A quarter of a century ago, Chile made a radical and pioneering move on pension reform. Despite public opposition – the country was under a military dictatorship – it simply scrapped its bankrupt pay-as-you-go system and opted for what was then a revolutionary approach based on mandatory individual savings accounts. Today, few doubt that the decision was the right one. The new system, managed by private fund administration companies (AFPs), has cushioned the state against the financial burden of a population that is now ageing rapidly. And, at the same time, it has vastly boosted household savings, fuelling the development of Chile’s equity and debt markets to which it has also brought improved regulation.
According to a study published in 2003 by Vittorio Corbo (now governor of the Chilean central bank) and Klaus Schmidt-Hebbel, the pension reform alone may have accounted for almost one percentage point of Chile’s average 4.6% GDP growth between 1981 and 2001. As well as its impact on domestic savings and the country’s financial markets, the study found that, by reducing labour costs, the reform had also meant an increase in employment and in the formality of the job market. But the reform scheme reverberated far beyond Chile’s frontiers, helping to trigger international debate on pensions and the development of the so-called multi-pillar approach, combining both state support for poor retirees and individual savings, subsequently advocated by the World Bank. Other Latin American countries – starting with Peru in 1992, Colombia in 1993 and Argentina in 1994 – followed Chile’s example (although with some important variations). Since then, countries in east Europe and some in Africa have also adopted systems that include a savings-funded pillar.
But Chile, where the system has hardly been modified since its launch, is not altogether satisfied with its approach. During the presidential election campaign of 2005, different candidates popularly suggested that the system was “in crisis” and, although the government has since denied this, president Michelle Bachelet, who heads the fourth government of the centre-left Concertacion coalition, is proposing a reform of the system that she has identified as her administration’s single most important undertaking. Although it would increase state protection for the elderly poor, the reform would not undermine the basic principles of the system’s savings-funded-pillar. Responsible countries do not start from scratch, argued President Bachelet during her presentation of the proposed reform, but build on what they have already achieved. “And our aim is to improve and perfect the AFP system,” she insisted.
Cheaper fees, better pensions
According to Mario Marcel, the chairman of a commission set up last year to advise the government on the reform, one of the AFP system’s most important drawbacks is that, despite all its macroeconomic advantages, it has failed to achieve public legitimacy. According to a poll carried out for the commission, 50% of Chileans think their pension system is bad or very bad, while only 6% judge it to be good. This lack of acceptance is partly a hangover from the system’s forced implementation by the Pinochet military dictatorship, but it also reflects reservations about its performance. “Dissatisfaction has emerged for two reasons – coverage and costs; too many people are outside the system, and too many of those in it have found that saving via the pension funds is expensive,” finance minister Andres Velasco tells Emerging Markets. At around 0.6% of assets under management, the commissions charged by AFPs are reportedly lower than in other countries that have introduced individual savings accounts, but their profits are exceptionally high. A study, cited by Minister Velasco, found that, over a recent five-year period, they had averaged in excess of 50% annually.
But rather than attracting new entrants, the industry has shrunk to just six players, down from a peak of 21 in 1994. More competition would mean lower commissions and better pensions, concludes Velasco. To that end, the reform bill, presented to Congress in December, would introduce an “auction” system, through which workers entering the labour force would be able to group together once a year to tender the management of their pension savings to the AFP offering the lowest commission. The winning AFP would then also be obliged to charge this commission to all its contributors. The beauty of this innovation, say its advocates, is that it would cut through the scale economies that are the industry’s main entry barrier by allowing new players to gather around 200,000 contributors cheaply and in one swoop. Existing AFPs oppose the initiative, arguing that it would focus competition on commissions away from investment return on contributors’ savings, which is more decisive in determining their final pension.
But, in a move welcomed by the industry, the reform would also increase their ability to compete on investment return by pruning a maze of portfolio restrictions. This is partly a recognition of the risk-management expertise the industry has gained over the years but also of the fact that, with assets of $88 billion, or just over 60% of GDP, it is now bursting the banks of local capital markets. Under the reform, the present cap on an AFP’s investments abroad would be raised from 30% of total portfolio to 80%. In mid-February, the mere suggestion that Congress might fast-track this part of the reform triggered a sharp drop in share prices, suggesting that AFP pressure could be creating a share-price bubble. Since 1981, the AFPs’ return on contributors’ savings has averaged over 10% a year in real terms, but this partly reflects the growth of the local equity market that they themselves drove. As a result, there is consensus that they now need more freedom not only to chase high returns elsewhere, but also to reduce the exposure of their investments to Chilean risk.
Roll in the customers
However, as well as seeking to reconcile Chileans to their pension system, the reform would also use more concrete inducements and, in some cases, obligations to increase its coverage. At just over 60% of employed workers – almost four million people – this is one of the highest in Latin America. However, it is still below the levels found in developed countries and is particularly low among women, where it reaches only around 40%, notes Velasco. One of the reform’s main goals, he says, is to draw both more women and more young people into the AFP system. Women having a child would receive a bonus savings contribution from the state while, in the case of young people entering the workforce, the state would not only supplement the pension contributions of low earners but also pay a small subsidy to their employers.
The advantage of this measure, according to the government, is that it would help to create a lifelong habit of contribution, with future fiscal savings amply compensating for its upfront costs. But, more importantly for the system’s coverage, the reform would gradually make it obligatory for the self-employed to contribute to an AFP and, eventually, to a health insurance scheme. Chile has around 1.5 million self-employed workers, representing almost a quarter of the labour force, but only an estimated 5% currently contribute to a pension fund. The reform would also allow the country’s banks to operate in the pension market through subsidiaries, and this includes – controversially – the state-owned BancoEstado. To the conservative political opposition and many businesspeople – wary of finding themselves with a representative of the state on their company boards – this is anathema and smacks of underhand nationalization. “The entry of BancoEstado into the pension industry is not one of the objectives of this reform,” reassures Minister Velasco. However, proponents of its participation, including some leading government politicians, argue that the bank, with its branches around the country and successful track record on microfinance, could play a key role in expanding the reach of AFPs. And, they add, there are enough controls in place to ensure that a state AFP could not be forced to buy bad government debt, as has happened in some other countries.
For those who, despite the reform, still fall through the net or whose income is insufficient to generate a decent pension, the government is planning to step up state benefits. All over 65s in the poorest 60% of the population, who have not contributed to an AFP, would be entitled to a state pension of 60,000 pesos per month (approximately $110), rising to 75,000 pesos in 2009 and, for those receiving a low AFP pension, the state would provide a sliding-scale top-up. As well as substantially increasing the current level of state support for the elderly, the reform also seeks to tailor it more closely to the savings-funded pillar, removing some perverse incentives that currently encourage low-earning workers and, particularly, women to opt out of the AFP system in favour of reliance on state support. Compared to the leap in the dark that Chile took in 1981, the proposed reform – which the government hopes to have in operation in mid-2008 – is mere fine-tuning and, on paper, seems sensible. But, for the Chilean government, it entails a heavy responsibility because its delivery could affect not only the future welfare of its own pensioners, but also those in many other countries. That, after all, is the price of being a pioneer.