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«Empowering Workers: The Privatization Of Social Security in Chile by José Piñera is a series of distinguished essays on political economy and ...»

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The Privatization

Of Social

Security in Chile


José Piñera

is a series of distinguished

essays on political economy

and public policy. The Cato

Institute takes its name from an earlier series of

Cato’s Letters, essays on political liberty written

by John Trenchard and Thomas Gordon in the

18th century, which were widely read in the

American colonies and played a major role in

laying the philosophical foundation for the

American Revolution.

Cato’s Letter #10

Empowering Workers:

The Privatization of Social Security in Chile by José Piñera Copyright © 1996 by the Cato Institute A specter is haunting the world. It is the specter of bankrupt state-run pension systems. The pay-as-you-go pension system that has reigned supreme through most of this century has a fundamental flaw, one rooted in a false conception of how human beings behave: it destroys, at the individual level, the essential link between effort and reward—in other words, between personal responsibilities and personal rights. Whenever that happens on a massive scale and for a long period of time, the result is disaster.

Two exogenous factors aggravate the results of that flaw: (1) the global demographic trend toward decreasing fertility rates; and, (2) medical advances that are lengthening life. As a result, fewer and fewer workers are supporting more and more retirees. Since the raising of both the retirement age and payroll taxes has an upper limit, sooner or later the system has to reduce the promised benefits, a telltale sign of a bankrupt system.

Whether this reduction of benefits is done through inflation, as in most developing countries, or through legislation, the final result for the retired worker is the same: anguish in old age created, paradoxically, by the inherent insecurity of the “social security” system.

In 1980, the government of Chile decided to take the bull by the horns. A government-run pension system was replaced with a revolutionary innovation: a privately administered, national system of Pension Savings Accounts.

After 15 years of operation, the results speak for themselves. Pensions in the new private system already are 50 to 100 percent higher—depending on whether they are old-age, disability, or survivor pensions—than they were in the pay-as-you-go system. The resources adminJosé Piñera is President of the International Center for Pension Reform and Co-Chairman of the Cato Project on Social Security Privatization. As Minister of Labor and Social Security from 1978 to 1980, he was responsible for the privatization of the Chilean pension system. This paper is based on a presentation made at the Mont Pèlerin Society’s regional conference in Cancun, Mexico, January 17, 1996. The author wishes to thank Edward H. Crane for helpful comments.

This essay is reprinted from the Cato Journal, vol. 15, no. 2.

istered by the private pension funds amount to $25 billion, or around 40 percent of GNP as of

1995. By improving the functioning of both the capital and the labor markets, pension privatization has been one of the key reforms that has “A specter is haunting the world. It is the specter of bankrupt state-run pension systems.” pushed the growth rate of the economy upward from the historical 3 percent a year to 6.5 percent on average during the last 12 years. It is also a fact that the Chilean savings rate has increased to 27 percent of GNP and the unemployment rate has decreased to 5.0 percent since the reform was undertaken.

More important still, pensions have ceased to be a government issue, thus depoliticizing a huge sector of the economy and giving individuals more control over their own lives. The structural flaw has been eliminated and the future of pensions depends on individual behavior and market developments.

The success of the Chilean private pension system has led three other South American countries to follow suit. In recent years, Argentina (1994), Peru (1993), and Colombia (1994) undertook a similar reform. In the four South American countries, around 11 million workers have personal retirement accounts.

The Chilean experience can be instructive to countries around the world. Even the United States is beginning to seriously debate privatizing its 60-year-old pension scheme. It should be noted that the U.S. Social Security system is the largest single government program in the world, spending more than $350 billion per year (more than the U.S. defense budget during the Cold War).

As an indication of the power of ideas, even officials from the People’s Republic of China have come to Chile to study the private pension system. One of the results is this particularly interesting feud reported recently by The


There is usually more acrimony than comedy in the long-running row between Britain and China over the future of Hong Kong. Yet a smile may have flickered across the face of Chris Patten, Hong Kong’s governor, even as China scuppered his plans to introduce a (pay-as-you-go) pension scheme in the colony. Zhou Nan, Communist China’s main representative in Hong Kong, harrumphed that Mr. Patten, a British conservative, was trying to bring ‘costly Euro-socialist’ ideas to Hong Kong [February 11, 1995].

It is possible that before entering the new millennium, several other countries, including all those in the Americas, will have privatized their pension systems. This would mean a massive redistribution of power from the state to individuals, thus enhancing personal freedom, promoting faster economic growth, and alleviating poverty, especially in old age.

The Chilean PSA System Under Chile’s Pension Savings Account (PSA) system, what determines a worker’s pension level is the amount of money he accumulates during his working years. Neither the worker nor the employer pays a social security tax to the state. Nor does the worker collect a government-funded pension. Instead, during his working life, he automatically has 10 percent of his wages deposited by his employer each month in his own, individual PSA. This percentage applies only to the first $22,000 of annual income. Therefore, as wages “... pensions have ceased to be a government issue, thus depoliticizing a huge sector of the economy and giving individuals more control over their own lives.” go up with economic growth, the “mandatory savings” content of the pension system goes down.

A worker may contribute an additional 10 percent of his wages each month, which is also deductible from taxable income, as a form of voluntary savings. Generally a worker will contribute more than 10 percent of his salary if he wants to retire early or obtain a higher pension.

