Executive Summary

In May 1981 Chile replaced its gove rn m e n t -run pay - a s - yo u - go re t i rement system with an

i nvestment-based private system of indiv i d u a lre t i rement accounts. The new system hasa l l owed Chile and other Latin A m e rican coun-t ries that have fo l l owed the Chilean example todefuse the fiscal time bomb that is ticking fo rc o u n t ries with pay - a s - yo u - go systems, as fewe rand fewer wo rke rs have to pay for the re t i re m e n tb e n e fits of more and more re t i rees. More impor-t a n t , Chile has cre ated a re t i rement system that ,by giving wo rke rs cl e a rly defined pro p e rt yrights in their pension contri bu t i o n s , o ffe rs pro p-er wo rk and investment incentives; acts as ane n gine of, not an impediment to, e c o n o m i cgrowth; and enhances personal freedom andd i g n i t y.

In the 18 ye a rs since the Chilean system wa si m p l e m e n t e d, l abor fo rce part i c i p at i o n , p e n s i o nfund assets, and benefits have all grown. To d ay,m o re than 95 percent of Chilean wo rke rs havetheir own pension savings accounts; assets havegrown to over $34 billion, or about 42 percent ofgross domestic product; and the ave rage re a l

rate of re t u rn has been ap p rox i m at e ly 11.3 per-cent per ye a r, wh i ch has allowed wo rke rs tore t i re with better and more secure pensions.

Its success notwithstanding, the Chilean sys-tem has found many cri t i c s , who often point to high administrat ive costs, l a ck of port fo -lio ch o i c e, and the large number of tra n s fe rsf rom one fund to another as evidence that the sys-tem is inhere n t ly flawed and inap p ro p ri ate fo rother countri e s , i n cluding the United Stat e s .Some of those criticisms are misinfo rm e d.M a ny other criticisms re flect real pro bl e m s , bu tt h ey are large ly the result of ex c e s s ive gove rn-ment reg u l at i o n .

The spirit of the re fo rm has been to relax reg-u l ations as the system has mat u red and as thefund manage rs have gained ex p e ri e n c e. All thei n gredients of success—individual ch o i c e,cl e a rly defined pro p e rty rights in contri bu t i o n s ,and private administration of accounts—havebeen present since 1981. If Chilean authori t i e sa dd ress the remaining shortcomings with bold-n e s s , we should expect Chile’s private pensionsystem to be even more successful in its adult-hood than it has been during its first 18 ye a rs .

1

L. Jacobo Rodríguez is assistant director of the Project on Global Economic Liberty at the Cato Institute.

July 30, 1999 SSP No. 17

C h i l e ’s Private Pension Systemat 18: Its Current State and

Future Challengesby L. Jacobo Rodríguez

IntroductionChileÕs private pension system, implemented

on May 1, 1981, has become the model forcountries interested in Þnding a Þscally viableand enduring solution to the problem of payingfor the retirement beneÞts of aging populations.1

By completely replacing its pay-as-you-go gov-ernment-run social security system with aninvestment-based private system of individualretirement accounts, Chile has managed todefuse the Þscal time bomb that faces countrieswith pay-as-you-go social security systems, asfewer and fewer workers have to pay for theretirement beneÞts of more and more retirees.More important, Chile has created a retirementsystem that, by giving workers clearly deÞnedproperty rights in their pension contributions,offers proper work and investment incentives;acts as an engine of, not an impediment to, eco-nomic growth; and enhances personal freedomand dignity.

That retirement programs Þnanced on a pay-as-you-go basis are on the verge of collapseshould come as no surprise. Such programs,which in essence are intergenerational transfersof wealth, have made old-age Þnancial securitydependent on the political process. The substitu-tion of political action for private action has sev-ered the link between individual efforts andrewards. In other words, individuals try to min-imize their contributions to the system whilethey are active workers and to maximize theirretirement beneÞts.

In a pay-as-you-go system, the governmenttaxes active workers to pay for the beneÞts ofretired workers. Under such systems, retirementbeneÞts are a function of the rate of growth ofthe tax base, which in turn depends on the rateof growth of the labor force and the rate ofgrowth of real wages per worker (i.e., increasesin labor productivity). But payroll taxes artiÞ-cially increase the cost of labor and thus have anegative effect on employment and distort theallocation of resources.2

That precarious and unsustainable situationno longer exists in Chile, where a workerÕsretirement beneÞts depend on his own work andthe functioning of the economy, rather than onthe governmentÕs ability to tax future genera-tions of workers. In recent years, seven otherLatin American countriesÑPeru (1993),Colombia (1994), Argentina (1994), Uruguay(1996), Bolivia (1997), Mexico (1997), and ElSalvador (1998)Ñhave also privatized their

retirement systems, following, to varyingdegrees, the lines of the successful Chileanmodel.3 In March 1999 Poland became the Þrstcountry in Eastern Europe to implement a par-tial privatization reform based on the Chileansystem. ChileÕs experience, however, remainsthe most successful example of social securityprivatization. Notwithstanding its success, theChilean system has received many criticismsÑsome valid, others notÑthat the present studywill address. Furthermore, enough time haspassed since the Chilean system was imple-mented that its results can be evaluated in a sys-tematic way.

Chile’s Pay-As-You-GoRetirement System

In 1924 Chile became the Þrst country in theWestern Hemisphere to introduce a state-runretirement system when it established a retire-ment fund for manual workers. That fund wasthe predecessor of the Servicio de SeguroSocial, or the social security service, which wasto become the main retirement system for themajority of Chilean workers until 1981.4 In1925 two more funds were created: one, Caja deEmpleados Particulares, for (nonmanual) pri-vate-sector workers and the other, CajaNacional de Empleados P�blicos y Periodistas,for public-sector workers and journalists. Soonthose state-run collective capitalization fundsevolved into a pay-as-you-go system in whichthe beneÞts of retirees were paid from the con-tributions of active workers.5 In addition, spe-cial-interest legislation led to the creation ofmore than 100 different pension regimes withwidely different beneÞts that were not related tothe level of contributions and different retire-ment ages for different groups of workers. In1968 then-president Eduardo Frei Montalvasummed up the chaotic nature of ChileÕs retire-ment program:

There are two thousand social securitylaws in Chile. Think what this means. Twothousand social security laws, togetherwith the regulations and the agreements ofthe social security institutions; in otherwords, a growing monstrosity. In the read-justment law of 1966, 46 new social secu-rity rules were introduced, followed by 44in 1967 and 1,238 in 1968. However, theExecutive has no means of stopping this

Chile hasmanaged todefuse thefiscal timebomb thatfaces coun-tries with pay-as-you-gosocial securitysystems.

