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Social Security Privatization in Chile:
A Case for Caution
By Steve Idemoto, September 29, 2000
A Need for Reform
Pinochet's Privatization Scheme
The Consequences of Social Security
Reform
High Cost of Transition
Exorbitant Management Fees
Pension Non-Participation
Affects on Low-Income Workers and
Women
Vulnerability to Market Risk
Lessons for the U.S.
Conclusion
Endnotes
Related Link(s)
In order to pay for the transition to a fully privatized system, Chile had
to drastically cut public spending, raise taxes, lower benefits, sell
government assets, and issue bonds.
Proponents of Social Security privatization often trumpet the Chilean ?success story.? Right wing
economists (and the finance industry-funded think tanks that sponsor them) spin fabulous yarns about
the way the free market transformed Chile?s pension system. In doing so, however, they leave out
crucial parts of the plot. Privatization advocates paper over very serious problems with Chile?s social
security program.
While the full impact of privatization cannot be known until the system completely matures, a number
of troubling issues have already arisen. For example:
Transition costs have negatively impacted public spending.
Pension fund management fees are exorbitant.
Non-participation threatens the overall viability of the system.
Individual accounts replace less of low-income workers and women?s wages.
Private accounts leave workers susceptible to market downturns.
Given the distinct social, political, and economic differences between Chile and the U.S., the
relevance of Chile?s privatization experience to U.S. policy-makers is debatable. While this concern is
legitimate, we would be remiss if we failed to take note of the results of Chile?s 19-year social
experiment.
A Need for Reform
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By all accounts, Chile?s public pension program was foundering in the 1970s. The system was
extremely complex, consisting of over 100 different retirement regimes. Contribution rates, retirement
ages, and benefits all varied by type of occupation. Inevitably, perhaps, this excessive complexity
resulted in substantial administrative inefficiency.[1]
The retirement program?s funding situation was similarly dire. The system was not generating
adequate revenue to pay retirees despite payroll taxes as high as 25 percent.[2] Even with
government general fund subsidies equivalent to 4 percent of Chile?s GDP, a substantial majority of
retirees were receiving benefits at a level below the official minimum pension.[3] Manual workers, for
example, were supposed to receive benefits that would replace 70 percent of their wages, but by the
1970s the rate was closer to 20 percent.[4]
The program?s numerous problems were exacerbated by widespread tax evasion. The pension
system lost a significant amount of revenue to unscrupulous employers who skirted contribution
requirements and to workers who joined the burgeoning underground economy. The fact that the
Chilean government lacked the resources or the political will to adequately police the system no doubt
contributed to the situation.[5]
Pinochet?s Privatization Scheme
In 1981, the Chilean government under military dictator Augusto Pinochet took the radical step of
phasing out the country?s troubled publicly funded social security program and mandating participation
in a system of privately managed individual accounts. Under this program, workers must contribute 10
percent of their wages, up to a specified ceiling, to a government-approved investment fund. Workers
are required to pay another 3 percent to cover term life and disability insurance. Participation is not
mandatory for self-employed workers, but they may voluntarily set up accounts with the same basic
features.
Individual account contributions are managed by private investment firms (called Administradoa de
Fondos de Pensiones, or AFPs). Once a worker signs on with an AFP, he or she must stay with the
investment firm for at least four months before switching. Contributions, including voluntary
contributions of up to an additional 10 percent, are tax deductible. Upon retirement, workers have two
withdrawal options: they may purchase an annuity or withdraw money based on a
government-determined schedule. At the time of withdrawal, pension benefits are taxable as
income.[6]
The Consequences of Social Security Reform
The Chilean experience with social security privatization gives much reason for pause. Major
concerns include: the high cost of transition to a privatized system, exorbitant pension fund
management fees, non-participation in the scheme, the effects on low/middle-income workers and
women, and the vulnerability of workers to market risk. These concerns are examined more closely in
the following sections.
