In 1981, Chiles 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 systems
deficit had risen to 25% of Chiles gross domestic product, yet 93% 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 Chiles example by allowing workers to redirect all of their Social
Security contributions to personal pension accounts. A closer look at the Chilean
systems performance over the past seventeen years, however, should be
cause for caution.
How Chile Privatized Pensions
General Augusto Pinochets 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.
Every worker participating in this defined-contribution system designates an
AFP to receive a mandatory payroll deduction of 10% of salary (up to $22,000),
plus an additional 2.5% to 3.7% 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, as with an individual retirement account (IRA) in the United States.
Retirement plans in the United States and many other countries have traditionally
depended on contributions from both employers and workers. But the Chilean system
puts the burden on employees alone. In order to offset the absence of employer
contributions to AFP accounts (as well as to health care and other social insurance
programs), the dictatorship ordered a salary hike of 18%, so that workers took
home more in wages even after contributing to the new system. Qualified workers
were also issued interest-bearing "recognition bonds," yielding a
4% real return, corresponding to the accrued value of their contributions to
the old social security system. There is a backup provision for retired workers
with twenty years of previous contributions to AFPs. If their personal accounts
become exhausted or cannot provide a specified minimum benefit, the government
guarantees a minimum pension that is periodically adjusted for inflation; this
minimum pension amounted to $119 a month in September 1997. The government also
requires AFPs to pay an average annual return equal to at least 50% of the average
return of all AFP accounts or two percentage points below it, whichever figure
Within thirteen months of imposition of the new plan, more than a million employees,
36% of the Chilean workforce, had signed up with an AFP. By late 1995, the AFPs
assets totaled $25 billion, equal to 40% of Chiles GDP, and by the year
2010, they are projected to grow to 110% of GDP. Today, almost 99% of the workforce
has, at one time or another, affiliated with an AFP. But, by several measures,
Chiles workers may not be getting their moneys worth.
What Went Wrong
1. Volatility. For more than a decade, the returns on AFP accounts seemed spectacular.
The selling off of state enterprises and, from 1985 to 1991, high interest rates
contributed to an average annual real return over fifteen years of 16.6%, peaking
at 35% from 1989 to 1991. Almost half of the investments were in government
bonds that were indexed to inflation, which was high during that period. But
subsequently Chiles economy cooled, and so have returns on personal pension
accounts. In 1994, more than half of the AFPs incurred losses. In 1995, average
returns fell to -2.5%, and over the past three years they have averaged only
1.8%. Since 1995, the average dollar amount of pensions paid has also dropped.
2. High Expenses and Fees. Total AFP expenses range from 15% to 20% of annual
contributions--an average of $62 per enrollee in 1995. (U.S. Social Security
expenses, by way of contrast, amount to less than 2% of contributions.) Approximately
one third of these expenses represent sales costs, which from 1988 to 1995 more
than doubled as a percentage of total expenses as AFPs competed for enrollees,
not by reducing charges but by mounting ever more extravagant marketing campaigns.
Swayed by free toaster ovens and other prizes or the promise of bigger returns,
25% of enrollees switch AFPs each year. These expenses consume a higher percentage
of low earners contributions than high earners contributions, and
they reduce the rate of return for every Chilean. In 1995, fees and commissions
amounted to 23.6 percent of contributions, or 2.4 percent of average wages.
According to World Bank economist Hemant Shah, commissions reduced individuals'
average rates of return between 1982 and 1995 from 12.7% to 7.4%, and between
1991 and 1995 from 12.9% to a mere 2.1%. One actuary has calculated that for
a new enrollee the 3.5% gross yield in 1996 actually amounted to a return of
-6.8%. That same year the profit margins for AFPs--five of which controlled
80% of the market, constituting an implicit cartel--averaged more than 22%.
3. Evasion and underreporting. According to Chilean economist Jaime Ruiz-Tagle,
workers contributing to AFPs earned an average of $1,000 in February 1995 but
declared an average taxable income of only $460. Only 58% of workers contributed
anything at all. Evasion through underreporting is particularly widespread among
low earners, who figure that the guaranteed minimum pension will exceed what
their retirement funds can yield. Employers, too, often underreport payroll
in order to evade other taxes and charges. In February 1996, there were 150,000
unresolved suits against employers for insufficient or nonexistent deposits
of worker contributions.
4. Inadequate coverage. A United Nations Development Program report estimates
that 40% of AFP contributors will require additional assistance. The less one
earns and the longer one lives, the more likely it is that an AFP account will
not suffice. Since women in Chile, as in the United States, earn less on the
average, leave the workforce more frequently to bear and raise children, and
outlive men, they are particularly at risk. U.S. women, in contrast, benefit
from the redistributive nature of Social Security, which provides more generous
benefits, as a proportion of income, to low earners. The only safety net for
the poor is a minimal pension that provides barely enough to pay for a loaf
of bread and a cup of coffee each day. And even that austere program is limited
to 300,000 Chileans, excluding thousands of the most destitute citizens. Moreover,
most of the self-employed, who constitute more than 28% of the Chilean workforce,
are especially vulnerable because participation in an AFP plan is not mandatory
for self-employed workers; as of 1996, only 10% of them had voluntarily enrolled.
5. High transition and supplementary costs. Add up the pensions under the new
system and those still being paid under the old one, the "recognition bonds,"
the minimum pension, and other guarantees, and the private pension system is
at least three times as costly to run as the system it replaced. Government
spending on pensions currently amounts to 6% of Chilean GDP.
The junta protected one class of Chileans from privatization. The military
continues to this day to receive pensions under the old governmental system.