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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 annuity guarantees a constant monthly income for life, indexed to inflation (there are indexed bonds available in the Chilean capital market so that companies can invest accordingly), plus survivors’ benefits for the worker’s dependents. Alternatively, a retiree may leave his funds in the PSA and make programmed withdrawals, subject to limits based on the life expectancy of the retiree and his dependents. In the latter case, if he dies, the remaining funds in his account form a part of his estate. In both cases, he can withdraw as a lump-sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages.

The PSA system solves the typical problem of pay-as-you-go systems with respect to labor demographics: in an aging population the number of workers per retiree decreases. Under the PSA system, the working population does not pay for the retired population. Thus, in contrast with the pay-as-you-go system, the potential for intergenerational conflict and eventual bankruptcy is avoided. The problem that many countries face—unfunded pension liabilities—does not exist under the PSA system.

In contrast to company-based private pension systems that generally impose costs on workers who leave before a given number of years and that sometimes result in bankruptcy of the workers’ pension funds—thus depriving workers of both their jobs and their pension rights—the PSA system is completely independent of the company employing the worker.

Since the PSA is tied to the worker, not the company, the account is fully portable. Given that the pension funds must be invested in tradeable securities, the PSA has a daily value and therefore is easy to transfer from one AFP to another.

“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.” The problem of “job lock” is entirely avoided. By not impinging on labor mobility, both inside a country and internationally, the PSA system helps create labor market flexibility and neither subsidizes nor penalizes immigrants.

A PSA system is also much more efficient in promoting a flexible labor market. In fact, people are increasingly deciding to work only a few hours a day or to interrupt their working lives— “The PSA system solves the typical problem of pay-as-you-go systems with respect to labor demographics: in an aging population the number of workers per retiree decreases. Under the PSA system, the working population does not pay for the retired population.” especially women and young people. In pay-asyou-go systems, those flexible working styles create the problem of filling the gaps in contributions. Not so in a PSA scheme where stop-andgo contributions are no problem whatsoever.

The Transition One challenge is to define the permanent PSA system. Another, in countries that already have a pay-as-you-go system, is to manage the transition to a PSA system. The transition has to take into account the particular characteristics of each country, of course, especially constraints posed by the budget situation.

In Chile we set three basic rules for the


1. The government guaranteed those already receiving a pension that their pensions would be unaffected by the reform.

This rule was important because the social security authority would obviously cease to receive the contributions from the workers who moved to the new system.

Therefore the authority would be unable to continue paying pensioners with its own resources. Moreover, it would be unfair to the elderly to change their benefits or expectations at this point in their lives.

2. Every worker already contributing to the pay-as-you-go system was given the choice of staying in that system or moving to the new PSA system. Those who left the old system were given a “recognition bond” that was deposited in their new PSAs. (The bond was indexed and carried a 4 percent real interest rate). The government pays the bond only when the worker reaches the legal retirement age. The bonds are traded in secondary markets, so as to allow them to be used for early retirement.

This bond reflected the rights the worker had already acquired in the pay-as-you-go system. Thus, a worker who had made pension contributions for years did not have to start at zero when he entered the new system.

3. All new entrants to the labor force were required to enter the PSA system. The door was closed to the pay-as-you-go system because it was unsustainable. This requirement assured the complete end of the old system once the last worker who remained in it reaches retirement age (from then on, and during a limited period of time, the government has only to pay pensions to retirees of the old system). This rule is important because the most effective way to reduce the size of the government in our lives is to end programs completely, not simply scale them back so that a new government might revive them at a later date.

After several months of national debate on the proposed reforms, and a communication and “In contrast with the pay-as-you-go system, the potential for intergenerational conflict and eventual bankruptcy is avoided.” education effort to explain the reform to the people,1 the pension reform law was approved on November 4, 1980.

To give equal access to creating AFPs to all those who might be interested, the law established a six-month period during which no AFP 1See Piñera (1991) and (1995).

could begin operations (not even advertising).

Thus, the AFP industry is unique in that it had a clear day of conception (November 4, 1980) and a clear date of birth (May 1, 1981).

In Chile, as in most countries (but not the United States), May 1 is Labor Day. The choice of that date was not a coincidence. Symbols are important, and that date of birth allows workers to “The problem that many countries face— unfunded pension liabilities—does not exist under the PSA system.” celebrate May 1 not as a day of class struggle but as the day when they were freed to choose their own pension system and thus freed from “the chains” of the state-run social security system.

Together with the creation of the new AFP system, all gross wages were redefined to include most of the employer’s contribution to the old pension system. (The rest of the employer’s contribution was turned into a transitory tax on the use of labor to help the financing of the transition; once that tax was completely phased out, as established in the pension reform law, the cost to the employer of hiring workers decreased). The worker’s contribution was deducted from the increased gross wage.

Because the total contribution was lower in the new system than in the old, net salaries for those who moved to the new system increased by around 5 percent.