2

monstrosity. Each group of social securitycontributors has many laws . . . some arevery small groups, very respectable, natu-rally. . . . There are some fabulous cases:the racetracks have nice social securityinstitutions. . . . What is worse is that thecountry is spending 18.1% of gross nation-al product on social security. . . . What Þs-cal budget can survive this?6

By the early 1970s the system had clearlygotten out of hand. Contribution rates hadincreased from 16 to 26 percent of total payroll;the governmentÕs contribution to the pensionsystem had increased to about 38 percent of thesystemÕs total revenues, or about 4 percent ofgross domestic product; and the implicit debt ofthe system was over 100 percent of GDP. Inaddition, demographic changes worked againstthe pay-as-you-go system in Chile. The ratio ofworkers to retirees had declined from 10.8 in 1960 to 4.4 in 1970, to 3.2 in 1975, and to 2.2in 1980, when the pension reform law wasadopted.7

In 1978 the government introduced a numberof changes to the pay-as-you-go systemÑsuchas standardizing retirement ages at 65 for menand 60 for women, eliminating special regimes,and rationalizing indexingÑthat preceded theimplementation of the new private system.

Chile’s PrivateRetirement System

On November 4, 1980, the Chilean govern-ment approved the law that established a newprivate pension system based on freedom ofchoice and clearly deÞned property rights inretirement accounts.8 This system is a fullyfunded, deÞned-contribution scheme, mandato-ry for all dependent workers and administeredby specialized, single-purpose private compa-nies called administradoras de fondos de pen-siones (AFPs), which are pension fundadministrators. The aim of the reform was, inthe words of Jos� Pi�era, who was then secre-tary of labor and social security and architect ofthe system, to create Òa social security systembased on individual freedom and, at the sametime, solidarity; a fair social security system, butyet an efficient one; a social security system forall . . . for the beneÞt of all Chileans and alwaysto the service of freedom, progress and justice.Ó9

Main Features of the New System

Coverage. The system is mandatory for alldependent workers who entered the labor forceafter January 1, 1983, and optional for self-employed workers, just like the governmentsystem was. Workers who were already in thelabor force before January 1983 had the optionof staying in the old, government-run system ormoving to the new system. Workers who movedreceived from the government recognitionbonds that acknowledged the contributions theyhad already made to the old system; and thosewho stayed in the government-run system hadtheir pension rights guaranteed under the newlaw.

Contribution Rates. Each month workersdeposit 10 percent of their wages in their ownindividual pension savings accounts. That per-centage applies only to the equivalent of the Þrst$22,300 of earnings.10 (Since that levelremained unchanged in real terms during theÞrst 18 years of the private system, the Òmanda-tory contentÓ of the private system went downautomatically as economic growth increasedreal wages.) Those contributions and the returnsearned on them belong to the workers and aredeductible from taxable income. Any workermay contribute up to an additional 10 percent ofwages, which is also deductible for income taxpurposes.11 In addition, since 1987 workers havebeen able to maintain Voluntary SavingsAccounts, also administered by the AFPs butcompletely separate from the pension savingsaccounts, where they can deposit additional sav-ings.12 It is worth noting that Voluntary SavingsAccounts beneÞt mostly low-income workers,since those accounts allow workers access tosophisticated tools of investment at little or nocost (AFPs usually waive their fees and com-missions on those accounts).13 Employers mayalso make contributions, called contracteddeposits (dep�sitos convenidos), to theiremployeesÕ accounts and count those contribu-tions as a business expense, which makes themdeductible for tax purposes for the employer.

Freedom of Choice. Workers are free to selectthe AFP of their choice. They are also free totransfer from one AFP to another as often astwice a year. There is a minimum stay require-ment of six months, implemented in late 1997 inan effort to bring down administrative costs andprevent frequent rotation of workers amongAFPs.14

3

By the early1970s theChilean pay-as-you-gosystem hadclearly gottenout of hand.

If an AFPgoesbankrupt, the retire-ment fund isnot affected.

4

Administration. As stated above, the system isadministered by single-purpose private AFPs.Each company manages an investment fund ofbonds, stocks, and other Þnancial instruments.The AFPs and the retirement funds they admin-ister are two completely separate legal entities,so that if an AFP goes bankrupt, the retirementfund is not affected. There is free entry and exitinto the industry, even for foreign companies,provided that certain capital requirements aremet.15 AFPs are required to maintain a legalreserve, a cash reserve, and a proÞtabilityreserve. In addition, they are required to provideat least one statement of account every fourmonths to their customers free of charge, as wellas a pension savings passbook (la libreta), whereworkers can keep track of contributions madeand of how well their investment funds haveperformed.16

Fees and Commissions. For the services theyprovide, AFPs may charge monthly a Þxed com-mission, which currently ranges from $0 to$2.11, and a variable commission expressed as apercentage of the workerÕs taxable income,which currently ranges from 2.49 to 2.95 per-cent of that income (Table 1). The variable com-mission includes the premiums for the term lifeand disability insurance the AFPs take out onbehalf of their customers. Since 1987, however,AFPs have not been allowed to charge a Þxed orpercentage commission on assets under man-agement or on inactive accounts (i.e., accountsthat did not receive a contribution in the monthbefore the commissions are assessed). Thatchange has created distortions in the AFP indus-try. AFPs are not allowed to offer discounts forgroups, for voluntary contributions, for perma-nence, or for maintaining a certain balance in theaccount.

