Above: Running ‘Cause I Can’t Fly
It’s no secret that the United States’ brand of old-age safety net, known as “Social Security” is aging and failing. Due to the changing demographic nature of the U.S. labor force and the American people as a whole, the program is headed for collapse and insolvency. While the exact date of this collapse is hotly disputed, its inevitability is not. Given this situation, solutions are desperately needed and free-market proponents are stepping up to the plate to offer help. Reformers commonly reference Chile’s privatization of its old-age pension program as a source of inspiration for changes to Social Security. Under the current setup of Social Security, the pensions of retirees are paid for by current workers. Thanks to increased life expectancies, declining fertility rates, and the en masse retirement of baby boomers, the ratio of workers not collecting social security to the number of pensioners receiving benefits continues its steady decline. In addition to retirees aged 64+, approximately 1 million permanently disabled individuals receive social security payments along with spouses and children of disabled or deceased workers. In 1924, Chile was the first Western hemisphere country to introduce a social insurance scheme that covered retired workers, their survivors, and disabled persons. By 1980, the Pinochet military junta was faced with the failure of this pay-as-you-go (PAYGO) pension system. Taking inspiration from Milton Friedman, Pinochet and his team of “Chicago Boys” transformed Chile’s pension system into the capitalist wonder that it is today. In the old system, there were three major branches of the system: one for government workers, one for salaried employees, and one for manual workers. In addition, there were more than 30 other funds for workers in various professions. Each fund had its own particular administrative bureaucracy and set of rules. Some retirees were even allowed to draw from multiple funds. The system also guaranteed a minimum pension to each worker, irrespective of previous contributions or earnings. On top of all that, a worker’s pension payments were calculated based on the earnings from his final 5 years of work, prompting many to under-report their income (and, thus, contribute less to the fund) until those final five years. Above: Augusto Pinochet Ugarte
Europeans take note; efforts throughout the 1970’s to prolong the expiration date of this system such as raising the retirement age and limiting pension adjustments to less than the rate of inflation, did little to assuage the nation’s economic crisis. The new system, begun in 1980 operates on the principle of choice by giving workers options at all stages of the process. Under the current Chilean model, a worker chooses which private AFPs (Administradoras de fondos de pensiones) he wants to manage his individual “nest egg” account that will fund his pensions later in life. Each worker may have only one such account with one AFP. Each worker is required to contribute 10% of his monthly earnings to the account. This mandatory contribution is tax-exempt while any additional contributions, which are permitted up to a predetermined amount of money tied to the CPI, are taxed. Participation in the system is completely optional for self-employed workers. If the worker so desires, he may set up additional savings accounts with the same AFP. Workers may make up to four withdrawals from these accounts per year and may draw from these accounts as well as from the primary account to finance retirement. Since the government does not officially recognize these accounts as retirement contributions, the money is subject to income tax. A worker may retire early if his account has the funds to support a pension that equals at least 50% of his average annual indexed wage over the previous 10 years and at least 110% of the government’s minimum old-age pension. If a worker retires at the normal retirement age (65 for men and 60 for women), he can choose to make scheduled withdrawals from his account, purchase an annuity, or form some combination of the two. Whatever he decides, his pension payments will be subject to income tax. The privately-operated AFPs, are setup to manage a single pension fund comprised of a collection of workers’ accounts. Any organization of shareholders may form an AFP except banks. AFPs are bound by stringent regulations and expectations. Originally permitted to invest only in low-risk domestic ventures (e.g. government bonds, time deposits, etc.), AFPs may invest in various international ventures, private stocks, company bonds, mortgage loans, and more. Pension funds are obligated to maintain a ROI (rate of return on investment) between maximum and minimum ROI rates tied to the average 12-month return for all pension funds. In order to protect individuals’ retirement accounts, pensions funds are required to abide by a 1% investment ratio, whereby 1% of the fund’s value is held in the form of reserves. Should the ROI of a pension fund exceed the average ROI of all pension funds by 2 percentage points or 50%, whichever is greater, the excess profit must be transferred to a profitability reserve. If the ROI of a pension fund falls below the average ROI of all pension fund by 2 percentage points or 50%, whichever is lesser, funds from the investment or profitability reserves must be transferred to the pension fund to make up the difference. If an AFP with a below-average ROI fails to make up the difference within 6 months, the government takes control of the AFP, pays the pension fund, and then assigns the accounts to other AFPs. Of course, the individual owners of the accounts may choose to which AFP they want to move their account. Above: Profitability of Chilean AFPs vs. banks
There is a provision to protect people in the unlikely event that their privately-managed retirement funds don’t pan out when it’s time to retire. The government steps in and pays a retiree a minimum pension if the individual is of retirement age or older, has paid contributions for at least 20 years and either exhausts his retirement savings or whose accrued savings can’t support the minimum pension payments as set by law. As far as the effectiveness of the Chilean model, the proof is in the pudding. According to the OECD, the average real ROI for private Chilean pension funds was 6.1% between 2000 and 2005 while it was 1.5% in the United States. By 2005, Chile’s pension fund assets, the money available to pay out to pensioners, was equal to 59% of the value of GDP, a figure well above the average of 15% for Latin America. That statistic is a testament to the wisdom of the Chilean reforms for two reasons: 1) it demonstrates a remarkable turnaround for a retirement system that was nearly bankrupt only 25 years prior and 2) the figure is comparable to those of more advanced economies such as Canada(60%) and the Australia (69%). If you trust the figures from Chile’s Superintendency of Pensions, this success is generally pretty evenly spread among the various pensions fund. While Chile’s system is far from perfect, as evidenced by its severely fluctuating ROI rates from year to year and the need for reforms in 2008, it’s private model certainly has turned things around. The U.S would be wise to learn from, not duplicate, the Chilean model by implementing more of the personal choice and private oversight of pensions that has worked so well for Chile.