NCPA - National Center for Policy Analysis


March 31, 2010

In 2008 Chile initiated a major reform of its personal account social security system.  The personal account system, established in 1981, replaced a traditional pay-as-you-go (PAYGO) system in which workers paid taxes that financed the benefits of those who had already retired -- similar to Social Security in the United States.

Chilean personal accounts worked well for individuals who contributed on a regular basis.  Workers who contribute most of their adult lives can expect their pensions to replace 57 percent of their final salary.  However, many problems became apparent with Chile's system, says Estelle James, senior fellow with the National Center for Policy Analysis, along with co-authors Alejandra Cox Edwards and Augusto Iglesias:

  • A minimum old age pension was guaranteed by the government, but only to workers who had contributed for at least 20 years -- a criterion many workers did not meet.
  • It provided meager benefits for those who didn't earn wages, were self-employed or worked outside the formal labor market.
  • Once the 20-year requirement was met, additional contributions by low-wage workers displaced the government subsidy rather than raising the total benefit. This was, effectively, a 100 percent implicit tax on incremental contributions.

In 2008, a council appointed by Chile's new government extended the system to groups previously required to participate, providing more generous public benefits. 

  • Under the new regime, two-thirds of all seniors will receive some government-funded public benefit (compared with 40 percent previously).
  • Public benefits will comprise over half of all pension income for seniors in the bottom three quintiles of households.

Overall, practically everyone will be eligible for some benefit and two-thirds of all pension income will continue to come from prefunded retirement accounts (compared with 77 percent previously).

The danger under these new reforms is that fiscal costs may grow faster than expected.  According to the Ministry of Finance, the new benefits will cost 1.4 percent of gross domestic product (GDP) by 2025.  But according to James et al:

  • Public costs could double by 2028 and triple by 2048 if political pressures lead the government to link benefits to wage growth instead of price growth, as currently planned, and to extend benefits to seniors in the top two quintiles.
  • Additionally, workers may try to evade contributions in the future more than in the past.
  • Due to the higher public benefit and the 29.4 percent implicit tax on private pensions, individuals now face a greater incentive to become independent contractors, who are not required to contribute, or to work in the informal sector where productivity may be lower but compliance is difficult to enforce.

If the government cannot forestall these dangers, private accounts will provide a smaller proportion of benefits and the government's fiscal obligations will grow, says James.

Source:  Estelle James, Alejandra Cox Edwards and Augusto Iglesias, "Chile's New Pension Reforms," National Center for Policy Analysis, Policy Report No. 326, March 31, 2010.

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