own them." "There is a minimum pension guarantee designed to keep a pensioner out of poverty." "Pension fund investments are limited to conservative options." "The insurance and administrative fee currently averages about 2.7 percent (down in the last year from about 3 percent)." "About 0.7 percentage points is used to acquired private life insurance for the worker." "Retirees can choose three options: An immediate life annuity, scheduled withdrawals or a blend of temporary income with a deferred life annuity." |
Like most state-run programs, including that of the United States, Chile's old social security system operated on a pay-as-you-go basis. Taxes collected from current workers paid benefits to current retirees. The benefits workers ultimately received from the system bore little relationship to the amounts they contributed through payroll deductions.
Defects of the Old System.
The old system comprised a number of separate social security systems. There was one system for manual workers, another for salaried employees, still another for government workers and about 50 additional programs for workers in different occupations and different locations. The groups with the greatest political influence had the most favorable programs.1- Some workers paid lower payroll taxes than others for similar benefits.
- Some salaried workers received retirement benefits equal to 100 percent
of average wages for their last five years of employment, while manual workers
received only 75 percent.
- Some workers were allowed to collect benefits after only 35 years of employment, while the general system for manual workers had a retirement age of 65.
Reform Options: Insurance or Capital Accumulation? Once the decision had been made that benefits would directly relate to contributions, Chile considered two ways to organize the new system: on the basis of insurance or of capital accumulation.
Under an insurance-based system, workers would contract with an insurance company to receive a pension in exchange for regular contributions (premiums). The relationship between the contribution and the pension would be determined by expected long-term market returns in effect at the time the agreement was signed.
The primary advantage of this defined-benefit approach is that workers know exactly how much their monthly benefit will be upon retirement. However, such a system presents a significant risk for the insurer, which must commit to a specific rate of return in order to pay benefits. Moreover, long-term investment instruments of this type were rare in Chile, and the likelihood that such a program could succeed was greatly diminished by the fact that Chile's (exclusively domestic) financial markets were underdeveloped.
Insurance companies might have been able to offset their risks through large capital holdings and reserves. However, only the most heavily capitalized companies could have taken part, which would have reduced competition in the system. In addition, even with increased capital and reserves, insurance companies still would have had limited opportunities for diversified investment, given the condition of Chile's financial market. Thus policymakers concluded that only foreign companies might have the strength to manage an insurance-based system - a politically difficult situation.
The better option - the one chosen - was a defined-contribution approach, allowing the amount of the pension to vary with the return on investment made with funds accumulated in individual accounts. While the risk to the worker was greater, the overall danger to the system itself was modest. What's more, the accumulation system ensured greater competition because it did not require large amounts of investment capital. To compensate for the risk individuals undertook, they were permitted to make additional, voluntary contributions to supplement their pensions so they could retire early.
The Creation of Private Investment Funds. The designers of the new system realized that private institutions were needed to make the new system a reality. Banks were one option. However, the designers had doubts about both the stability and the supervision of Chile's banks. (Two years later, a crisis in Chilean capital markets proved that not using banks had been a wise decision.) Further, there was a question of a possible conflict of interest, given that bank deposits were one logical investment option for social security funds.
Instead, Chile's policy planners created a system of wholly new private entities called Pension Fund Administrators (known from their Spanish initials as AFPs) to manage the retirement funds.2 They created a regulatory agency with a small, highly qualified staff to oversee the system. The period between the passage of legislation and the actual launch of the new system gave the private sector enough time to design the AFPs. The AFPs were to manage and administer the new accounts, not own them. This was important because the workers' money in the separate equity accounts would not be affected even if an AFP went bankrupt.
There currently are nine AFPs, and they compete actively for workers' accounts.3 Workers may move their accounts among the various AFPs. About one-third of the active accounts are moved each year.4
Transition from Old to New Systems.5 Pensions for workers already retired when the privatized system was inaugurated and for those choosing to stay in the old system were paid from Chile's general treasury. "Recognition bonds" covering credits earned under the old system were issued to workers who switched from the old to the new. These nontransferable bonds earned 4 percent interest (adjusted for inflation). Upon retirement, individuals could redeem the bonds for lump sum payments into their retirement accounts.