In that way, we ended the illusion that both the employer and the worker contribute to social security, a device that allows political manipulation of those rates. From an economic standpoint, workers bear nearly the full burden of the payroll tax because the aggregate supply of labor is highly inelastic. Also, all the contributions are ultimately paid from the worker’s marginal productivity, and employers must take into account all labor costs—whether termed salary or social security contributions—in making their hiring and pay decisions. By renaming the employer’s contribution, the system makes it evident that all contributions are made by the worker. In this scenario, of course, the final wage level is determined by the interplay of market forces.

The financing of the transition is a complex technical issue and each country must address this problem according to its own circumstances.

The implicit pay-as-you-go debt of the Chilean “Since the PSA is tied to the worker, not the company, the account is fully portable.” system in 1980 has been estimated at around 80 percent of GDP.2 (The value of that debt had been reduced by a reform of the old system in 1978, especially by the rationalization of indexing, the elimination of special regimes, and the raising of the retirement age).

A recent World Bank study (1994: 268) stated that “Chile shows that a country with a reasonably competitive banking system, a well-functioning debt market, and a fair degree of macroeconomic stability can finance large transition deficits without large interest rate repercussions.” Chile used five methods to finance the

short-run fiscal costs of changing to a PSA system:

1. In the state’s balance sheet (in which each government should show its assets and liabilities), state pension obligations were offset to some extent by the value of state-owned enterprises and other types of assets. Therefore privatization was not only one way to finance the transition but had several additional benefits such as increasing efficiency, spreading ownership, and depoliticizing the economy.

2. Since the contribution needed in a capitalization system to finance adequate pension levels is generally lower than the current payroll taxes, a fraction of the difference between them can be used as a temporary transition tax without reducing net wages or increasing the cost of labor to the employer.

2See World Bank (1994).

3. Using debt, the transition cost can be shared by future generations. In Chile roughly 40 percent of the cost has been financed issuing government bonds at market rates of interest. These bonds have been bought mainly by the AFPs as part of their investment portfolios and that “bridge debt” should be completely redeemed when the pensioners of the old system are no longer with us.

4. The need to finance the transition was a powerful incentive to reduce wasteful government spending. For years, the budget director has been able to use this argument to kill unjustified new spending or to reduce wasteful government programs.

5. The increased economic growth that the PSA system promoted substantially increased tax revenues, especially those from the value-added tax. Only 15 years after the pension reform, Chile is running fiscal budget surpluses.

The Results The PSAs have already accumulated an investment fund of $25 billion, an unusually large pool of internally generated capital for a developing country of 14 million people and a GDP of $60 billion.

This long-term investment capital has not only helped fund economic growth but has spurred the development of efficient financial “The problem of ‘job lock’ is entirely avoided. By not impinging on labor mobility, both inside a country and internationally, the PSA system helps create labor market flexibility and neither subsidizes nor penalizes immigrants.” markets and institutions. The decision to create the PSA system first, and then privatize the large state-owned companies second, resulted in a “virtuous sequence.” It gave workers the possibility of benefiting handsomely from the enormous increase in productivity of the privatized companies by allowing workers, through higher “Thus, a worker who had made pension contributions for years did not have to start at zero when he entered the new system.” stock prices that increased the yield of their PSAs, to capture a large share of the wealth created by the privatization process.

There are around 15 AFP companies and they are a diverse group. Some belong to insurance or banking conglomerates. Others are worker-owned or tied to labor unions or specific industry or trade associations. Some include the participation of international financial companies, such as AIG, Aetna, and Banco de Santander. Several of the larger AFP companies are themselves publicly traded on the Chilean stock exchange, and one of them recently issued American Depository Receipts on Wall Street (helped by the recent “A–” credit rating of Chilean sovereign bonds).

One of the key results of the new system has been to increase the productivity of capital and thus the rate of economic growth in the Chilean economy. The PSA system has made the capital market more efficient and influenced its growth over the last 15 years. The vast resources administered by the AFPs have encouraged the creation of new kinds of financial instruments while enhancing others already in existence but not fully developed. Another of Chile’s pension reform contributions to the sound operation and transparency of the capital market has been the creation of a domestic risk-rating industry and the improvement of corporate governance. (The AFPs appoint outside directors in the companies in which they own shares, thus shattering complacency at board meetings).

Since the system began to operate on May 1, 1981, the average real return on investment has been 13 percent per year (more than three times higher than the anticipated yield of 4 percent).

Of course, the annual yield has shown the oscillations that are intrinsic to the free market—ranging from minus 3 percent to plus 30 percent in real terms—but the important yield is the average one over the long term.

Pensions under the new system have been significantly higher than under the old, stateadministered system, which required a total payroll tax of around 25 percent. According to a recent study by Sergio Baeza (1995), the average AFP retiree is receiving a pension equal to 78 percent of his mean annual income over the previous 10 years of his working life. As mentioned, upon retirement workers may withdraw in a lump sum their “excess savings” (above the 70 percent of salary threshold). If that money were included in calculating the value of the pension, the total value would come close to 84 percent of working income. Recipients of disability pensions also receive, on average, 70 percent of their working income.

The new pension system, therefore, has made a significant contribution to the reduction of poverty by increasing the size and certainty of old-age, survivors, and disability pensions, and by the indirect but very powerful effect of promoting economic growth and employment.

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