03/02/05 - A Social Security Primer II
By: Frank Armstrong, CFP, AIF
Chile's Social Security Revolution
Investor Solutions is publishing a three part series on social security, prompted by the current efforts at reform being launched by the Bush Administration. We hope investors will educate themselves on this important issue.
Part two focuses on the controversial funded government pension plan in Chile.
Privatized Social Security: Love it or hate it, you can probably cite the Chilean Social Security System to bolster your case. Depending on who's telling the story, it's either the best or worst thing to ever happen to state-run pensions.
In 1924 Chile became the hemisphere's first country to establish a pay as-you-go national retirement system. Shortly thereafter, things got a little out of hand. Special interest groups established more than 100 separate retirement systems, with no linkage to contributions or no common retirement age. By 1970 Chile had more than 2000 retirement laws on the books to handle a system in chaos. Chiles unfunded pension liabilities mushroomed while the percent of Gross Domestic Product devoted to funding current benefits soared. The system had become completely unsustainable and the promises made by the government could never be delivered.
Under right wing dictator Augusto Pinochet, Chile made the decision in 1980 to convert to a funded, privatized, defined contribution plan, becoming the first country to abandon the payas- you-go model. As the world's oldest funded government pension plan, it is often cited as an example of either good or evil.
Pinochet tapped Jose Piñera, a University of Chicago/Harvard-trained economist to promote the new system and oversee the conversion. During the transition, workers were offered the right to stay in the old system or adopt the new one. The vast majority chose the privatized system. However, all new workers entering the system after 1983 were required to enter the new plan.
Employees that switched to the new system were given a "recognition bond" equivalent to the benefits they had earned under the old system. As they retire, this bond will be redeemed by the government to provide their previously earned benefits. It is expected that this cost will initially peak as converted workers retire and then eventually fall to zero.
Under the new system all participating employees pay into the system a flat ten percent of their wages up to a nominal cap. These payments are invested by one of 12 private companies (Administradoras de Fondos de Pensiones, or AFPs) approved by the government. Participants may switch from one AFP to another a maximum of two times a year. However, the system discourages each of the AFPs from straying too far from the average returns of their competitors by requiring that they make up any shortfall below the lesser of 2% below the average, or 50% of the average of all funds for the last 12 months. So investment returns look very similar because each manager shoots for only slightly better than middle-of-the-pack performance.
Workers may contribute an additional 10% to the program and may contribute voluntary savings if they so desire. While not required, employers may make tax deductible contributions to the system. Early and delayed retirements are both possible under the system.
Upon retirement, the worker may choose a series of payments tied to his life expectancy and that of his beneficiary, an annuity, or a combination of both. Any funds in excess of those required to purchase 120% of the minimum pension or 70% of his average pay for the last ten years may be withdrawn. Any amount in the account at death can be left to the heirs, creating real wealth which can be transferred between generations. If the account is exhausted, the government makes up the minimum pension guarantee.
Today, Chile is the economic success story of Latin America. Numerous factors contributed to that success. Economic reforms under the Pinochet dictatorship laid the groundwork for sustained real growth. And unlike much of Latin America, Chile is constantly cited as one of the least corrupt and most transparent countries in the world, leading to an excellent business climate. But, the contribution of a large and steadily growing capital pool in the privatized Social Security System was not insignificant to the country's economic expansion.
The system is not without its critics. Here are some of the most common complaints:
The minimum pension is not enough. By US standards, the minimum pension of about $135 is not high. However it is about the same percentage of pay represented by the US system.
Too few workers are covered. Self employed people are not required to be covered, and a large underground economy under-contributes. Significantly, the military exempted itself, as might be expected under a military dictatorship. However, about the same percentage of workers are covered as in the old system.
Costs are too high. Government tightly regulates costs and prohibits price competition. While some of the plan's costs cover required insurance, it is probably fair to say that administrative costs and commissions cut too deeply into the workers' accounts.
Some workers have smaller benefits than they might have had under the old system. True, but the old system offered benefits to some classes of workers that were simply not sustainable and not linked to contributions over the worker's career.
Some workers exhaust their benefits and must go on welfare. A forced savings and retirement program never eliminated the need for welfare programs and a social safety net.
Transition costs were high. Unless the government was prepared to renege on all of its previous pension programs, transition costs had to be high. Somehow the huge unfunded liability had to be funded as the transition occurred. These costs will decline, however, as the system matures.
Workers change companies too often. Few benefits and greater additional costs are generated by changes between AFP's.
Summary: No system is perfect. While there is merit to each of the above complaints, Chile has rationalized a chaotic system, contained costs, funded a huge unfunded liability, promoted capital formation, provided an "ownership" benefit to the program, and placed its Social Security System on a solid financial footing. Chileans did this all while at the same time keeping intact a welfare and social safety net. The alternative of remaining under the old system was not rational or sustainable. On balance, the system may still need substantial improvements, but is a great step forward from its unfunded pay-as-you-go predecessor.
Coming up:
We have the opportunity to learn from other countries' experiences with Social Security reform. Chile is only one of many that have adopted some type of funded plan. Examining the mistakes and achievements of these efforts can help us as we grapple with our own problems.
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