From the November 2010 issue of Investment Advisor • Subscribe!

November 1, 2010

Policy Without Politics

Chile's retirement plan system could set an example for the United States

The 17-year military dictatorship of General Augusto Pinochet has left an indelible mark on the history of Chile. Even as the Latin American nation celebrates this year its 200th anniversary of independence from Spain, that dark period remains first and foremost on peoples’ minds.

There can never be any justification for human rights abuses, but through the years Chile has nevertheless stuck to and expanded the free market model introduced during the Pinochet regime. Years of political consensus on key economic policies, sound fiscal and monetary management and a continued focus on structural reform have resulted in the kind of sustained economic growth that shielded Chile from the worst of the global financial crisis.

“Chile’s resilience is based upon the country’s strong macroeconomic framework and in addition to the management of fiscal and monetary policies, successive governments have always abided by stronger structural issues with respect to governance and the rule of law,” says Theresa Paiz, who covers Chile for credit rating agency Fitch Ratings.

But it wouldn’t be possible to discuss Chile’s economic success without speaking about the role that pension reform has played. The system of privatized pensions introduced by Pinochet, which put workers in charge of their own retirement finances and replaced a severely crippled, state-supported pay-as-you-go defined-benefit model, resulted in radical changes to the Chilean economy. It led to an impressive growth in the domestic savings rate, which in turn catalyzed financial market expansion and innovation. It has been, Paiz says, one of the greatest contributors to economic growth in Chile over the past decades.

The system of private retirement accounts in Chile is a model that successive governments, regardless of their political bent, have continued to support. Through the years, Chilean administrators have worked on the model in order to increase its efficiency and performance, says Edward Whitehouse, pensions expert in the social policy division of the Organization for Economic Cooperation and Development (OECD) in Paris, taking steps wherever necessary to address any flaws or weaknesses. Whether that means increasing the number of investment funds available to the public; honing the risk/reward profile of each one; educating the general public on retirement finance or tackling the issue of high administrative charges, the pension system, Whitehouse says, is at the heart of the Chilean state.

Because of its importance to the Chilean economy and the work that has been done upon it through the years, the private retirement system is much more resilient to shocks and it held up relatively well during the financial crisis compared to retirement systems in other countries. “Chileans had built up large balances in their accounts over the years, so that helped, and Chile is a resource rich country—its largest export is copper—so the country didn’t suffer from an economic crisis in the way that other nations did,” Whitehouse says.
Nevertheless, certain core weaknesses had come to the fore in recent years, not least the fact that a significant number of Chileans—non-working women, the self-employed, and the very poor, to cite a few examples—had not been contributing to the system and were therefore not getting any disbursements from it. Chile set about in 2008 to address these flaws, undertaking the most serious reform to its retirement model in a long time through the introduction of a new publicly financed program—a “solidarity pillar” designed to support those who had been excluded from contributing to a private account, either because they didn’t contribute or they simply couldn’t contribute.

The reform—which came into effect during the tenure of former president Michelle Bachelet and her center-left coalition government—relies on public funding to finance more than half the total pension for those individuals who had fallen through the cracks of the privatized system. The rest of the population, meanwhile, will continue to pay into and rely exclusively on on their private retirement accounts. The reform’s end goal is to redistribute funds from the more financially comfortable segment of the population to the needy, Whitehouse says, and it is a move that was deemed necessary by the authorities since despite Chile’s economic success, there are still large gaps between the country’s haves and have-nots.

“The government has launched this as a big public program designed to alleviate poverty and we believe it makes sense because they are insuring lower income workers against different kinds of risk and giving them a guaranteed minimum income in retirement,” Whitehouse says. “In essence, the richer segments of the population are not getting anything from the new program, and they are the ones who, being best able to cope with risk, are taking on more of it while those who can’t cope with it that well don’t have to take on that much.”
According to Estelle James, former director of the Pension Flagship Course at the World Bank in Washington, D.C., and a consultant to the World Bank, USAID and other organizations, the problem of contributions that cannot be collected from the many individuals who don’t regularly work in the formal labor market is common to contributory schemes in all low- and middle-income countries where the informal sector is large. However, the approach taken in Chile’s 2008 reform raised some issues, not least the threat of moral hazard, which could compromise the sustainability of the contributory system.

