Milevsky: Solving Chile’s Annuity Puzzle

To an academic economist—which is something I occasionally fancy myself to be—exquisite Chile is somewhat of a utopia. I’m not referring to the Andes Mountains or Atacama Desert, although they are remarkable. Rather, I’m referring to its government’s approach to economic policy.

As in a number of other South American countries, many of Chile’s cabinet minsters and even elected politicians earned graduate degrees and doctorates in economics, having been trained in the best universities. In fact, none other than the great Milton Friedman himself helped design the plumbing of their economic system in the early 1980s. Even today, public and political discourse is replete with phrases usually reserved for graduate courses on microeconomics.

Yet, what might be of special interest to the readership of this column is Chile’s retirement system, also redesigned from scratch a mere 25 years ago, in the post-Allende epoch. Remarkably, Chileans have no universal government-run pension program, like Social Security in the U.S.

Rather, Chilean citizens save and invest for their own retirement. What is even more striking is that when they reach retirement age—and transition to the de-accumulation phase, withdrawing money from their individual accounts—they do something few retirees do anywhere else in the world. Most of them voluntarily annuitize. To put it bluntly, they walk into their neighborhood insurance company with their accumulated nest egg and say: “Please give me an income for life.”

So, this is the desafío de la renta vitalicia (annuity puzzle, very loosely translated) that placed me in Santiago at the behest of the Chilean government. Why do so many Chileans buy life annuities? Is it something they put in all those pisco sours?

Some Background

Chile mandates that all employees in the workforce must contribute at least 10% of their pre-tax salary into an individual account defined-contribution (DC) plan, managed through the payroll system. Within these accounts they are allowed to allocate wealth between a limited set of diversified (low-cost) mutual funds, all of which are managed by the private sector. These individual accounts are held by custodians and are completely independent from the employer.

With such an arms-length approach, portability, ownership and even employer bankruptcy risk shouldn’t be a concern. The closest analogy I could find in North America would be replacing Social Security with one big 401(k) plan, in which every single worker is obligated—not just defaulted or merely nudged—to contribute.

The value of the account grows with time and age, but obviously varies depending on the particular funds selected, asset allocation, etc. As with everyone else, the 2008-09 global financial crises adversely affected Chileans’ account values—especially those participants who allocated to equities—but the Chilean economy has grown at a very impressive pace, of late. And, like so many home-biased investors all over the world, the majority of these individual accounts are allocated to stocks and bonds in—you guessed it—Chile and many copper companies.

Also, unlike for the Greeks, Spaniards and Portuguese, for example, this bias didn’t bite them.

The Chilean Pension Model, as it is called, has been exported to a number of other Latin American countries in the region—much to the Chileans’ pride and delight. Similar models have been implemented in much larger countries such as Mexico, Peru, Colombia and even Argentina (until the government in Buenos Aires absconded with the money a few years ago, but that is a story for another column).

Retirement Time

While this relatively young model isn’t immune to the mind-numbing rules and exclusions that afflict all government-administered plans anywhere else on planet earth, Chilean retirees have two basic options: They can either (1) continue to invest their account in a variety of stock and bond funds while withdrawing money from the account, a.k.a. self-annuitization or (2) use the accumulated funds to purchase a life annuity. Technically, a third option could be any combination of (1) and (2).

But, as I mentioned earlier, approximately 65% of Chileans in this system get to retirement, sit down with a financial advisor—which is mandated, by the way—and provide very simple instructions: “Please buy me a life annuity, with all of it.”

Now, lest you suspect I am talking about small sums in a small country, each year over 20,000 life annuity contracts are voluntarily issued in Chile. This is the second highest number in the world after the grand-annuity-daddy of them all, the U.K. (selling 400,000 policies per year.) Remember, though, Chile has a population of 17 million people and its insurance companies issue more life annuity policies than the U.S., Japan or Germany. It is no surprise that many international insurance companies have been setting up shop in Santiago, as more and more Chileans reach retirement.

This 65% rate of annuitization is quite puzzling, when contrasted with a 5% rate (at best) in the U.S. So, in an odd twist of fate that might only happen south of the equator, I—your humble correspondent and annuity uber advocate—was approached by economists within the Chilean Superintendent of Pensions: “We worry that the annuitization rate might be too high. How do we make systematic withdrawals plans (SWiPs) more appealing to Chileans?”

You see, some regulators are getting concerned that over 85% of insurance industry reserves are linked to life annuity liabilities, while the other 15% is in life insurance liabilities. Most companies don’t use reinsurance, which means that this lopsidedness exposes the industry to a unique type of longevity risk. What if Chileans live longer than projected by the actuaries? And, to be honest, after having spent a week in charming Santiago, I wouldn’t be surprised if their tranquil lifestyle produces a disproportionate number of centenarians.