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Chile's Privatization Failures
The Century Foundation
April 26, 2005
Proponents of privatizing Social Security often look to Chile as a model system, most recently in an April 26 New York Times column by John Tierney. A closer look at the Chilean system's performance over the past quarter century, however, reveals high management fees, low participation rates, unexpectedly heavy dependence on an inadequate safety net, and prohibitively high costs to government. This has led to largely disappointing results, leaving many Chilean workers with no reliable retirement plan. Is this really the model the United States hopes to replicate?
For more about Chile's failed privatized pension plan, read recent articles by Greg Anrig, Jr., vice president of programs at The Century Foundation, No Way, José! and Lost in Translation, by Richard C. Leone, president of The Century Foundation, about the serious disappointments caused by changes to pension systems in Britain and Chile. Continue reading to understand how Chile's privatized system was supposed to work, what went wrong, and why it would be a mistake for the United States to follow Chile's lead.
Chilean Privatized Pension System: How It Was Supposed to Work
In 1981, Chile's military dictatorship sought to reduce government spending and labor costs by privatizing the oldest social insurance program in the Americas.
The Chilean pension system was, by all accounts, in need of reform. The system's deficit had risen to 25 percent of Chile's gross domestic product, yet 93 percent of retirees received only the minimum pension benefit. Today, some people argue that American Social Security is also in need of reform. They urge America to follow Chile's example by allowing workers to redirect all of their Social Security contributions to personal pension accounts. A closer look at the Chilean system's performance over the past twenty five years, however, should be cause for caution.
General Augusto Pinochet's regime created a system of private funds-called Administradores de Fondos de Pensiones, or AFPs-to manage and administer workers' individual retirement accounts and survivors' and disability benefits. The new system was mandatory for all workers entering the labor force after 1981. Workers already in the labor force had the option of participating or remaining in the traditional government program.
. Every worker participating in this defined-contribution system designates an AFP to receive a mandatory payroll deduction of 10 percent of salary (up to $22,000), plus an additional 2.5 percent to 3.7 percent for death and disability insurance and administrative fees. (Employees may voluntarily contribute up to an additional $2,000 a month to their retirement accounts, although only the mandatory contribution is tax-deductible.)?
. When workers who have contributed to an AFP for twenty years retire (at age sixty-five for men, sixty for women), they can use the accumulated funds to buy an annuity or draw down their account according to an actuarially determined schedule.
. The government requires AFPs to pay an average annual return equal to at least 50 percent of the average return of all AFP accounts or two percentage points below it, whichever figure is higher.
What Went Wrong: The Reality of Chile's Privatized Retirement Plan
A quarter of a century since privatization took effect, Chilean's retirement security is on shaky ground. Recent reports by the World Bank and the Federal Reserve have highlighted some of the many problems with Chile's system. A combination of high management fees, low participation rates, unexpectedly heavy dependence on an inadequate safety net, and prohibitively high costs to government have led the system along a path of failure and left many Chilean workers with no reliable retirement plan. Is this really the model the United States hopes to replicate?
There are prohibitively high expenses and fees. Voracious commissions and other administrative costs have swallowed up large shares of personal accounts. It is estimated that roughly 28 to 33 percent one-quarter to one-third of contributions made by employees retiring in 2000 went toward fees.
. The brokerage firm CB Capitales calculated (see English language discussion by Stephen Kay of the Federal Reserve Bank of Atlanta here) that when commission charges are taken into consideration in Chile, the total average return on worker contributions between 1982 and 1999 was 5.1 percent-not 11 percent as calculated by the superintendency of pension funds. That report found that the average worker would have done better simply by placing their pension fund contributions in a passbook savings account.
There are low participation rates. Half of Chileans, primarily the poorest, do not contribute to a pension fund at all. The New York Times notes, "Many [Chileans]-because they earned much of their income in the underground economy, are self-employed, or work only seasonally-remain outside the system altogether. Combined, those groups constitute roughly half the Chilean labor force. Only half of workers are captured by the system."
. Even the military does not participate in the privatized system. While the military imposed the private accounts on all other workers entering the labor force after 1981, it continues to receive pensions under the old, favored governmental system.
There is unexpectedly heavy dependence on an inadequate safety net. Stephen J. Kay of the Federal Reserve Bank of Atlanta recently found that investment accounts of retirees are much smaller than originally predicted-so low that 41 percent of those eligible to collect pensions continue to work.
. The New York Times revealed in an article earlier this year that under the old pay-as-you-go system, the maximum monthly benefit is $1250. Under the privatized system, a worker would have to contribute more than a quarter of a million dollars over the course of his or her career to receive as much in retirement benefits each month. Just 500 of the seven million participants in private accounts, has been able to do so.
There are unexpectedly high transition and supplementary costs. The transition costs of shifting to a privatized system in Chile averaged 6.1 percent of GDP in the 1980s, 4.8 percent in the 1990s, and are expected to average 4.3 percent from 1999 to 2037. Those costs are far higher than originally projected, in part because the government is obligated to provide subsidies for workers failing to accumulate enough money in their accounts to earn a minimum pension.
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