Retirement BeneÞts. The new private systemprovides workers with three different types ofretirement beneÞts:

1. Old-Age Pensions: Male workers must reachthe age of 65 and female workers the age of60 to qualify for this pension. However, it isnot necessary for men and women who reachthose ages to retire, nor are they penalized ifthey choose to remain in the labor force.There are no other requirements.

2. Early-Retirement Pensions: To qualify for thisoption, a worker must have enough capitalaccumulated in his account to purchase anannuity that is (1) equal to at least 50 percentof his average salary during the last 10 years

of his working life and (2) at least 110 percentof the minimum pension guaranteed by thestate.17

3. Disability and SurvivorÕs BeneÞts: To qualifyfor a full disability pension, a worker musthave lost at least two-thirds of his workingability; to qualify for a partial disability pen-sion, a worker must have lost between halfand two-thirds of his working ability.Survivor beneÞts are awarded to a workerÕsdependents after the death of the worker. If hedid not have any dependents, whatever fundsremain in his pension savings account belongto the beneÞciaries of his estate.

Types of Pensions. There are three retirementoptions:

1. Lifetime Annuity: Workers may use themoney accumulated in their accounts to pur-chase lifetime annuities from insurance com-panies. Those annuities provide a constantincome in real terms.

2. Programmed Withdrawals: A second option isto leave the money in the account and makeprogrammed withdrawals, the amount ofwhich depends on the workerÕs life expectan-cy and those of his dependents. If a workerchoosing this option dies before the funds inhis account are depleted, the remaining bal-ance belongs to the beneÞciaries of his estate,since workers now have property rights intheir contributions.

3. Temporary Programmed Withdrawals with aDeferred Lifetime Annuity: This pensionoption is basically a combination of the Þrsttwo. A worker who chooses this option con-tracts with an insurance company for a life-

Table 1Commission Structure for Dependent

Workers (as of December 1998)

FixedCommission Variable

AFP (in dollars)a Commissionb

Aporta $1.01 2.95Cuprum .0 2.69Habitat 1.03 2.49Magister 0.95 2.85Planvital 2.11 2.55Protecci�n 0.82 2.61Provida 0.41 2.62Santa Mar�a 1.03 2.59Summa Bansander 0.83 2.72Source: Superintendencia de Administradoras de Fondos de Pensiones,

Boletín Estadístico, no. 146 (1998): 41.a $1 = 474 Chilean pesos in December 1998.b The variable commission is expressed as a percentage of taxable salary.

time annuity scheduled to begin at a futuredate. Between the start of retirement and theday the worker starts receiving the annuitypayments, the worker makes programmedwithdrawals from his account.18

In all three cases a worker may withdraw in alump sum (and use for any purpose) any fundsaccumulated in his account over and above themoney necessary to obtain a pension equal to atleast 120 percent of the minimum pension andto 70 percent of his average salary over the last10 years of his working life.

The Government’s Role

The governmentÕs role in the private systemis twofold: Þrst, it acts as a regulator of the system; second, it is the Þnancial guarantor oflast resort. The pension reform established an independent and highly technical govern-ment agency, the Superintendencia de Admini-stradoras de Fondos de Pensiones (Super-intendency of Pension Fund Administrators), to oversee the private retirement system. As a regulator, then, the main functions of the SAFP are

1. to approve or reject proposals for the creationof AFPs, approve their by-laws, and authorizetheir existence;

2. to supervise the operations of the AFPs inlegal, Þnancial, and administrative mattersonce they are in existence;

3. to ensure compliance by the AFPs with mini-mum capital and cash reserve requirements;

4. within the framework of the law, to set gener-al investment rules in conjunction with theCentral Bank of Chile and make sure that theinvestments made by the AFPs comply withthose rules;

5. to enforce present regulations and enact newones, if necessary;

6. to levy Þnes on those participants in the sys-tem who violate regulations and, when applic-able, enforce the dissolution of an AFP as setforth by law; and

7. to serve as an arbitrator should disputes arisebetween an AFP and its customers.

Second, the government provides a safety netfor those workers in need of it. The beneÞtsguaranteed by the government are as follows.

1. For workers with fewer than 20 years of con-tributions, the government provides a welfare-type pension funded from general revenues.

2. For workers with at least 20 years of contri-butions but without enough capital accumu-

lated in their accounts to fund a pension thatmeets the legally deÞned minimum pension,the government adds the money necessary toprovide that pension. Similarly, if the funds inthe retirement account of a worker are deplet-ed before the worker dies, the governmentwill give that worker the minimum pension.

To reduce the moral hazard inherent in thegovernmentÕs guarantee, the SAFP sets maxi-mum percentage limits both for speciÞc types ofinstruments and for the overall mix of theinvestment portfolio that each AFP manages(Table 2) and has imposed on the AFPs a mini-mum return guarantee.

Minimum Return

Each year each AFP must guarantee that thereal return of the AFP is not lower than the less-er of (1) the average real return of all AFPs inthe last 12 months minus 2 percentage pointsand (2) 50 percent of the average real return ofall AFPs in the last 12 months. If the returns arehigher than 2 percentage points above the aver-age return of all AFPs over the last 12 months,or higher than 50 percent of the average returnof all AFPs over the preceding 12 months,whichever is greater, the Òexcess returnsÓ areplaced in a proÞtability ßuctuation reserve, fromwhich funds are drawn in the event that thereturns fall below the minimum returnrequired.19 Should an AFP not have enoughfunds in the proÞtability reserve, funds aredrawn from a cash reserve, which is equivalentto 1 percent of total assets under management. Ifthat reserve does not have enough funds, thenthe government makes up the difference and theAFP is liquidated.

Table 3 summarizes the main characteristicsof ChileÕs private pension system.

