March 21, 1997
Chile's Privatized Retirement System: A Model for U.S.?
By PETER PASSELL
It's such a difference," bubbled Isabel Margarita Perey, a 45-year-old secretary in Santiago, Chile. "I love my pension plan."
So apparently do most Chileans, who have enjoyed spectacular returns on their nest eggs since the country dumped the national pension system in 1981 for a savings plan that makes individuals responsible for financing their own retirement.
And so do the governments of Argentina, Mexico and Peru, which are all following Chile's lead, switching to private -- though heavily regulated -- pension accounts.
Indeed, what began as a model for born-again free marketers in stagnant Latin American economies is inspiring policy-makers in the high churches of capitalism. Earlier this month, Prime Minister John Major announced plans to privatize Britain's pension system.
And in the United States, where many younger people doubt that Social Security will provide even a modest pension when they retire unless it is overhauled, a variety of similar proposals have been floated as the answer to low savings rates and high Social Security payroll taxes.
Over the years, "the gains from privatization would be worth $10 trillion to $20 trillion," argues Martin S. Feldstein, an economist at Harvard who was the chairman of President Ronald Reagan's Council of Economic Advisers.
For all its apparent success in Chile, though, the question remains whether what works for a poor but rapidly developing economy would work in the United States and Europe -- which cannot hope to pay for the retirement of aging populations with the dividends from growth.
Advocates of privatization in rich countries do not see it as a miracle cure. But, like Feldstein, they do say it is a way to spur growth and a means of distancing the national pension system from the rough and tumble of entitlement politics.
For their part, skeptics focus on the drawbacks to privatization -- the relatively high costs of operation and its potential for unraveling support for a social safety net. They also caution that in the event investment returns go south in a privatized system, the government may still be on the hook -- a debacle that could shake an economy unprepared for it.
Given such concerns, the skeptics see no compelling case for leaping into the unknown. "Chile couldn't fix the system they had," argues Peter Diamond, an economist at the Massachusetts Institute of Technology. "Ours ain't broke."
Chile's pension reform was driven by a mix of ideology and necessity. In 1973, after he brought down the elected Socialist government in a bloody coup, Gen. Augusto Pinochet was left to cope with a moribund economy. He turned to a group of economists later known as the "Chicago boys," U.S.-trained Chileans who shared a commitment to the libertarian ideas of the University of Chicago's Milton Friedman.
One of them, Jose Pinera (who earned his Ph.D. at Harvard), pushed tirelessly to change Chile's pay-as-you-go national pensions to a system of privately funded individual retirement accounts.
Pinera, then minister of labor and social security, was pushing on an open door. The existing hodge-podge of industry-based social insurance plans was unpopular, in no small part because it exacted payroll taxes in excess of 25 percent.
Today, workers deposit 13 percent of their wages in the retirment accounts. The accounts, which move from job to job with their owners, are managed by some 20 private mutual fund groups, known as Administradora de Fondos Pensiones, or simply AFPs.
To achieve what Pinera, who is now associated with the libertarian Cato Institute in Washington, calls "radical reform with a conservative execution," the government strictly limited the AFPs discretion to take investment risks. At the end of last month, the AFPs held 40 percent of their assets in government-backed debt, 24 percent in interest-bearing bank deposits and 35 percent in Chilean stocks.
Buoyed by high interest rates and phenomenal gains on Chilean stocks, the AFPs have delivered a stunning 13 percent average annual return after inflation over the last 15 years.
Equally important, Pinera argues, the switch to "defined contribution" accounts has ended the government's discretion to raise pensions at the expense of future generations of taxpayers. But what intrigues observers most is the way the pension reform has meshed with Chile's goal of moving the economy to the fast growth track.
The economist's prescription for growth these days invariably includes prudent fiscal policies, high savings rates, tax reform and the development of liquid financial markets. Chile's pension makeover, Pinera argues, helped to accomplish each.
For starters, he notes, privatization made it impossible to paper over government budget deficits with current cash flow from the pension system. The resulting fiscal austerity (combined with increased confidence that personal savings would not be taxed or inflated away) raised the savings rate from 16 percent in 1980 to an astonishing 28 percent.
Pinera also argues that the substitution of mandatory pension savings for the 25 percent social security tax on wages sharply increased incentives to work.
Last but hardly least, the reform guaranteed a flow of savings to jump-start the small domestic capital market. The assets in AFPs now exceed $30 billion.
Diamond suggests that Pinera confuses cause and effect. The political will to contain government spending, control inflation, reduce tax distortions and put out a welcome mat for private enterprise made pension privatization work, he suggests -- not the other way round. Pinera meets him halfway: "Pension privatization was part of a virtuous circle of economic reforms," in which successes built on successes, he argues.
A closer look at the Chilean system does disclose some weaknesses. With regulation effectively forcing the AFPs to pursue me-too investment policies, competition is driven in wasteful directions.
Just as U.S. banks used to give away toasters to attract new accounts, AFPs employ armies of salesmen and pour on extraneous services. Provida, the largest AFP, with some 1.7 million accounts, "never forgets my birthday or Christmas," said Ms. Perey, the secretary from Santiago.
And while the resulting costs are not absurdly high -- about 1 percent -- customers are paying for annual turnover exceeding 30 percent.
More important, there is an inherent tension between the private pension approach and the government's guarantee of a minimum pension. Since their contributions will not increase the size of their retirement checks, Chileans with low wages have strong incentives to hide income.
Finally, the jury is out on how the Chilean system would fare in hard times. If returns on pension assets fell to disappointing levels, there would surely be pressure on the government to subsidize pensions from other sources.
Back in the United States, the debate over Social Security continues. Earlier this year, a sharply divided advisory commission recommended that the system needed an injection of funds to restore its balance and a majority favored allowing investments in the stock market. For now, though, little action is expected from lawmakers.
The question preoccupying U.S. pension specialists is what lessons they should draw from the Chilean experience. One of the benefits of Chile's privatization -- the nurturing of nascent capital markets -- obviously does not apply. But as in Chile, private accounts might inhibit politicians from using the cash surpluses of Social Security to balance the budget.
"Might" is the operative word, Diamond counters. Congress might not dare to use private assets to offset budget deficits. But it might deny government benefits -- unemployment payments, food stamps, Medicare, Medicaid -- to those with substantial pension accounts.
Another question is the relevance of Chile's relatively painless transition from an underfunded public system to a fully funded private one. The unfunded liability of Chile's system in 1980 was roughly the same percentage of national income as Social Security's unfunded liability in 1997, Pinera says.
But Chile had one giant advantage: the potential to pay off the liability very rapidly since undeveloped economies have the potential to grow so fast.
The biggest issue is whether privatization would distance the national pension system from interest- group politics in Washington, as it has in Chile. On the one hand, Washington would lose the discretion to set benefits. On the other, there is nothing to stop retirees from turning to Congress for help if the return on their savings was disappointing.
"One thing you don't want," cautions Carolyn Weaver, an economist at the American Enterprise Institute, is to replace the unfunded government liabilities of Social Security with ill-defined liabilities to pensioners who, deep-down, believe the government owes them a comfortable retirement. She sees less political risk in a two-tier approach that layers a private account on top of a modest basic benefit funded from tax revenues.
For his part, Feldstein estimates that the most likely consequences of privatization -- higher national savings rates and lower payroll taxes -- would ultimately raise national income by 5 percent, or about $350 billion a year.
In the end, suggests Olivia Mitchell of the Wharton School, Social Security privatization fits neatly into the parable of the three blind men and the elephant.
"Each touches a different part of the elephant," she says, "and feels something different."