In the period of time preceding the 1980’s confidence in the government social security system among Chilean citizens was declining. In a survey conducted just prior to the privatization of social security in 1981, 90% of Chileans expected it as a major source of income, but only 40 % reported themselves as confident in social security (Reno; Friedland). In what was considered a radical endeavor by many, the Pinochet government implemented the new social security reform after a significant fiscal surplus had been built during the late seventies (Diamond).
The Chilean reform has been one of the most successful of its kind, but despite functioning for two decades now it is still difficult to determine with certainty the long run performance of the new scheme. As in the case of liability insurance involving long-term risks, new pension schemes tend to look good in the beginning and take a long time to mature. In particular, funded defined contribution schemes in which the contributors assume all the investment risk are subject to this long-term factor. However, as I will discuss later, there are clear signs that the new system has been firmly established in Chile. At the same time, there are indications that some of the goals of the new system have not been met, and will remain unmet if the system continues in its present form (Barrientos).
The Privatization Reform
The core of the reform is a privatized mandatory savings plan, together with a market for indexed annuities for the diversion of accumulations into flows of retirement income. Every covered worker is required to place ten percent of her monthly income in a savings account with an Administradora de Fondos de Pensiones (AFP), which is an approved, highly regulated intermediary. Each AFP manages just one fund, with 100% of the fund’s returns being allocated into each member’s individual account.
According to the rules instituted by the government, the AFP’s also provide disability and survivor’s insurance. In addition to the mandatory ten percent workers must pay a fee to the AFP, not only to finance the required disability and survivor’s insurance but to also cover the costs and profits of the AFP’s. The fees are set by the AFP’s in competition, with the government regulating their structure, but not their level. Workers are free to select their AFP and to switch among them (Diamond).
Eligibility for pension benefits is according to age. For early retirement, the size of a worker’s accumulation is considered. These benefits can be received either as a sequence of phased withdrawals or as a real annuity. Such an annuity option requires switching financial intermediaries, as the annuity option must be bought from an insurance company. It has been easier for Chile to restrict the annuity option to indexed annuities due to the country’s history of using indexed debt. The private providers of social security are closely regulated (unregulated market forces are not relied on at all). Concerning redistribution, there is a guaranteed minimum pension for those with the required years of coverage. The minimum pension is financed from general revenues and entails an implicit 100 percent tax on the retirement value of accumulations below the minimum (Diamond).
Has the Reform Seen Positive Results?
In the time since the social security system was privatized in 1981, the results have been seen as largely positive, particularly for the functioning of the capital market, the effects on capital accumulation, and the inherently low levels of political risk. But in the face of these benefits, negative effects have developed as well, such as the much higher administrative cost, the weaker provision of insurance, and an inefficient annuity market (Diamond).
Privatization in the case of social security would seem to imply lower costs. However, to the apparent surprise of many, the Chilean reform has incurred exceptionally high costs for those running a privatized social security system. Particularly, the insurance companies that produce disability insurance and annuities, and the AFP’s that manage mandatory accumulation. Valdes-Prieto examined the administrative costs, turning them into yearly average charges while doing covered work. He figured that the average administrative charge per effective affiliate while active (assuming purchase of an annuity) is $89.10, per year for 1991, roughly 2.94 percent of average taxable earnings. This 2.94 percent is over 20 percent of roughly 13.5 percent of earnings paid for the program. Compared to the administrative costs in well-run unified government management systems, the Chilean system’s cost per person is very high. The Social Security Administration in the United States reports a cost of $18.70 per person per year on the same basis (Diamond).
These high costs are naturally correlated to the departure from economies of scale that are automatic in a single, unified system. The individual organizations also face competition costs such as advertising and sales personnel. Aside from facing difficult consumer preferences the organizations obviously have increased administrative costs as well.
The lack of insurance over different periods of a worker’s life is also an impending risk and a large concern for workers. There is a lack of incentives for doing work in the insurance-covered sector and making payments of the mandatory contributions, as well as the distortions that develop from financing the minimum pension. This lack of incentives is rooted in conducting redistribution by a government-guaranteed minimum pension. Because incentives for labor supply depend on all of the programs providing retirement income, there is no gain to be made in efficiency from separating redistributional and nonredistributional parts into separate programs (Diamond).
In the interest of retirement income, the most desirable form of benefit is typically an annuity, not an accumulated lump sum. Not many programs -including the Chileans’- have been successful at organizing an efficient annuity market based on individual preference. The result of this is that many retirees decide against purchasing annuities, opting instead to take the risk of outliving their lump sum of money, ultimately falling back on the government-provided minimum pension. In addition, those who have bought annuities have reported them to be very expensive (Diamond).
It can be surmised that not much consistency lies within the government and the leaders in office over long terms, as different administrations often embody different priorities. As a result, the elderly often have high concerns over politically promised benefits. The privatized system provides them with an increased confidence in their future. Since legislating a benefit formula can easily lead to a program that is not viable in the long run, individual accounts can appear very appealing because they essentially can insulate the pension system from political efforts to increase benefits without direct financing. Also, isolating the privatized pension from the government budget helps protect benefits from the condition of the government budget or the political stance of the party in power (Diamond).
Perhaps the two most praised results of the Chilean reform are the exceptional accumulation of capital and the increased efficiency of the capital markets. The large accumulation of funds invested in the Chilean economy is the result of a combination of constant flows of contributions and high real rates of return (an average of 14.5 percent per year from July 1981 to July 1992. As of June of 1992, the total accumulations were equal to %35 of all of 1992 GDP; equity holdings by pension funds were 9.6 percent of the value of the Santiago Stock Exchange; and pension funds held %61 percent of outstanding registered corporate bond issues (Diamond).
Another positive result of this capital accumulation has been the improvement of regulation of the markets in which the funds are invested. The government vastly increased the regulation of the capital markets because the mandatory social security funds were being invested there. The set of capital markets that now exist function far better than they did before the reform. As noted by Diamond, careful regulation of capital markets is a necessary part of successful privatization. For example, one regulation guarantees that no fund will do too much worse than the average of all funds. Regulations like this are key factors behind the improvement of the Santiago stock exchange and the ensuing development of a corporate bond market.
So we can see from the extensive analyses formed by economists like Diamond and Barrientos that the privatization of social security in Chile is an example of one of the most successful initiatives of its kind that can be found. It is successful primarily in terms of the broader Chilean economy, particularly in the capital market, but it proves to be an economic failure in the example of the much higher costs of managing these privatized organizations. But at the higher cost of this privatized system comes an increased confidence in social security, as difference among successive office holders is extinguished as a threat to consistency in social security.
1. Diamond, Peter. "Proposals to Restructure Social Security", The Journal of Economic Perspectives, Vol. 10, No. 3, Summer 1996, pp. 67-88.
2. Barrientos, Armando. "Pension Reform and Economic Development in Chile", Development Policy Review, Vol. 11, 1993, pp. 91-107.
3. Diamond, Peter. “The Future of Social Security”, Social Security: What Role for the Future.
4. Pinera, Jose. "Empowering Workers: The Privatization of Social Security in Chile", Cato Journal, Vol. 15, Nos. 2-3, Fall-Winter 1995/1996, pp. 155-166.