Evolution and Results of thePrivate Pension System

Enough time has passed since the private sys-tem was implemented that a systematic analysisof its results can be made today. Labor force par-ticipation, pension fund assets, and beneÞtsobtained under the new system have all grown.The number of Chilean workers with a pensionsavings account (affiliates) increased from 1.4million workers at the end of 1981 to 5.9 millionworkers at the end of 1998, an increase of 421.4percent. The number of workers who kept their

Thegovernmentprovides asafety net forthose workersin need of it.

5

accounts active by making contributions to themin the previous month (contributors) went from1 million workers at the end of 1982 to 2.6 mil-lion workers by the end of 1998, an increase of260 percent (Table 4).

Assets have grown to over 40 percent of GDPin the 18 years since the system was implement-ed, an unusually high percentage for a smalldeveloping country where capital markets werevery underdeveloped at the time of the reform(Table 5). According to Chilean economistRoberto Fuentes, assets are projected to grow to134 percent of GDP by 2020.20 This has con-tributed to the development and deepening ofChilean capital markets, which are by far themost advanced in Latin America today, as wellas to the development of a risk-rating industry.

The most notable feature of Table 6 is theincreasing number of workers choosing earlyretirement, which is a sign of the success of thenew system for two reasons: Þrst, it is an indi-

cation that workers are accumulating enoughfunds in their accounts to choose this option;second, it allows workers to make individualdecisions about their work and leisure prefer-ences. As Jos� Pi�era has stated, ÒSome peoplewant to work forever; others cannot wait tocease working and to indulge in their true voca-tions or hobbies, like writing or Þshing. . . . [Theprivate pension system] allows for individualpreferences to be translated into individual deci-sions that will produce the desired outcome.Ó21

Table 7 shows the average amount of month-ly pensions paid by the new private retirementsystem. The most interesting feature of Table 7

6

Table 3Basic Characteristics of ChileÕs

Private Pension System

Inception date 1981Mandatory/optional MandatoryParallel public systema NoContribution rate as a

percentage of salaryb 10 percentVoluntary contributions YesGovernment contribution NoAdditional savings YesFixed commission YesVariable commission on

assets under management NoVariable commission on

contributions YesDiscount allowed NoOld-age pension YesDisability and survivorsÕ

pension YesEarly retirement YesNumber of funds per AFP 1Investment limits YesGuaranteed minimum return YesProÞtability ßuctuation

reserve YesLegal reserve YesNumber of AFPs 8 (as of May 1999)Number of contributors 2,619,616

(as of Dec. 1998)Number of affiliates 5,966,143 (as of

Dec. 1998)Assets under management $34.1 billion

(AUM) (as of May 1999)Rate of return (real annual

average, 1981Ð98) 11 percentAUM/GDP Approx. 42 percenta The parallel public system exists for those workers who had contributed to it

before January 1, 1983, and chose to remain in the old system. When the last

of those workers retires, that system will automatically disappear.b This rate applies to only the first $22,300 of salary.

Table 2AFP Investment Limits

(as a percentage of fund asset value)

Limits Set by the Instruments Central Bank of Chilea

Government securities 50 percentTime deposits and Þnancial institutionsÕ securities 50 percent Securities guaranteed by Þnancial institutions 50 percentLetters of credit issued by Þnancial institutions 50 percentPublic and private corporate bondsb ÑConvertible bonds 10 percentStocks of publicly traded corporations 37 percentStocks of real estate companiesc ÑShares in real estate investment fundsc ÑShares in corporate development investment funds 5 percentShares in personalty investment funds 5 percentShares in securitized-debt investment funds 5 percentCommercial paper 10 percentForeign instruments: 20 percent

Fixed income 10 percentVariable incomed 10 percent

Hedging instruments 20 percentOther publicly traded instruments 1 percentSource: Superintendencia de Administradoras de Fondos de Pensiones, El Sistema Chileno de Pensiones, 4th ed.

(Santiago: SAFP, 1998): pp. 78–79.aAlthough the upper limit has a range set by the SAFP, the effective limit is the limit set by the Central Bank of Chile, an

institution that has been constitutionally independent since 1990 and thus insulated from political pressures. It is crucial to

note that the lower limit is, of course, zero—that is, the AFPs are under no obligation to buy government securities or any

other type of financial instruments.bThere is no specific limit on the amount of bonds in the fund, although the aggregate limit on corporate and convertible

bonds is 45 percent.cThe aggregate limit on real estate stock and shares in real estate investment funds is 10 percent.dForeign instruments of variable income include (but are not limited to) equity of foreign corporations publicly traded on the

New York Stock Exchange, NASDAQ, the London Stock Exchange, the Tokyo Stock Exchange, the Frankfurt Stock

Exchange, and the Paris Stock Exchange.

is the pension amount received by workerschoosing the early-retirement option. Between1988 and 1998 those pensions ranged between$258 (in 1989) and $318 (in 1994). By compar-ison, the representative worker in the UnitedStates retiring at age 62 is getting monthly ben-eÞts that range from $506 to $743 under SocialSecurity.22 This is an indication of the efficiencyof the private system in Chile, not just in com-parison with the old Chilean government-runsocial security system, but also in comparisonwith the government-run system in the UnitedStates, a country where per capita income ismore than Þve times that in Chile.23 Old-agepension beneÞts in Chile are also higher relativeto per capita income than they are in the UnitedStates.

Some Objections to the Private Pension System

As the global crisis in public retirement sys-tems has grown, so has interest in the Chilean

reform. Advocates of Social Security privatiza-tion in the United States and other industrializedcountries often cite the success of the Chileanreform, while opponents of privatization pointto high administrative costs, lack of portfoliochoice, and the high number of switchoversfrom one fund to another in the Chilean systemas evidence that that system is inherently ßawedand inappropriate for other countries, includingthe United States.24 Those and other criticismsare addressed below.

