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Privatizing Social Security

Mandated Savings and the Experience of Chile

By Jared Miller

Around the world, national governments are considering how best to maintain pension plan benefits as populations enter the final stages of a demographic transition; the economically unproductive elderly rely on fewer young workers to support them. Proponents of social security privatization argue that decentralizing social security programs will allow individuals to save with market returns and market efficiency. To date, Chile has involved the private sector in its social security program more than any other country. As the free-market vanguard of Latin America, Chile’s economic decisions are closely scrutinized and copied by many Latin American countries. Although privatization has often been associated with increased efficiency for many industries, other countries should be especially cautious of recreating Chile’s privatized pension "model." Privatization has not worked perfectly in Chile because the theory and practice of the Chilean program prevent it from being successful. This paper considers the theory of social security privatization and illustrates the experience of Chile.

Theory of Mandatory Savings

Individually mandated savings programs are fundamentally different than the tax within a pay-as-you-go system because, as in Chile’s new privatized system, savings are placed into private accounts. Personal savings are mandatory so that fewer workers rely on the government for retirement savings. Obligatory savings plans have gained attention in recent years because they attempt to address three principal problems of unfunded pension plans. First, people do not save for the future and rely on the state in old age. Second, centralized funds are mismanaged. And third, centralized funds are vulnerable to political influence and manipulation(World Bank, 203). The ability of privatized savings plans to answer such problems in practice will be addressed in the second part of this essay.

A New Scale

One of the most distinct features of a privatized social security system is that it reinvents the scale of state mandated retirement savings. In a privatized system, the benefits are a function of one’s commitment to save. José Piñera, of the CATO institute, argues that the new scale will better reflect human nature by recreating "the essential link between effort and reward(Piñera, 155)." Indeed under a privatized system with mandated savings, workers would have the right to retire when they please, and save as much, or as little(to a government set minimum) as they choose. Chile has converted such arguments into reality.

A New Economy

Privatization proponents also argue that mandated savings have favorable macroeconomic effects. For example, they assume that increased personal responsibility for retirement savings will increase the savings rate and, thus, investment. Similarly, when only workers are mandated to save, employers benefit from reduced labor costs. The long-term effect, presumably, would be increased growth rates(Barrientos, 93).

Pension Reform in Chile

The Chilean government, led by the repressive, conservative dictator Augusto Pinochet, replaced the existing pay-as-you-go "Social Insurance Scheme" with a privatized mandatory savings plan in 1981. Started in 1924, the previous pay-as-you-go plan was plagued by an inefficient bureaucracy and a lack of economic incentives to participate(Diamond 1996, 75). Furthermore, until the 1981 Chilean social security program

As inflation during the 1970s deteriorated pension reserves, Pinochet’s government planned the conversion to a privatized pension plan. In the early 1980’s the new program was started in full. The previous system is still being phased out. Until the last retiree in the pay-as-you-go system dies, the Chilean government has come up with inventive ways to pay for the transition cost. However, very little money is being contributed to the old plan although many retirees are still receiving checks.

In the new plan all workers pay a minimum of 10% of monthly earnings in an approved financial fund. Workers can access the savings after a certain age in the form of phased withdrawals or an annuity purchased from an insurance company(Diamond 1996, 74-75). There are a number of funds, called Administradoras de Fondos de Pensiones(AFPs), that provide financial services. Workers are free to deposit their savings in any fund and switch between at any time. Although there is no attempt at income redistribution, the plan does provide a minimum pension plan for workers who have worked the minimum number of years, even if they have not accumulated a sufficient amount of savings.

Results of Reform

Economic Results

With yields of 14% on individual funds, it is not surprising that the number of workers with private pensions and the number of AFPs have increased dramatically since the early 1980’s(Diamond and Meyers 1996, 231). The combined value of AFPs grew from 3.6% of GDP to 26.5% in the first eight years of the program(Barrientos, 96). Even though the growth of the funds has been impressive, some say it could have even been much higher(Piñera, 103). The AFP scheme has also led to a boom in the Santiago stock market and the creation of a corporate bond market(World Bank, 231). More brazen supporters of the privatized system claim that it is also responsible Chile's high growth rates during the 1990s(Piñera, 156).

Social Results

While the growth of individual funds has been remarkable, the social benefit is less impressive; many Chileans are not involved in the privatized system and those that have "cashed out" have not received the expected results. Although many workers switched over from the pay-as-you-go plan, fewer total workers are covered today. This is especially problematic because the groups who are less likely to contribute are seasonal workers and women. Without a personal savings account, both groups will have to rely on the inadequate minimum government pension after retirement (Barrientos, 98).