The unfunded pension liability from the old state system was estimated to have a present value in 1981 of about 80 percent of Chile's gross domestic product.6 Part of the funds to pay for the recognition bonds came from a budget surplus in existence before the new system was introduced. The country also sold the assets of many state-owned enterprises to help pay for the recognition bonds. Spending to redeem recognition bonds has declined annually since 1991, and the last bond is expected to be cashed around 2025.
The new system provides a minimum pension guarantee for all workers who have contributed for at least 20 years, topping up the pension if funds accumulated in the worker's account are not enough to finance the minimum. The minimum pension guarantee, with the difference coming from general tax funds, is designed to be enough to keep the pensioner out of poverty.
Rates of Return. Because the merits of the new system depended on the level of benefits paid to participants, policymakers wanted to ensure that the rates of return on workers' accounts were adequate. Actuarial calculations indicated that if workers contributed 10 percent of their earnings, men could retire at age 65 and women at age 60 with a pension equal to approximately 75 percent of their final year of income if the average annual return on contributions was 4 percent. This figure appeared to be realistic for the Chilean economy.
The next challenge was to formulate an investment portfolio that would allow the private investment funds to compete profitably and still achieve the needed rate of return while protecting the workers' contributions. In addition to the supervisory agency to watch over the system, the designers established regulations requiring that investments be diversified to reduce risks. Furthermore, new laws established conservative investment options and limits, initially oriented toward debt instruments, particularly public debt.
The pension funds were permitted to invest only in government-issued instruments, bank time deposits, corporate bonds and shares of other pension funds. Any percentage could be invested in government-issued instruments, but no more than 40 percent could be invested in time deposits, 60 percent in corporate bonds and 30 percent in shares of other pension funds.
As the system matured, AFPs were allowed to invest in corporate stocks, a move that provided higher rates of return and more opportunities to diversify. This also helped reduce Chile's debt-to-capital ratio by recapitalizing companies hit by the 1982 financial crisis. Of equal importance, the option of investing in private stocks helped the government pursue its policy of privatizing state-owned companies. Beginning in 1985, the funds were allowed to invest up to 30 percent of their assets in stocks. The availability of institutional buyers for the shares issued by these companies was a distinct boon to the privatization program, which required large-scale acquisitions and vast purchasing power to be successful.
As of September 1997 the pension funds had 28.4 percent of their assets invested in Chilean stocks and held about 14 percent of the country's publicly traded stocks.7
The new retirement system has been continually fine-tuned to ensure its integrity. Eventually it became clear that investment instruments needed to be classified for risk, and the government created a risk-rating commission. Most rating commission members are from the private sector.
The new system requires each AFP to earn, over a 12-month period, a minimum return on workers' investments equal to 50 percent of the average return of all AFPs or the average return minus 2 percent, whichever is lower.
An AFP must keep a reserve equal to 1 percent of the total assets in the fund it manages and must invest the reserve in the same assets as the fund. If the fund's rate of return is not within the maximum deviation, the AFP must make up the difference from this reserve.
Administrative Costs. In addition to contributing 10 percent of their income to the private retirement accounts, Chilean workers pay a fee for survivors and disability insurance and administrative costs. The insurance and administrative fee can range from 2 percent to 3.75 percent, depending on the AFP, and this is a point of competition among the AFPs. From this fee, currently averaging about 2.7 percent (down in the last year from about 3 percent), an AFP must buy the insurance for the worker, pay expenses and get its profit.
Some critics of privatized systems have pointed out that administrative costs for government-run pay-as-you-go systems are much lower. Decentralized systems offering a choice of funds and allowing switching among funds do have additional marketing expenses, but they also provide a higher rate of return for participants than do the pay-as-you-go systems.