AFPs compete against one another for work-ersÕ savings by offering lower prices for a givenproduct, products of a higher quality, better ser-vice, or a combination of the three. The prices orcommissions workers pay the AFPs are heavilyregulated by the government. As a result, notmuch competition exists in this area. The prod-uct that the AFPs provideÑthat is, the return oninvestments madeÑis also heavily regulated bythe government because the existence of a min-imum return guarantee forces the AFPs to make

7

Theincreasingnumber ofworkerschoosing earlyretirement isa sign of thesuccess of thenew system.

Table 4AFP Affiliates and Contributors, 1981Ð98

Ratio of Contributorsto Affiliates

Year Affiliates Contributors (%)

1981 1,400,000 NA NA1982 1,440,000 1,060,000 73.611983 1,620,000 1,229,877 75.921984 1,930,353 1,360,000 70.451985 2,283,830 1,558,194 68.231986 2,591,484 1,774,057 68.461987 2,890,680 2,023,739 70.011988 3,183,002 2,167,568 68.101989 3,470,845 2,267,622 65.331990 3,739,542 2,289,254 61.221991 4,109,184 2,486,813 60.521992 4,434,795 2,695,580 60.781993 4,708,840 2,792,118 59.301994 5,014,444 2,879,637 57.431995 5,320,913 2,961,928 55.671996 5,571,482 3,121,139 56.021997 5,780,400 3,296,361 57.031998 5,966,143 2,619,616 43.91Sources: Superintendencia de Administradoras de Fondos de Pensiones,

Evolución del Sistema Chileno de Pensiones, no. 3 (1998): 33; and

Superintendencia de Administradoras de Fondos de Pensiones, Boletín

Estadístico, no. 148 (1999): 57, 73.

Notes: NA = not available.

The figures are for the month of December of each year, with the exception

of 1990, for which the figures are for November.

Table 5Pension Fund Assets, 1981Ð99

Pension Fund Annual Assets (millions Growth Assets/GDP

Year of U.S. dollars) Rate (%) (%)

1981 305.74 0.841982 970.63 217.47 3.291983 1,757.02 81.02 5.861984 2,324.01 32.27 7.731985 3,200.60 37.72 10.031986 4,184.05 30.79 12.671987 5,129.52 22.54 14.201988 6,279.28 22.41 14.971989 7,742.67 23.31 17.651990 10,254.75 32.44 24.211991 14,503.29 41.43 31.371992 16,160.43 11.43 30.561993 20,770.47 28.53 37.021994 25,066.68 20.68 40.991995 26,646.02 6.30 38.761996 28,235.80 5.97 39.451997 30,862.90 9.30 40.601998 31,145.57 4.20 42.00a

1999b 34,192.93 9.78 NASources: Superintendencia de Administradoras de Fondos de Pensiones,

Evolución del Sistema Chileno de Pensiones, no. 3 (1998): 51;

Superintendencia de Administradoras de Fondos de Pensiones, Press

release, December 1998, http://www.safp.cl/prensa/1998/dic/pag1.html; and

Superintendencia de Administradoras de Fondos de Pensiones, Press

release, May 1999, http://www.safp.cl/prensa/1999/may/pag1.html.

Notes: NA = not available.a Estimate.b From January to May 1999.

Thus, the easiest way for an AFP to differen-tiate itself from the competition is by offeringbetter customer service, which explains whymarketing costs and sales representatives aresuch an integral part of the funds managersÕoverall strategy and why workers switch sooften from one company to another.25 I willexamine each of those three criticisms in turn.

The Investments of the AFPs Are Very Similar

The Òreturn band,Ó or minimum return guar-antee, encourages all AFPs to invest workersÕsavings pretty much the same way, because fundmanagers who deviate too far from the indus-tryÕs average performance get severely penal-ized if that deviation is a downward one and arenot appropriately rewarded if the deviation is anupward one. One of the reasons for implement-ing that band was to prevent investment productdifferentiation at the beginning of the system toreduce the variance in the return rates of the dif-ferent AFPs and, thus, avoid the negative politi-cal implications of having a brand newretirement system with wide disparities in theresults it provided. However, those regulationswere meant to be temporary and the reformersshould have included sunset clauses in thereform law.26

8

very similar investments and, consequently,have very similar returns. Again, competition inthis area is heavily curtailed by the government.

Table 6Number of Pensions Paid under the New System, 1982Ð97

(data through December of each year)

Old Early Full PartialYear Age Retirement Disability Disability Widows Orphans Others Total

1982 791 1,108 2,566 4,4651983 393 2,272 2,521 5,821 164 11,1711984 1,730 4,058 4,340 9,665 292 20,0851985 2,647 5,729 5,872 11,768 410 26,4261986 4,835 7,979 7,740 14,539 572 35,6651987 7,980 10,620 9,797 16,847 671 45,9151988 11,819 772 12,786 11,506 18,669 814 56,3661989 17,129 2,824 14,388 14,245 19,798 1,051 69,4351990 23,876 5,790 15,777 17,214 23,079 1,325 87,0611991 30,141 15,673 15,479 20,472 29,414 1,621 112,8001992 35,763 26,054 15,404 32 22,810 29,262 1,805 131,1301993 43,089 37,521 15,189 107 25,848 31,450 2,122 155,3261994 51,440 53,355 15,265 800 29,965 34,616 2,544 187,9851995 55,591 69,537 16,760 1,216 32,279 36,107 2,863 214,3531996 61,374 80,576 17,864 1,441 35,516 38,468 3,252 238,4911997 67,405 94,116 18,917 1,626 38,792 41,097 3,648 265,601Source: Superintendencia de Administradoras de Fondos de Pensiones, Evolución del Sistema Chileno de Pensiones, no. 3 (1998): 51.

