March 22, 2006

Rethinking the Chilean Model

Reforms are in the making for the nation's privatized social security system--Retirement Plan Advisor, March 2006

Since its inception in 1981, many the world over have lavished praise upon Chile's privatized pension system, citing it as an example to follow. President George Bush proposed reforming U.S. Social Security along the same lines as Chile, and is reportedly being advised on the matter by Jose Pinera, Chile's labor minister between 1978 and 1980 and architect of the privatized pension system. Pinera is also the founder of the International Center for Pension Reform.

But even as the Chilean model has galvanized nations over the past two decades to jump on the privatization bandwagon, and proponents say it has been a boon to both the Chilean economy and the country's population, the system has been sharply criticized in recent years, and many have highlighted certain flaws in the model they say need to be rectified.

In fact, during the presidential election that took place in Chile last December, both candidates--the center-left contender Michelle Bachelet (who won) and the right-wing Sebastian Pinera (who is the brother of Jose Pinera)--agreed upon the need to reform the Chilean pension system, and bring about what's been labeled a "Chile II," a model that would aim to be more equitable and rectify the flaws in the current system. In Chile today, the overhaul of the pension system is a top item on the political agenda. While details are yet to be ironed out, the need for greater government intervention is at the center of discussions, and the Chilean authorities are working with agencies like the International Labor Organization to decide how best this can be achieved.

The Chilean pension system that was introduced in 1981, Pinera has written, was revolutionary in that it marked a "privatization from below." The model put workers in charge of their own retirement finances: They did not have payroll taxes, but instead contributed 10%-12% of their pre-tax wages to a privately managed retirement account. In return, salaried workers were and still are eligible for a pension amounting to 70% of their working income, assuming a 4% return on investment, which has been exceeded.

From the mid-1980s to the mid-1990s, the increase in personal savings through the private retirement accounts translated into a dramatic rise in the domestic savings rate in Chile, a country where pension reform was sorely needed. As they saw the Chilean economy grow, governments in neighboring South American nations sought to follow the same path, while institutions like the World Bank and the International Monetary Fund advocated privatized pension systems as an integral component for countries moving toward a market model.

"By increasing savings and improving the functioning of both the capital and the labor markets, this reform has been the single most important structural change that has contributed to the doubling of the growth rate of the economy in the 1985-1997 period," Pinera wrote about pension reform in a paper entitled "Empowering Workers: The Privatization of Social Security in Chile."

But while Chile's domestic savings rate did undeniably grow, the privatized system as it now stands is not sustainable, say experts like Alejandro Bonilla-Garcia, of the Geneva, Switzerland-based International Social Security Association (ISSA). The system is based upon the assumption that workers will keep paying for most of their working lives, but it does not account for the many people that are not contributing at all, he says.

Indeed, recent studies have shown that two-thirds of Chileans will not have sufficient pension savings for their retirement, Bonilla-Garcia says. Self-employed persons, for whom contributions are not mandatory, will have nowhere to turn, while women with family responsibilities (whose salaries are already lower than their male counterparts) have large gaps in their contributions. Soon, many will be turning toward the government, which does provide a safety net for those who do not have sufficient pension accounts. The number of claims, though, is going to be too large for the Chilean government to support, Bonilla-Garcia says, and this is why there is now a move toward reforming the system.

Of course, in many countries of the world, notably the U.S., the bent toward a fully privatized pension system is still very strong (even though it's pretty much understood that there will be no changes made to Social Security for the rest of Bush's tenure), and this is a topic of discussion that is not about to be exhausted any time soon.

Yet the Chilean example casts a new light on the public vs. private debate, and according to experts like Bonilla-Garcia, highlights the need for people to think again about both working together in order to bring about a system that ensures that citizens of a country are better equipped for their financial future.

"The conditions of retirement finance need to adapt themselves to how a person's life changes, they have to consider the life cycle," says Bonilla-Garcia. "A professional, a laborer, and a sailor all have life cycles and all earn differently. There needs to be some acknowledgement of the fact that not everyone can save from what they earn, that many just need their wages to get by."

Governmental backing can provide a solid backbone for a properly privatized retirement savings system, Bonilla-Garcia says. The idea of a social safety net is something all countries, even the U.S., should keep in mind, he says, even as they attempt to also provide a good legislative and regulatory framework to support some of the private savings models that have come into being over the past years, and foster the development of new ones.

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