High Cost of Transition
Transition from a pay-as-you-go social security system to a privatized system entails substantial
costs. Under a pay-as-you-go system, the contributions of today?s workers fund the benefits of today?s
retirees. Under a newly privatized system, where workers? contributions are diverted into individual
accounts, cash must be found to fund the benefits of retirees and workers nearing retirement (who
paid into the old system but didn?t have a chance to save up an adequate nest egg under the
privatized system).
Chile funded its transition to a privatized system in five ways: drastically cutting public spending,
raising taxes, reducing benefits, selling government assets, and issuing debt.
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Cutting public spending. The Chilean government has cut social expenditures, including health
and education spending, to help pay the pensions of retired and retiring workers.[7]
Raising taxes. Chile introduced a value-added tax in 1975 in order to raise revenue for the
anticipated transition.[8]
Reducing lifetime benefits. In order to cut costs, the Chilean government raised the retirement
age for beneficiaries. Prior to reform, retirement ages varied?ranging from 44 to 65. In order
to cut costs, the Pinochet regime standardized retirement at 65 for men and 60 for women. The
dictatorship also eliminated special pensions based on years of service.[9]
Selling government assets. Transition to a privatized system was partially subsidized through
the sale of state-owned enterprises to the private sector.
Issuing debt. Government bonds finance approximately 40 percent of the annual costs of
transition. These bonds are sold to AFPs and will be gradually redeemed by the government
using general revenue.[10]
Analysts project that costs from the transition to a privatized system will be completely paid by 2050, at
which point there should no longer be any beneficiaries in the old system.[11]
Exorbitant Management Fees
At first glance, returns on individual account investments in Chile appear quite respectable. After
factoring in management fees?which currently range from 16 to 20 percent of annual
contributions?the situation can look much different.
Over certain periods, management expenses dragged rates of return to nearly negligible levels. For
example, although the average rate of return on individual accounts from 1982 to 1986 was 15.9%, the
real return after commissions was just 0.3%. Returns between 1991 and 1995 averaged 12.9%, but
management fees lowered the return to 2.1%.[12] For a new worker enrolling in 1996, the 3.5% gross
yield actually amounted to a ?6.8% return after taking management fees into account.[13] These
adjusted returns, moreover, do not include the cost of annuitizing retirement accounts, which in Chile
entails a fee equivalent to 8 to 9 percent of total retirement assets.[14]
A substantial proportion of these fees are used to pay sales staffs and to cover marketing expenses.
AFPs compete fiercely for new enrollees, offering inducements such as toaster ovens and promising
workers higher returns if they switch plans. Between 1990 and 1997, the AFP sales force in Chile
grew from 3,500 to 20,000. The upshot of this intense marketing is that 50 percent of all enrollees
switch investment funds each year.[15]
Pension Non-Participation
In Chile, only 50 percent of the workforce regularly contributes to the social security system.[16] Of
workers who do participate, many underreport their income in order to lower their tax liabilities. A
study by Chilean economist Jaime Ruiz-Tagle, for example, found that workers contributing to AFPs
earned an average of $1000 in February 1995, but declared only $460 for tax purposes.[17] If, as
could be expected, these non-contributing and underreporting workers retire with inadequate savings,
the fiscal and social implications for future governments will be substantial.
Effects on Low-Income Workers and Women
While actual returns on investments are the same for all contributors to a particular fund, a number of
flat fees and expenses siphon off a greater proportion of the contributions of low- and middle-income,
than higher-income, workers. Moreover, individual accounts do not allow for redistribution of income
the way pay-as-you-go systems do. This leaves many low- and moderately-paid workers worse off
under a privatized system than they would have been under a public system.
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Chilean women?who are paid less, work more intermittently (often taking time off to give birth and
raise children), and live longer than men?will inevitably receive lower benefits than men. While public
systems tend to compensate for women?s social and economic situations, private programs do not.
Chilean women, then, are at particular risk under the privatized system.