Table 7Average Amount of Monthly Pensions Paid bythe Chilean Private Pension System, 1982Ð98

(through December of each year, in 1998 dollars)

Old Early Full PartialYear Age Retirement Disability Disability Widows Orphans Others

1982 436.41 158.44 45.45 99.301983 90.89 369.49 143.19 40.15 84.981984 100.54 305.99 124.20 34.86 69.731985 96.50 282.95 118.91 33.31 64.121986 112.99 279.22 119.22 34.86 64.121987 118.91 275.17 115.48 33.62 72.221988 134.47 294.78 287.93 121.09 35.18 67.551989 150.04 258.98 287.93 125.76 40.47 69.731990 150.97 268.32 282.33 122.64 42.02 74.081991 171.82 292.29 294.16 131.67 42.02 70.971992 179.61 302.25 293.54 172.45 140.39 47.62 74.391993 175.56 301.01 287.31 251.51 146.92 47.94 80.001994 185.83 318.44 293.99 262.41 147.86 53.54 79.691995 189.57 313.77 297.58 289.49 152.53 54.78 79.401996 187.75 312.07 284.27 242.45 148.00 54.08 73.691997 189.99 303.35 273.54 231.08 146.51 53.08 71.851998 185.66 285.97 270.37 194.24 150.84 53.73 76.47Source: Superintendencia de Adminstradoras de Fondos de Pensiones, Boletín Estadístico, no. 148 (1999): 381.

Note: $1 = 474 Chilean pesos in December 1998.

Another problem with the minimum returnguarantee is that it can lead to a misallocation ofcapital if the AFPs are forced to invest in somecompanies more heavily than they otherwisewould to stay within the return band. Chileanauthorities have recognized some of the prob-lems that the minimum return guarantee hasposed, and in June 1997 a bill was introducedbefore the Chilean congress that would lengthenthe period used to calculate the minimum returnfrom 12 months to 36 months.27 Although thatmeasure would give the AFPs more ßexibility intheir investmentsÑand, thus, allow them tohave greater diversity in their portfoliosÑonlythe elimination of the return band will allow theAFPs to offer consumers portfolios with thedesired mix of risk and return.28 Table 8 showsportfolio diversiÞcation among the differentAFPs at the end of 1998.

Two things stand out in Table 8. First, there isvery little variance among the different AFPs,which means that they all have similar portfo-lios. Second, the investment ceilings set by theSAFP and the Central Bank of Chile are highenough now that they do not appear to affect theinvestment strategies of the AFPs.29 (By com-parison, those rules would produce huge distor-tions in the investment decisions of the 10

largest mutual funds in the United States, whichinvest most of their assets in stocks.)

The System Has HighAdministrative Costs

The often-cited Þgure of 20Ð22 percent rep-resents administrative costs as a percentage ofcurrent contributions, which is not how admin-istrative costs are usually measured. This Þgureis usually obtained by dividing the commissionfeeÑwhich currently ranges between 2.49 and2.95 percent of taxable wages (see Table 1) andis on average equivalent to 2.7 percent of tax-able wagesÑby the total contribution (10 per-cent plus the commission).30 This calculationfails to take into account that the 2.7 percentincludes the worker-paid life and disabilityinsurance premiums (about 0.5 percent of tax-able wages on average), which are deductedfrom the variable commission, and thus over-states administrative costs as a percentage oftotal contributions.31 Also, if, for instance, themandatory contribution were lowered to 5 per-cent of total wages instead of 10 percent, thenadministrative costs measured as a percentageof the total contribution would increase from21.26 percent to 35.06 percent (2.7/[2.7 + 5]),

Table 8Investment Portfolio DiversiÞcation by Type of Instrument and AFP, 1998

(as a percentage of total portfolio assets)

Total Portfolio

Bonds and Stocks Other Fixed-Income Securities

Non- Total Non- Total Cash andAFP Chilean Chilean Stocks Government Corporate Chilean Bonds Others Equivalents

Aporta Fomenta 12.89 0.00 12.89 38.90 41.58 1.35 81.83 5.25 0.03

Cuprum 15.40 0.00 15.40 44.88 31.25 5.50 81.63 2.89 0.08Habitat 14.91 0.01 14.92 43.87 34.46 4.48 82.81 1.74 0.53Magister 17.03 0.00 17.03 33.54 41.97 1.56 77.07 5.52 0.38Planvital 15.61 0.00 15.61 40.26 36.28 4.46 81.00 3.07 0.32Protecci�n 14.68 0.00 14.68 34.18 42.34 5.97 82.49 2.81 0.02Provida 14.72 0.00 14.72 38.31 36.62 6.82 81.75 3.37 0.16Santa Mar�a 14.73 0.00 14.73 39.81 36.01 6.12 81.94 3.29 0.04

Summa Bansander 14.68 0.00 14.68 43.29 33.03 6.00 82.32 2.98 0.02

Mean 14.90 0.00 14.90 40.96 35.44 5.63 82.03 2.88 0.19Variance 1.18 0.00 1.18 16.05 16.38 3.96 2.95 1.45 0.04Source: Superintendencia de Administradoras de Fondos de Pensiones, Boletín Estadístico, no. 148 (1999): 221–23.

Note: Percentages may not add to 100 due to rounding.

9

even if those costs measured in absolute termsor as a percentage of assets under managementremained the same.

In comparison with those of the old govern-ment-run system, administrative costs of thenew system are not high. Chilean economistRa�l Bustos Castillo has estimated the costs ofthe new system to be 42 percent lower than theaverage costs of the old system.32 However,comparing the administrative costs of the oldsystem with those of the new one is inappropri-ate, because the underlying assumption whenmaking that comparison is that the quality of theproduct (or the product itself) is similar underboth systems, which is certainly not the case inChile.