The participants of the privatized savings plan have consistently been disappointed because of two design flaws: the annuity problem and the timing problem. Although annuities are seemingly the most desirable form of retirement income, in Chile they are very expensive and salespeople are not always forthright with information(World Bank, 226 - 231). Also, with an annuity it is difficult to access large sums of money for medical expenses or education etc… The solution for many Chilean retirees, therefore, is to receive the lump sum of their savings at retirement. In doing so, they risk outliving their savings.

The annuity problem is compounded by the timing problem. While the market has yielded high returns, it is also vulnerable to crashes. Accounts of retirees change with fluctuations in the market and some retirees will suffer from retiring at the wrong time in the market cycle. While workers control how much they contribute, because of market instability and unpredictability, they do not control how much they receive at retirement. Recently, the Chilean AFPs were granted more freedom in their investments. While some will most likely benefit from high returns, the retirement savings of many Chileans will also be more exposed to market crashes. It is not unreasonable to expect, therefore, that workers will leave the workforce when the market is good and keep working when the market is bad. Because the retirement savings of Chileans are at the mercy of the market, retirees have less choice about when to leave the workforce.

Political Results

Although one goal of a mandated savings plan was to insulate pension programs from governmental meddling, the Chilean government actively regulates the AFPs in an attempt to alleviate worker’s risk while simultaneously guaranteeing the success of the funds. Because mandated savings are designed to include all segments of the workforce, investment choices are kept simple – one account per worker and one fund per AFP. By regulating the type of financial services available the government, in essence, diminishes the individual scale of investment decision-making it initially proposed to enhance. To further constrain the market in tailoring AFPs to fit the age and taste of workers, AFPs are guaranteed by the state against financial failure(World Bank, 220). In the absence of competition, there is neither incentive for the funds to outperform each other nor reason to create more suitable products.

Interestingly, privatization of social security in Chile is more expensive for the workers. Pay-as-you-go social security plans often incur lower costs because of the inherent economies of scale resulting from a single pension, a single fund to invest. For example, the United States employs 0.5 social security employees for every 1,000 workers while the new Chilean system employs 3.5 people per 1,000 workers. With the myriad of investment options and imperfect competition, many AFPs are spending more on marketing costs and less on product development(Diamond, 1996, 76-77). Although it does not improve the product, the retiree eventually pays for the price of marketing.

Mandated savings also impose considerable costs to the Chilean government. Workers without sufficient personal savings, and those that spend theirs before they die, rely on government pensions even though they have not contributed to a state pension plan. Furthermore, regulating a growing industry demands the creation of a new and costly bureaucracy to increase worker coverage while preserving the high yields of funds(Diamond 1996, 77). For many Chileans, privatization has become synonymous with efficiency. The case of mandated savings, however, shows that reliance on the market is more expensive for both the government the workers.

Conclusion: The Great Chilean Contradiction

Taken alone, the macroeconomic indicators tell the story of a successful transition to a mandated savings plan. Yet, both socially and the politically privatization has exacerbated problems it was supposed to solve(from page 1). First, the shortsighted workers who depended upon the state under the previous pension plan are not actively participating in the new personal savings plans and will eventually depend upon the government. Second, the bureaucracy controlling the AFP market is equally, or perhaps more vulnerable to mismanagement. Third, although private companies are involved, there is still considerable political interference and a lack of competition in the new system(Diamond 1996, 203). Privatization in Chile was designed wrong and implemented wrong. Structurally, it does not solve the problems it is supposed to address. In practice it recreates many of the issues that defined the problem of the previous plan. Whether it is worse than the previous system is unclear. What is clear, however, is that other countries should be cautious of Chile’s social security program as a "model."

Interestingly, supporters of the Chilean privatized social security contradict themselves when they consider the theory and practice of privatization. They claim that the individual is the base of a strong economy yet they judge the practice of privatization with aggregate indicators. Instead of highlighting Chile’s growth rates and the performance of the Santiago stock exchange, they should listen to the experiences of individuals they champion in their theoretical support of privatization – many Chileans do not participate and retirees do not receive the expected benefits. In summary, privatization has worked for the Chilean capital markets and especially for the fund managers. However, it is value to the majority of Chileans is mixed.

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