Vulnerability to Market Risk
From the mid-1980s to the early 1990s, returns on AFP accounts were impressive (as noted above,
returns after fees were less so). Recently, however, returns have been poor. In 1994, more than half
of AFPs incurred losses. Between 1995 and 1998 returns were -2.5%, 3.5%, 4.7%, and -l.1%
respectively.[18] Taking management costs into account, workers actually lost a substantial amount of
money over this period. In fact, when financial markets slid again in 1998, Chilean officials asked
workers to defer retirement until the situation improved.[19]
Lessons for the U.S.
The United States and Chile are very different in many ways. Politically, the U.S. has a strong,
functioning democracy that has been in place for over 200 years. Chile, on the other hand, only
emerged from military rule 10 years ago. Chile?s economy, likewise, is much less developed than that
of the U.S. The U.S. has a per capita GDP nearly 3 times that of Chile ($31,500 vs. $12,500 in
1998).[20]
More importantly, America?s Social Security system is in a very different position than was Chile?s in
1981. Chile?s social security administration was highly inefficient. The U.S. system, in contrast, is run
extremely proficiently. All administrative duties are performed at a cost of 0.9 percent of net
contributions, or less than a penny per dollar contributed.[21] Moreover, Chile?s public program was
having serious funding problems. Even with substantial general fund injections and payroll tax rates
more than double those in the U.S., the system was not able to pay promised benefits. In the U.S.,
even according to the pessimistic projections of the U.S. Social Security Trustees, the system will be
completely self-sufficient and fully funded until 2037.[22] If economic growth in the U.S. continues at
the same average rate it has been for the past 50 years, then our system will be fully funded
indefinitely. With some minor changes to the program (i.e. lifting the cap on taxable wages), Social
Security in the U.S. would be fully funded past 2075, even under the pessimistic growth scenario of the
Social Security Trustees. Despite these differences, however, there are a number of lessons that we
can take away from Chile?s experience with privatization.
First, transition to a privatized system would be extremely expensive. In order to pay for the transition
to a fully privatized system, Chile had to drastically cut public spending, raise taxes, lower benefits,
sell government assets, and issue bonds. In the U.S., researchers estimate that even a plan to
privatize 2% of the 12.4% Social Security payroll tax would cost $74 billion per year, or 4% of the
annual federal budget.[23] This is a substantial loss of funding and would necessitate substantial
general fund transfers, spending cuts, tax increases, benefit reductions, or some combination of these
options.
Second, exorbitant management fees in Chile wipe out a significant portion of workers? returns.
Experience with individual accounts in Britain suggests that administrative fees in the U.S. would
average 2.5 percent of assets per year. Over an average career and retirement, fees charged at this
level would reduce the total value of a worker?s account by 25 percent. Add in alteration costs
(incurred when a worker switches pension providers or temporarily stops making contributions) and
annuitization expenses and approximately 43 percent of the average worker?s account will be spent on
fees before the first retirement check is cut. [24]
Third, privatized pension accounts put Chilean women and low-income retirees at risk. The U.S.
Social Security system has a progressive benefit structure that replaces a larger proportion of
low-earners? wages. Moreover, the system provides a guaranteed, inflation-adjusted benefit for life.
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These features help low-income workers generally, but particularly help women (who tend to live
longer than men). Under a privatized system, these beneficial features would be lost.
Lastly, private accounts leave workers at the mercy of the market. In Chile, a market downturn in
1998 drained many retirement accounts leaving officials in the awkward position of urging workers to
defer retirement indefinitely. Privatization advocates in the U.S. note that the 70-year average real
rate of return on the stock market has been 7 percent. While this is true, it ignores the fact that the
stock market is very volatile. According to John Mueller, former economic counsel to the U.S. House
of Representatives? Republican Caucus, the 20-year average real return on the stock market fell to
zero three times since 1900?from 1901 to 1921, from 1928 to 1948, and from 1962 to 1982.[25]
Factor in administrative costs and actual returns dipped significantly below zero during these periods.