Furthermore, in a recent study, the Congres-sional Budget Office reported that Òin Chile, thecountry with the longest experience with privateretirement accounts, [administrative costs] canbe equivalently expressed as 1 percent of assets,which is similar to costs of mutual funds in theUnited States.Ó33 The CBO report goes on to saythat Òit is difficult to convert a charge on contri-butions to a charge on assets (typical for a U.S.mutual fund). The calculation depends on therate of return and the length of the investmenthorizon and therefore does not yield a single Þg-ure.Ó34 More recently, Chilean economistSalvador Vald�s has estimated the averageannual cost of the AFP system to be equivalentto 0.84 percent of total assets under manage-ment over the life of a worker, which is lowerthan the average cost of the mutual fund indus-try in Chile but higher than the cost of other sav-ings alternatives.35

To the extent that such administrative costsare still considered too high, that is the result ofgovernment regulation of the commissions theAFPs can charge and the investments thosecompanies can make. The existence of a ÒreturnbandÓ prevents investment product differentia-tion by the different AFPs. As a result, the wayan individual AFP tries to distinguish itself fromthe competition is by offering better service toits customers. One way to provide better servicewould be to offer a discount on the commissionfee to workers who Þt a certain proÞle (e.g.,workers who have maintained their accounts foran extended period of time or who contribute acertain amount of money to their accounts);however, government regulations do not allowthat. Those regulations state that the AFPs maycharge only a commission based on the work-

erÕs taxable income and expressed as a percent-age of that income.

Another reason administrative costs are not aslow as they could be is that AFPs have a monop-oly on the administration of pension savingsaccounts. Mutual funds, banks, insurance com-panies, and individuals themselves are notallowed to manage those accounts. The exis-tence of this monopoly (which is part of thefragmentation of the Þnancial services industryin Chile) prevents the establishment of one-stopÞnancial supermarkets, where consumers canobtain all their Þnancial services if they sochoose.36 Such supermarkets would substantial-ly reduce administrative costs by eliminating theduplication of commercial and operationalinfrastructure.37

The Commission Structure Is Too Rigid

When the system began, AFPs were allowedto charge Þxed and variable commissions onassets under management and Þxed and variablecommissions on contributions, or any combina-tion thereof. AFPs were not allowed to offer dis-counts for permanence, for groups, for makingvoluntary contributions, or for maintaining aspeciÞc balance in the account. In 1987 thecommission structure was changed by eliminat-ing all commissions on assets under manage-ment.38 That change had the effect of providinga cross-subsidy to (1) workers who do not con-tribute to their accounts regularly, because thefund manager is still providing a service (admin-istering the accounts of those workers) forwhich he is not receiving compensation and (2)to low-income workers, because the administra-tive costs of managing the accounts of wealthi-er workers are not proportionally higher than theadministrative costs of managing the accountsof low-income workers, although the commis-sions paid by high-income workers are propor-tionally higher than those paid by low-incomeworkers. In that sense, it cannot be said that thecommission structure is fair, because someworkers are paying more than others for thesame type of service.39

The rigidity in the commission structure pre-vents the AFPs from adapting the quality of theirservice to the ability to pay for that service ofeach segment of the population40 and alsoexplains why the AFPs have an incentive to cap-ture the accounts of high-income workers andattempt to do so by offering them better cus-

In comparisonwith those ofthe oldsystem, theadministrativecosts of thenew systemare not high.

10

tomer service.41 AFPs will continue to spendmoney until the marginal cost of trying to cap-ture new accounts is equal to the marginal rev-enue derived from those accounts. In addition,the AFPs generally do not charge entry fees,even though the law allows them to do so, whichmeans that consumers do not pay a penalty forchanging from one AFP to another.42

Another problem with the commission struc-ture, one that has been present since the begin-ning of the system, is that AFPs are not allowedto offer discounts for permanence, for makingvoluntary contributions, for groups, or for main-taining a speciÞc balance in an account. Forinstance, if workers were able to negotiate groupdiscounts, then their bargaining power wouldsigniÞcantly increase. That would allow them tonegotiate lower commissions. Again, Chileanauthorities have realized that the commissionstructure has created some problems, and, con-sequently, they are seeking to eliminate some ofthe restrictions AFPs now face in this area. InJune 1997 a bill was introduced in the Chileancongress that would allow the AFPs to offer dis-counts, both for individuals and groups and fortime commitments.43

Workers Change AFPs Frequently

Because of investment regulations and ruleson fees and commissions, product differentia-

tion is low. Thus companies compete by offer-ing gifts or other incentives for workers toswitch companies. As Table 9 shows,switchovers have increased dramatically since1988, when the requirement to request in personthe change from one AFP to another was elimi-nated. In 1997 the government reintroducedsome restrictions to make it more difficult forworkers to transfer from one AFP to another.Indeed, the number of transfers in 1998decreased to fewer than 700,000 from an all-time high of almost 1.6 million in 1997.44 Thenumber of switchovers is likely to remain highso long as the current rules on investment andcommissions remain unchanged.45 Althoughthere are some entry fees, which may serve as adeterrent to workers who want to switch AFPs,those fees are sometimes waived and sometimesoffered to the worker who switches as a rebateby the sales agent responsible for the switch.

Transition Costs Are Too High

The true net economic costs of moving froman unfunded pay-as-you-go system to a fullyfunded system are zero. That is to say, the totalfunded and unfunded debt of a country does notchange by moving from an unfunded system toa funded one.46 There is, however, a cash ßowproblem when moving toward a fully fundedretirement system. In the case of Chile, transi-tion costs can be broken down into three differ-ent parts: First, there is the cost of paying for theretirement beneÞts of those workers who werealready retired when the reform was implement-ed and of those workers who chose to remain inthe old system. As Table 10 shows, those costsmake up by far the largest share of the transitioncosts at present. Those costs, of course, willdecline as time goes by. Second, there is the costof redeeming the recognition bonds given toworkers who moved from the old system to thenew in acknowledgement of the contributionsthey had already made to the old system.47 Sincethose bonds will be redeemed when the recipi-ents retire, the cost to the government will grad-ually increase as transition workers retire andthen will eventually disappear.48 It is worthstressing that these are new expenditures only ifwe assume that the government would renegeon its past promises. The third cost to the gov-ernment is that of providing a safety net to thesystem, a cost that is not new in the sense thatthe government also provided a safety net under

Administrativecosts are notas low as theycould bebecause AFPshave amonopoly on theadministrationof pensionsavingsaccounts.

