The Chile Con: Privatizing Social Security in South America

Advocates of privatizing Social Security point to the success of Chile. In 1981, Chile replaced its inefficient state-run pension program with a private system where workers fund their own retirements through compulsory private savings. The Chilean solution has captured the imagination of free-market believers the world over. But a closer look suggests that Chile is no model for the United States.

One problem is huge management fees. Up to 20 percent of worker contributions go to middlemen. A second failing is that only a little over half of Chilean workers make regular social security contributions. And even for those who do contribute, Chile's new private system provides little progressive redistribution of income. Chile has also benefited from fortuitous timing. Unsustainable high rates of return in both stocks and bonds have exaggerated its long-term success.

Even more fundamentally, the two systems are not comparable. Chile's old system was an administrative mess. Like many other Latin state-run pension systems, it was underfunded and failed to provide adequate coverage to most workers. Our system, by contrast, is well managed, clean, and nearly universal. In the U.S., privatization is far too radical a cure for what is essentially a modest actuarial shortfall.

THE PRIVATE GRAIL

In the Latin American context, privatization seemed a plausible remedy to the corruption and inefficiency of state-run systems, in nations not noted for clean and reliable government. In the Southern Cone of South America, aging populations and massive evasion by both employers and workers created a system disastrously out of balance. Surpluses had been wasted on bad investments; benefits were often inegalitarian and financed regressively; deficits were mounting; and management was inefficient. By the 1980s, ever fewer contributions were supporting more pensioners, and payroll taxes were among the highest in the world. Latin America's large informal sector left millions more with no coverage at all.

By the end of the 1980s (that "lost decade" of Latin American economic development), an era of crushing interest rates, negative growth, and fiscal calamity, there was broad support for pension reform, coupled with intense political conflict over the particulars. Reforms ranged from partial privatizations in Argentina and Uruguay, to an aborted privatization drive in Brazil, where reform is still underway. In recent years, Mexico, Peru, Bolivia, and Colombia have attempted variations on the theme.

Chile's plan, enacted during the Pinochet dictatorship, is the only case of total privatization. The Chilean approach reversed a 100-year global trend toward increased state sponsorship of social insurance. Most countries, including the United States, use a tripartite "pay-as-you-go" model, in which payroll taxes on workers and employers, supplemented by government contributions, fund current benefits. By contrast, in Chile's private plan workers are required to contribute 10 percent of their salaries to private investment accounts, whose funds are invested by private pension fund companies in closely regulated portfolios. Upon retirement, the accumulated capital can be used to purchase an annuity.

A MIDDLEMAN'S PARADISE

Seemingly, Chile's private system has achieved impressive average returns on investment. However, once commissions are factored in, the real return for individual workers is considerably lower. Nominally, the real annual return on investment between 1982 and 1995 averaged 12.7 percent. But a recent paper by World Bank economist Hemant Shah demonstrated that an individual's average rate of return over this period after paying commissions would have been 7.4 percent.

The real return after commissions over other periods of time is even lower. For example, although the average rate of return on funds from 1982 through 1986 was 15.9 percent, the real return after commissions was a mere 0.3 percent! Between 1991 and 1995, the pre-commission return was 12.9 percent, but with commissions it fell to 2.1 percent. Chilean regulators have sought to lower commissions, which have come down from their peak of 8.69 percent of taxable salary in 1984 to around 3.1 percent today (this includes a disability insurance premium of around 1 percent of income), but these middleman fees still represent between 16.7 percent and 20 percent of a worker's overall social security contributions (administrative costs under the old public system in Chile represented 5 percent of total contributions). By contrast, the U.S. system pays no commissions, and administrative costs are less than 2 percent of workers' contributions. Upon a Chilean worker's retirement, financial advisors charge fees as high as 3 percent to 5 percent of the worker's total accumulated funds to help the worker choose among various financial options.

Although market competition was supposed to lower commissions in Chile, the private pension fund market is dominated by a handful of companies. These, according to economists Peter Diamond and Salvador Valdes-Prieto, form a "monopolistic competitive market" rather than a truly competitive one. A similar process seems to be taking place in Argentina, where commissions have remained around 3.5 percent of taxable salary.

Private pension funds engage in costly sales campaigns to capture members from each other. An estimated 25 percent of affiliates in Chile switch pension fund companies each year. These marketing wars of attrition keep administrative costs high. Moreover, evasion, which was rampant in the old public system, has continued in the private one. While many believed that a private system would reduce evasion because workers have a greater incentive to contribute to their own personal retirement accounts, 43.4 percent of those affiliated with the new system in June of 1995 did not contribute regularly. Furthermore, while it is difficult to quantify, there is evidence that there is substantial evasion among workers who do contribute. Chilean economist Jaime Ruiz-Tagle reports that while income for contributing workers in February 1995 averaged $1,000 per month, the average declared taxable income was only $460 per month.

Even if commission costs were lowered, the impressive returns on capital likely cannot be sustained. The 12.7 percent average return between 1982 and 1995 coincided with boom years in Chile complemented by government's high borrowing costs. Because of the debt crisis of the 1980s, Latin governments were paying double-digit real interest rates on their bonds-the main investment vehicle of social security funds. In effect, government was subsidizing the "private" system by paying astronomical rates on government bonds. Today's rates on government securities are much lower. Predictions for future annual returns, which will determine pension benefits, range between 3 percent and 5 percent.