Under these circumstances, workers would have been hard-pressed to save for a decent retirement.
Conclusion
Advocates of Social Security privatization continually crow about Chile?s high returns under individual
accounts. In concentrating on returns, however, they miss crucial parts of the story. They ignore the
fact that Chile has cut social spending, raised taxes, and cut benefits in order to pay transition
costs?transition costs that the government will continue to pay until 2050. They ignore exorbitant
management fees that have, over a number of periods, cut these much-vaunted returns to nearly
zero. Advocates also fail to mention that these individual accounts have increased economic
inequality and left workers vulnerable to market downturns. Moreover, privatized systems must either
require retirees to convert a substantial portion of their account into an annuity ? which means that the
account can't be passed on to heirs other than the spouse ? or accept a high percentage of the very
elderly outliving their account and falling into dire poverty. Once these factors are taken into account,
the case for privatization becomes much shakier.
Endnotes
[1] Congressional Budget Office, ?Social Security Privatization, Experiences Abroad,? January 1999.
[2] John B. Williamson, ?Privatizing Public Pension Systems: Lessons for the United States from
Latin America,? Center for Retirement Research, November 1999.
[3] L. Jacobo Rodriguez, ?Chile?s Private Pension System at 18: Its Current State and Future
Challenges,? The Cato Project on Social Security Privatization, July 30, 1999.
[4] John B. Williamson, ?Privatizing Public Pension Systems.?
[5] Congressional Budget Office, ?Social Security Privatization, Experiences Abroad,? January 1999.
[6] In 1999, the cap applied to the first $22,300 of earnings.
[7] Stephen J. Kay, ?The Chile Con: Privatizing Social Security in South America,? The American
Prospect, July-August 1997.
[8] Congressional Budget Office, ?Social Security Privatization, Experiences Abroad,? January 1999.
[9] Stephen J. Kay, ?The Future of Social Security for this Generation and the Next,? Testimony
Before the Subcommittee on Social Security of the House Ways and Means Committee, U.S.
House of Representatives, September 1997).
[10] John B. Williamson, ?Privatizing Public Pension Systems.?
[11] Barbara E. Kritzer, ?Privatizing Social Security: The Chilean Experience,? Social Security Bulletin,
Fall 1996.
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[12] Stephen J. Kay, ?The Chile Con.?
[13] Twentieth Century Fund, ?Chile?s Experience with Social Security Privatization: A Model for the
United States or a Danger Sign?? June 1998.
[14] Congressional Budget Office, ?Social Security Privatization, Experiences Abroad.?
[15] John B. Williamson, ?Privatizing Public Pension Systems.?
[16] Stephen J. Kay, ?The Chile Con.?
[17] Twentieth Century Fund, ?Chile?s Experience with Social Security Privatization.?
[18] John B. Williamson, ?Privatizing Public Pension Systems.?
[19] Stephen J. Kay, ?The Perils of Private Pensions,? Foreign Policy, Winter 1999-2000.
[20] Central Intelligence Agency, World Factbook 1999,
http://www.odci.gov/cia/publications/factbook/.
[21] Social Security Administration, The Office of Policy, ?What are Social Security?s Administrative
Costs?? July 2000, http://www.ssa.gov/policy/pubs/BGP/bgpAdmCost.html.
[22] Annual Report of the Trustees of the Old Age, Survivors, and Disability Insurance Trust Funds,
2000. House Document.
[23] Edith Rasell and Christian E. Weller, ?The Perils of Privatization,? Economic Policy Institute, May
2000.
[24] Peter R. Orzag, ?Administrative Costs in Individual Accounts in the United Kingdom,? Center on
Budget and Policy Priorities, March 1999.
[25] John Mueller, ?Three New Papers on ?Privatizing? Social Security, One Conclusion: Bad Idea,?
http://www.globalaging.org/pension/us/socialsec/mueller.htm.
Related Link(s)
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