The real test of public policies often comes long after they were implemented – in the case of pensions, a working life later. And that is precisely where Chile’s private pension system, launched in 1981, is now.
By Ruth Bradley
Thirty-five years ago, Chile took what was then a radical step. It decided that, instead of financing pensions out of the social security contributions of the working population, it would oblige its citizens to begin to save for their own retirement.
The idea of individual pension savings accounts wasn’t altogether new but the Chilean system, with its private administrators (AFPs), became a model that was subsequently adopted, albeit with some modifications, by other Latin American and some East European countries. There were a number of powerful reasons why they followed suit.
As savings in the Chilean system gradually built up – today, they reach some US$173 billion or 70% of GDP – they provided a new source of investment financing for Chilean companies, fuelling the growth of the economy and the country’s capital markets and, in a virtuous circle, delivering high returns on the savings themselves. Moreover, by taking a large part of the burden of financing pensions off the government, the system also promised fiscal sustainability.
Chile’s private pension system is far from the only reason for the country’s healthy fiscal situation – a tradition of discipline enshrined in a fiscal rule that ties government spending to medium-term revenues is key – but it has helped. In the Global Aging Preparedness Index, developed by the US-based Center for Strategic and International Studies (CSIS) and published in 2013, Chile ranked third on fiscal sustainability, ahead of the US in 11th place.
But, since the early 1980s, pressures on pension systems worldwide – whether of the public pay-as-you-go type or those based on personal savings accounts – have mounted sharply. The population has, of course, aged – men of 65 in Chile can now expect to live another 21 years, up from 13 years when the private pension system was created, while, for women of 60, the increase has been from 21 to 30 years.
Real wages have increased too. For personal savings systems, that is a problem because the early years of a person’s savings will have been based on a much lower income than that with which, when they retire, they will compare their pension.
Then, there are international interest rates. Not only are they low now but there is a good chance they will remain so in the foreseeable future, reducing the return on pension savings.
The upshot is that, around the world, there is dissatisfaction with pension systems. And it may grow, with pressure for a shift to pay-as-you-go systems, warns Richard Jackson, president of the US-based Global Aging Institute and one of the authors of the Global Aging Preparedness Index.
The right pension
As well as being fiscally sustainable, pension systems also have to be socially and politically sustainable. That depends crucially on the pensions they pay and is where the Chilean system has run into problems.
When it was launched, it promised a replacement rate – a pension measured as a percentage of a person’s income at the end of their working life – of 70%. That promise was tied to a number of conditions, like the frequency of contributions, but what stuck in people’s minds was the magic 70% figure.
However, according to the Organisation for Economic Co-operation and Development (OECD), the replacement rate in Chile for an average earner is currently just under 40%. That is not only far below Chileans’ expectations but also well below the OECD average of just over 60%.
The Association of AFPs, the industry association, reckons that the rate is higher, pointing out that figures for the system as a whole can be misleading because they include people who, for whatever reason, did not contribute during all their working life. It cites a study it commissioned in 2012 which found replacement rates of 87% for men and 58% for women but that was based on a sample of only 25,000 pensioners.
What is a socially and politically sustainable replacement rate is a matter of debate and, in any case, depends on a person’s working income. Pablo Antolín, head of the OECD’s Private Pensions Unit, reckons that, for mid-income segments of the population, 60% fulfils the OECD’s definition of social sustainability as being sufficient to cover housing, food and other basic needs and leave a bit over for extras – “although not a trip to Europe every year,” he cautions.
For low earners, on the other hand, he says 60% is not enough. In Chile, though, low earners are closer to that figure than their better-off peers because, thanks to supplementary state pensions introduced in 2008, they have a replacement rate of almost 50%, according to the OECD.
This suggests that President Michelle Bachelet was right when, on announcing plans to reform the AFP system in August, she indicated that the challenge now is not so much old-age poverty – although that still exists – as inadequate pensions further up the income scale. The question, though, is why they are inadequate.
One common complaint is that the AFPs are “expensive” or, in other words, that their administration fees take too large a slice out of their contributors’ savings. Critics point out that, because these fees are charged separately from payments into contributors’ accounts, the return on the latter as published by the industry and the regulator, the Superintendency of Pensions, does not reflect this cost.
The fact that there are now only six AFPs – down from over 20 in the 1990s – and that the two largest account for over 50% of the industry’s assets under management gives credence to the argument of a lack of competition. Indeed, the government cites limited competition in the industry as the reason for a bill currently before Congress to create a state AFP.
Comparing pension systems’ administration fees across countries or with other financial service industries is notoriously tricky because they are charged in so many different ways. Are they charged, for example, as a percentage of a contributor’s monthly income as in Chile? Or, as more usually, on the balance in a contributor’s account?