EQUITIES AND EQUITY

Given the vast informal sectors in the region, the neediest members of the population remain outside of the social security system. Argentine economist Ruben Lo Vuolo estimates that given unemployment, underemployment, and the working poor, only 50 percent of the economically active population in Argentina are able to contribute regularly to the social security system. In Brazil, 57 percent of the workforce is in the informal sector.

Privatization also abandons the redistributive aspects of the public systems. As José Piñera, the founder of the Chilean system, noted, "the idea is not to redistribute income after a person retires." In a private system, benefits depend exclusively on the level of individual contributions and investment performance, so social security ceases to be an antipoverty program.

Public systems tended to compensate for the intermittent work history characteristic of women. But the private social security systems in South America favor men by placing men and women in separate actuarial categories. Because they tend to earn less, spend more years of their lives in unpaid labor, and have greater longevity, women purchasing annuities upon retirement will systematically receive lower benefits than men. Furthermore, certain predominantly male occupations continue to receive special treatment. Military and police pensions, which have traditionally been generous, have been exempted from privatization.

TRANSITION PROBLEMS

The extraordinary transition costs of privatization, and their distribution, is the most overlooked issue in the privatization debate. In a privatized system, workers stop paying social security contributions to the government, but the government must still pay benefits to those already retired. This shortfall in revenue can only be financed through cutting other government spending, raising taxes, or incurring debt. To pay for the social security debt in Chile, which is expected to be between 4 percent and 6 percent of their gross domestic product over the next seven years, the former military government ran a budget surplus while cutting spending on redistributive programs like health and education.

Argentina, which passed a partial privatization law in 1993, dealt with the revenue shortfall by cutting social security benefits. Such cuts would have been too controversial to include during the 1993 debate over the privatization law, which barely passed. However, once workers began affiliating with the new private system and the transition costs of privatization began to come due, the public social security system became vulnerable to further cuts.

The lesson here is that privatization is very expensive, and that the true costs of such a reform must be transparent. In one plan being discussed by the U.S. Social Security Advisory Council, 5 percent of workers' income would go into private accounts, diverting $1.2 trillion from the public system over 35 or 40 years. How the United States would eventually pay for this transition is anybody's guess, but if the South American cases are any guide, the public redistributive component of Social Security and other public programs would become vulnerable to cutbacks.

POLITICAL RISK VERSUS MARKET RISK

In Latin America, politicians have often used social security as a political tool, doling out benefits and administrative jobs to loyal political supporters. Leaders like Juan Peón in Argentina and Getulio Vargas in Brazil used social security to attract support for their urban-based populist political coalitions. For the politically connected, benefits were generous and easy to obtain, but average workers usually had to go through political intermediaries or endure long waits before getting benefits. Since industry and labor were protected from international competition, the costs were simply passed on to consumers.

Privatization, arguably, replaces political risk to pensions with market risk. In Latin America, social security benefits were always subject to political risk, because unlike in the United States, governments often failed to index benefits against inflation, or did not pay what they legally owed. By 1994, underpayment of benefits led to the filing of 335,000 lawsuits against the Argentine government for failing to fulfill its obligations.

Although Social Security has also been used by U.S. politicians to score points among voters, it has always paid its benefits on time, is fiscally solvent, and has never been subject to the episodes of fraud and mismanagement that have occurred in South America. Unlike their Latin American counterparts, would-be privatizers in the United States cannot substantiate rhetoric about government inefficiency ruining Social Security. Furthermore, although one of the virtues of privatization is that it removes Social Security from the hands of politicians, the vast sums invested in private pension funds will require adequate regulation, and hence will be subject to both political and market risks. The form of "political risk" can be modified, but in a government-mandated system that uses the power to tax, it cannot be eliminated.

As this brief description indicates, the Latin American social security systems suffered from financial and administrative problems that we in the United States can scarcely imagine, and their debates over privatization were informed by fundamentally different political and economic realities. Yet the private alternative displays serious flaws, and the rush to emulate it has slowed, even in Latin America. Ultimately, Argentina and Uruguay's governments divide political and market risks by passing privatization laws that preserved a strong public pillar.

Given that our own Social Security system does not suffer the maladies that plagued those in South America, privatization is a risky strategy for resolving a tractable actuarial shortfall. A key unresolved issue is how the transition costs of privatization would be distributed. Would they be paid for by new taxes, government borrowing, or cuts in other areas of public spending? Would cuts come in health or education, as in Chile? Would Social Security retain a progressive redistributional component? How much of the market risks of privatization would be shouldered by individuals, and how much by the government? Would membership in a private system be optional or mandatory? How closely would pension fund investments be regulated? Would men and women be placed into separate actuarial categories, with women receiving lower benefits? And finally, given the Chilean experience, how would administrative costs be kept down?

These policy questions-not fleeting, bull-market-inspired visions of high investment returns-should be at the center of any debate over privatization in the United States. So far, the South American experiments in privatization do not provide evidence that should compel us to exchange one of our government's most successful programs for the expense, risk, and inequity of privatization.

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