A worker chooses one of the private Pension Fund Administration companies (“Administradoras de Fondos de Pensiones,” AFPs) to manage his PSA. These companies can engage in no other activities and are subject to government regulation intended to guarantee a diversified and low-risk portfolio and to prevent theft or fraud. A separate government entity, a highly technical “AFP Superintendency,” provides oversight. Of course, there is free entry to the AFP industry.

Each AFP operates the equivalent of a mutual fund that invests in stocks and bonds.

Investment decisions are made by the AFP.

Government regulation sets only maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio;

and the spirit of the reform is that those regulations should be reduced constantly with the passage of time and as the AFP companies gain experience. There is no obligation whatsoever to invest in government or any other type of bonds.

Legally, the AFP company and the mutual fund that it administers are two separate entities.

Thus, should an AFP go under, the assets of the “It is possible that before entering the new millennium, several other countries, including all those in the Americas, will have privatized their pension systems.” mutual fund—that is, the workers’ investments—are not affected.

Workers are free to change from one AFP company to another. For this reason there is competition among the companies to provide a higher return on investment, better customer service, or a lower commission. Each worker is given a PSA passbook and every three months receives a regular statement informing him how much money has been accumulated in his retirement account and how well his investment fund has performed. The account bears the worker’s name, is his property, and will be used to pay his old age pension (with a provision for survivors’ benefits).

As should be expected, individual preferences about old age differ as much as any other preferences. Some people want to work forever;

others cannot wait to cease working and to “Workers are free to change from one AFP company to another. For this reason there is competition among the companies to provide a higher return on investment, better customer service, or a lower commission.” indulge in their true vocations or hobbies, like writing or fishing. The old, pay-as-you-go system did not permit the satisfaction of such preferences, except through collective pressure to have, for example, an early retirement age for powerful political constituencies. It was a onesize-fits-all scheme that exacted a price in human happiness.

The PSA system, on the other hand, allows for individual preferences to be translated into individual decisions that will produce the desired outcome. In the branch offices of many AFPs there are user-friendly computer terminals that permit the worker to calculate the expected value of his future pension, based on the money in his account, and the year in which he wishes to retire. Alternatively, the worker can specify the pension amount he hopes to receive and ask the computer how much he must deposit each month if he wants to retire at a given age. Once he gets the answer, he simply asks his employer to withdraw that new percentage from his salary.

Of course, he can adjust that figure as time goes on, depending on the actual yield of his pension fund. The bottom line is that a worker can determine his desired pension and retirement age in the same way one can order a tailor-made suit.

As noted above, worker contributions are deductible for income tax purposes. The return on the PSA is tax free. Upon retirement, when funds are withdrawn, taxes are paid according to the income tax bracket at that moment.

The Chilean PSA system includes both private and public sector employees. The only ones excluded are members of the police and armed forces, whose pension systems, as in other counThe old, pay-as-you-go system... was a one-size-fits-all scheme that exacted a price in human happiness.” tries, are built into their pay and working conditions system. (In my opinion—but not theirs yet—they would also be better off with a PSA).

All other employed workers must have a PSA.

Self-employed workers may enter the system, if they wish, thus creating an incentive for informal workers to join the formal economy.

A worker who has contributed for at least 20 years but whose pension fund, upon reaching retirement age, is below the legally defined “minimum pension” receives that pension from the state once his PSA has been depleted. What should be stressed here is that no one is defined as “poor” a priori. Only a posteriori, after his working life has ended and his PSA has been depleted, does a poor pensioner receive a government subsidy. (Those without 20 years of contributions can apply for a welfare-type pension at a much lower level).

The PSA system also includes insurance against premature death and disability. Each AFP provides this service to its clients by taking out group life and disability coverage from private life insurance companies. This coverage is paid for by an additional worker contribution of around 2.9 percent of salary, which includes the commission to the AFP.

The mandatory minimum savings level of 10 percent was calculated on the assumption of a 4 percent average net yield during the whole working life, so that the typical worker would have sufficient money in his PSA to fund a pension equal to 70 percent of his final salary.

The so-called legal retirement age is 65 for men and 60 for women. Those retirement ages— the traditional ages in the pay-as-you-go system—were not discussed in the privatization reform because they are not a structural characteristic of the new system. But the meaning of “retirement” in the PSA system is different than in the traditional one. First, workers can continue working after retirement. If they do, they receive the pension their accumulated capital makes possible and they are not required to contribute any longer to a pension plan. Second, workers with sufficient savings in their accounts to fund a “reasonable pension” (50 percent of the average salary of the previous 10 years, as long as it is higher than the “minimum pension”) may choose to take early retirement whenever they want.

Thus the 65-60 threshold is not a rigid fixture of the system. Rather, a worker must continue making a 10 percent contribution to his PSA until he reaches that age, unless he has chosen early retirement—that is, to retire his money, as a monthly pension, which is not the same as retirement from the workforce. In addition, however, a worker must reach those threshold ages to be eligible for the government subsidy that guarantees a minimum pension.

But in no way is there an obligation to cease working, at any age, nor is there an obligation to continue working or saving for pension purposes once you have assured yourself a “reasonable pension” as described above.

“The PSA system, on the other hand, allows for individual preferences to be translated into individual decisions that will produce the desired outcome.” Upon retiring, a worker may choose from two general payout options. In one case, a retiree may use the capital in his PSA to purchase an annuity from any private life insurance company.

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