Rodrigo Pérez, president of the Association of AFPs, estimates that the industry’s fees come in at around 0.6% of the balance in contributors’ accounts. That compares favorably with the commissions charged by both local and international mutual funds, he says.
Pablo Antolín, on the other hand, considers them on the high side. Thanks to the 2008 reform’s introduction of an auction system for new contributors, fees have dropped significantly, he notes, but there is, he believes, still room for improvement.
Crux of the problem
According to Antolín, however, the industry’s administration fees are not the big issue. That can be summarized very simply – Chile is getting the pensions it pays for.
The mandatory contribution rate – the percentage of their income that AFP contributors must pay into their account each month – has remained unchanged at 10% since 1981, even as life expectancy has lengthened. Rodrigo Pérez points out that, over a working life of 30 years, that is equivalent to paying in just three years’ earnings which, plus the return, pensioners must then try to spread over 20 or 30 years of retirement.
The government is now proposing to increase the contribution rate to 15%. It is not yet clear whether the additional 5% would go to AFP contributors’ personal accounts or to a common fund to finance top-ups of lower pensions. In the former case, however, it would represent a 50% increase in the amounts being paid in, suggesting that – all other things, like rates of return, being equal – the replacement rate ought eventually also to rise by 50% or, in other words, to a more sustainable 60%.
But the contribution rate is not the only problem. There is also the matter of the so-called density of contributions or, in other words, during what percentage of their working life people actually pay into the AFP system.
It is worryingly low. According to a report last year by an advisory commission on pension policy convened by the government, contribution density averages only around 50% – and drops sharply with income level – and, for women, who often take time out of the labor market to raise children, reaches a mere 33%.
That is, however, not strictly a pension issue and it would be a mistake to treat it as such, warns Pablo Antolín. “In the past, Latin America has tried to solve labor market issues through pension policy and it has backfired,” he says.
One of the issues is informal employment. That not only helps to explain why the density of contributions is lower among low-income segments of the population, but also means that it will tend to drop whenever the economy weakens and the labor market softens.
A further problem is self-employment. This can also be related to a soft labor market since it is often a stopgap in the face of the loss of a formal payroll job. In Chile, however, even the self-employed who are in the formal sector in the sense that they pay taxes regularly are rarely AFP contributors.
According to the National Statistics Institute (INE), some 2 million Chileans, or a quarter of the labor force, are self-employed. Under the pension reform introduced by the first Bachelet administration in 2008, pension contributions would have become mandatory for the self-employed as from 2015 but, during the prior voluntary period, over 70% opted out and mandatory contributions have yet to be enforced.
The AFP industry recognizes that some changes to the system are required. That is not only because of longer life expectancy but also because, with Chile close to being a developed economy, returns on the system’s assets under management will almost certainly drop.
Some of the decisions that need to be taken will be politically tough. The retirement age for women – an issue on which the government has not defined its position – will almost certainly have to increase from its current 60 years (as compared to 65 for men). At present, 13 OECD countries have a lower retirement age for women than men, but the difference is on the way to being eliminated in all but three – Chile, Switzerland and Israel.
Difficult decisions call for straight talking and, ahead of AmCham’s publication of a position paper on the government’s reform proposals, one of the key tasks is to manage expectations, says the Chamber’s president, Kathleen Barclay. “Any changes need to be based on a complete and shared diagnosis,” she says.
That, in turn, raises the matter of financial education. A survey carried out recently for Felices y Forrados, a company that advises AFP contributors on how to make best use of the system, found that 37% did not know that their pension savings actually belong to them, rather than their AFP. Moreover, according to Gino Lorenzini, the company’s founder, there is a close correlation between this misconception and inclination to participate in protest marches against the system.
Lack of understanding of the pension system is not a problem confined to Chile. “Financial education is a pending challenge worldwide and one we’re only just beginning to get to grips with,” says the Global Aging Institute’s Richard Jackson.
One consequence of this is that, in Chile, most people don’t seem to shop around for the best AFP deal. Administration fees range from 1.54% to 0.41% of monthly income but the AFP with the highest fee has 1.6 million contributors and the one with the lowest fee only 450,000.
Education about the pension system should be carried out through a public-private partnership, suggests Kathleen Barclay. “That’s the only way to ensure it has real credibility in people’s eyes,” she says.
Increasing the credibility of the AFP pension system is, indeed, a key challenge. Otherwise, demand for a return to a state-funded pay-as-you-go system, already voiced in recent protest marches, is likely to mount.
But that is a classic “the grass is greener on the other side of the fence” trap. After all, the same factors – an aging population and the prospect of lower returns – with which personal account systems around the world are battling are also a problem for the sustainability of pay-as-you-go systems. They are tests for all pension systems, not just one particular sort.