Since 2008, seniors in the bottom 60% of households have received a tax-financed public benefit, which is reduced as the pension from their own account rises. This implicit tax on accounts could lead workers to try to contribute less, by entering self-employment or jobs in the informal sector, James says, and if this happens it could undermine the defined-contribution scheme.

“The Chilean government made a very deliberate choice to redistribute from the upper 40% of the population to the lower 60% through the pension system, and many people would agree that this redistribution was desirable, although it could have been accomplished in other ways,” James says. “It has also retained emphasis on mandatory savings for all people who work in the formal market, so the system is still primarily contributory and market-based.” Under the 2008 program, the benefits disbursed to those who qualify are to be financed by the government’s general revenues, but the line dividing the bottom 60% from the upper 40% is blurry, James says, and it isn’t clear how large the total cost of the program will ultimately be. She believes that the cost will grow over time due to demographic, behavioral and policy changes, and the tax this would require could deter economic growth in the future.

Chile, though, will probably do just fine. Although economic growth is less than it was in the late 1990s, most analysts who follow the country have actually been revising upward their predictions for GDP. Fitch Ratings is expecting a growth of 5.3%, Paiz says, based on the fact that the Chilean economy has picked up rapidly this year as a result of the spending on reconstruction after the earthquake in February, and the increase in investment, bank lending and consumption. Revenues from copper exports are also significant and will continue to be so going forward if demand from Asia—the greatest driver in recent times—remains strong, she says. Moreover, copper revenues have been prudently managed by successive governments, which put in place measures to help control their cyclicality, Paiz says.

Now, the Chilean authorities need to tackle micro-level reforms in the areas of education, income disparity and labor market inefficiencies, among others, measures that are necessary to further strengthen the economy. Chile’s financial markets remain attractive to foreign investment, but the government should keep working to expand and deepen them in order to continue attracting investors and also allow for the continued performance of the pension funds, says Jose Luis Ruiz, a professor of finance at the Escuela de Negocios de la Universidad de Chile in the country’s capital, Santiago. Efforts in this direction will help to propel Chile into the next phase of growth and they will also add fuel to the pension system and ensure that it remains an integral part of the economy. The authorities must also continue to improve the efficiency of the system, Ruiz says, by ensuring a healthy balance between the pension fund administrators, their fees and the returns and quality of service that they provide.

[Read more about investor attitudes toward Chile.]

Overall, the Chilean experience underscores the fact that for any privatized retirement system to work, there has to be a level of governmental involvement. While a system of individual accounts with private management and choice can work and has worked very well, the term “privatization” in the case of Chile is a misnomer, James says, because the government has retained crucial roles as regulator and guarantor. Since 1981, Chilean workers have been required to contribute 10% of their wages to an individual retirement account that is then invested in a pension fund chosen by the worker, which accumulates a market rate of return, with payouts taking the form of inflation-protected annuities or gradual withdrawals during retirement. Private pension funds invest peoples’ savings, but they are still subject to a great deal of control and required to meet tight and rigorous standards. The system is far from laissez-faire as it includes many safeguards designed to protect uninformed investors, and any country seeking to implement a model like the one that exists in Chile needs to keep this in mind.

“We have been doing a lot of studies on risk and uncertainties and we argue that it makes sense for people to have a package of options at retirement because the risks of each one, private and public, are not really correlated,” The OECD’s Whitehouse says. “There is definitely some advantage to an economy as a whole to diversifying pensions and ensuring retirement funding comes from different sources. Chile has moved its pension scheme to look more like that which we see in OECD countries, but from the other way around, i.e. from greater reliance on the private to more reliance on the public.”

For James, though, one of the Chilean model’s greatest achievements—one that should serve as a lesson to the United States—is the way in which it has incentivized a greater number of people to remain a part of the work force even after the age of 60 or 65. Until 1988, no early benefits were permitted, and even afterwards very strict conditions applied to those seeking to withdraw, she says. Chilean workers are encouraged to continue working even after they start their pensions since they are no longer required to contribute and they get market rates of return for any voluntary contributions. This increases their take-home pay and incentive to work.

This has great benefits for the economy as a whole, James says, since more workers mean increased production, which then translates into greater economic growth. There is little doubt that this could benefit the U.S. economy as well.    

Savita Iyer-Ahrestani is a freelance writer and regular contributor to Investment Advisor and AdvisorOne.com based in New Jersey.

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