Opponents of privatized systems like to say, as one writer did, that "up to 20 percent of worker contributions go to middlemen."8 They obtain this figure by dividing the administrative fee by the total contribution. However, administrative costs as a percentage of total assets have fallen dramatically as the Chilean system has matured and now average less than 2 percent of total assets.9
One factor contributing to administrative costs in the Chilean system is the absence of any limit on the number and frequency of transfers a participant can make from one AFP to another. In 1996 there were 1.6 million transfers. A new regulation effective in late 1997 requires an affiliate to go in person to his or her AFP office to transfer. Previously, a worker could change AFPs simply by signing a piece of paper. The new regulation is expected to reduce transfers among funds - and consequently reduce operating costs of the AFPs.10
AFPs must provide statements to contributors three times a year, showing the last four monthly contributions paid by employers, the financial performance of the fund and the accumulated balance and rate of return on individual accounts.11
Other Benefits for Workers: Life Insurance. The new social security system provides three types of benefits: old age, disability and survivors. The different needs of each determined the new framework for the benefits. Since old age is predictable, old-age pensions can be covered by a straightforward accumulation of funds, given the contribution rate of 10 percent of worker income. (As previously noted, workers can make additional voluntary contributions.) Disability or death, on the other hand, are not predictable. A stricken worker may not have sufficient accumulated funds to ensure a pension somewhere near his or her level of income. This is the reason the AFPs acquire private insurance for the worker. The relationship between this insurance and the participant's income level is established by law. The insurance premium currently averages about 0.7 percentage points of the 2.7 percent insurance and administrative fee.
Other Benefits for Workers: Disability Pensions. Active workers who are below the minimum retirement age and who lose at least 50 percent of their ability to work are entitled to disability pensions. A committee of three physicians appointed by the AFP supervisory agency, which has offices throughout Chile, determines whether a person qualifies for the pension. To be declared completely disabled, the worker must lose more than 66 percent of capability. Those losing more than 50 percent but less than 66 percent of their capability are considered partially disabled. A "transitory disability" entitles a worker to a three-year pension; at the end of the three years, the worker undergoes a second examination which determines whether benefits will be retracted or made permanent.
Other Benefits to Workers: Survivors Pensions. Survivors pensions are provided by the private insurance purchased from the administrative fee the worker pays. The survivors benefits are the same whether the worker is active or retired at the time of death, and they are based on the worker's pension or average base salary for the last five years. Spouses, dependent children (whether legitimate or not) and orphan children receive survivors pensions - or the parents receive pensions if there are no other beneficiaries.
Retirement Withdrawal Options. Workers can retire when they reach retirement age (65 for men, 60 for women) or when their account has accumulated funds that are actuarially sufficient for early retirement. The amount required for early retirement is tied to preretirement income to ensure that workers do not experience a dramatic drop in living standards and do not become a burden to society.
Withdrawal Option: Immediate life annuity. Funds in the individual's account are transferred to a life insurance company the retiree chooses. In exchange, the retiree receives a life-long monthly payment that is periodically adjusted to economic indices. The annuity includes a survivors pension for beneficiaries.Withdrawal Option: Scheduled withdrawals. Funds in the account remain with the AFP and the retiree makes monthly withdrawals in indexed monetary units in accordance with a preestablished schedule, recalculated annually based on life expectancy.12 Unlike the traditional annuity, the amount of the pension payments under this option can change and may drop over time if the retiree lives longer than initial life expectancy calculations indicate. However, this option has two important advantages: the retiree can collect larger benefits during the early years of retirement and can authorize the transfer of any funds remaining in the account after death to his or her heirs.
Withdrawal Option: Temporary income with a deferred life annuity. This is a blend of the other two options. The retiree buys a life annuity to begin at a future date established by contract and leaves sufficient funds in the AFP account to provide a temporary income until the date the annuity payments begin.
Performance of the New System. From its inception in 1981 through September 1998, the average real return on assets of the privatized system has been 10.7 percent.13 Compared to the old system:14
- Retirement benefits are now 19.6 percent higher.
- Disability pensions are 30.9 percent higher.
- Survivors benefits are 17.8 percent higher for widows.
However, survivors benefits for orphan children currently are only 75 percent of those under the old system.
The reformed pension system favorably affected Chile's economy. As the AFPs have been allowed to diversify their investments, the financial markets have gained liquidity, with more trading of shares of stock and more variety in financial instruments. The increasing investments by the AFPs have encouraged the disclosure of information in financial markets and the development of credit rating institutions.15