11

Table 9AFP Transfers, 1983Ð98

Year Number of Transfers

1983 14,3801984 134,7201985 189,1631986 174,2371987 181,0481988 306,8191989 316,7631990 387,9551991 500,1761992 621,9191993 875,8741994 972,4821995 1,328,4111996 1,569,1851997 1,577,7091998 696,789

Sources: Superintendencia de Administradoras de Fondos de Pensiones, El

Sistema Chileno de Pensiones, 4th ed. (Santiago: SAFP, 1998), p. 219; and

Superintendencia de Administradoras de Fondos de Pensiones, Boletín

Estadístico, no. 148 (1999): 99.

The true netcosts ofmoving froman unfundedpay-as-you-gosystem to afully fundedsystem arezero.

12

the old pay-as-you-go system.49 Because thenew private system is much more efficient thanthe old government-run program and because,as stated above, to qualify for the minimum pen-

sion under the new system, a worker must haveat least 20 years of contributions, this cost has sofar been very close to zero.50 The size of thisexpenditure will, of course, depend on the suc-cess of the private system.

To Þnance the transition, Chile used Þvemethods: First, it issued new government bondsto acknowledge part of the unfunded liability ofthe old pay-as-you-go system. Second, it soldstate-owned enterprises. Third, a fraction of theold payroll tax was maintained as a temporarytransition tax. That tax had a sunset date and isnow zero.51 Fourth, Chile cut governmentexpenditures. And, Þfth, pension privatizationand other market reforms have contributed tothe extraordinary growth of the Chilean econo-my in the last 13 years, which has increasedgovernment revenues, especially those comingfrom the value-added tax.52

In sum, the transition to the new system hasnot been an added burden on Chile because thecountry was already committed to paying retire-ment beneÞts. On the contrary, the transitionÑthe Þscal requirements of which have variedbetween 1.4 and 4.4 percent of GDP per yearÑhas actually reduced the economic and Þscalburden of maintaining an unsustainable system.

Too Few Members of the WorkforceAre Covered

Contrary to what is often claimed, coverageunder the new system is about the same as it wasunder the old system, and arguably higher.According to Chilean economist Hern�nCheyre, coverage under the old system rangedbetween 74 percent of the workforce in 1976and 64 percent in 1980, with a clearly decreas-ing trend.53 In contrast, total coverage was about70 percent at the end of 1997, according to JulioBustamante, superintendent of AFPs.54 Perhapsthe main reason why analyzing the degree ofcoverage under the new system is such a diffi-cult task is that several factors must be takeninto account. It is not enough to look at the ratioof contributors to affiliates (as Table 4 does),because this ratio underestimates the systemÕscoverage. For example, many Chileans, espe-cially women, have left the workforce after par-ticipating in it for some time.55 Second, like theold government-run program, the system ismandatory only for dependent workers,although self-employed workers are not pre-vented from participating in it.56 In addition,unemployed workers are not required by law tocontribute to their accounts (although they maydo so). Fourth, we must account for the percent-age of the Chilean labor force that is covered bysome government-run program, including thepolice and armed forces, which have their ownretirement program,57 and those workers whochose to remain in the government-run pay-as-you-go system.

At the end of 1998, 25.4 percent of the work-force were self-employed and 2.3 percent wereunpaid relatives working in family-owned busi-nesses (Table 11). In addition, the unemploy-ment rate in December 1998 was 7.5 percent ofthe labor force, which means that those workerswere not required to contribute to any retirementsystem, but many of them still have pension sav-ings accounts. About 4.2 percent of the laborforce remained in the old system and about 1.8

Table 10Fiscal Requirements of the Reform, 1981Ð96

(as a percentage of GDP)

Expenditureon Pensionsof Workers

Retired TotalRecognition under the Fiscal

Year Bonds Old System Cost

1981 0.00 1.45 1.451982 0.09 1.85 1.931983 0.17 2.36 2.521984 0.22 3.22 3.431985 0.24 4.22 4.461986 0.33 3.94 4.271987 0.41 3.32 3.741988 0.42 3.40 3.821989 0.41 2.55 2.961990 0.50 3.23 3.731991 0.44 3.30 3.751992 0.49 3.10 3.591993 0.60 3.07 3.681994 0.65 2.97 3.631995 0.67 2.77 3.441996 0.69 2.60 3.29Source: Superintendencia de Administradoras de Fondos de Pensiones, El

Sistema Chileno de Pensiones, 4th ed. (Santiago: SAFP, 1998), p. 44.

13

percent of the labor force were covered by theretirement systems for the armed and policeforces. Thus, approximately 6 percent of ChileÕslabor force were covered by state-run retirementsystems. If 6 percent of the labor force werecovered by state-run retirement programs, 25.4percent were not forced to participate in the pri-vate system because they are self-employed, 2.3percent were unpaid relatives, and 5.6 percentwere not required to contribute to their accountsbecause they were unemployed dependentworkers,58 then only 60.7 percent of the laborforce were actually required to contribute totheir accounts in December 1998. If Chile had alabor force of 5,795,860 in December 1998,then 3,518,087 workers should have contributedto their accounts. The number of dependentworkers who contributed to their accounts inDecember 1998 was 2,897,957, or 82.37 per-cent of those who were supposed to contribute.59

Klaus Schmidt-Hebbel, an economist at theCentral Bank of Chile, puts the ratio of contrib-utors to dependent workers at 90 percent andattributes the disparity between the number ofcontributors and the number of dependent work-ers to Òevasion of contributions, large and time-varying degrees of labor informality, and largevariations in the composition of the officially-measured labor force and people moving in andout of the labor force.Ó60 Approximately 61.15percent of the employed workforce were cov-ered by some kind of retirement plan at the endof 1998.61

Another issue of concern is whether the per-centage of low-income workers covered islower than that of high-income workers. It is.The unemployment rate for younger workers ishigher than for older workers. If we assume that,on average, younger workers get paid lowerwages than older workers, then the percentageof low-income workers covered is lower thanthat of wealthier workers. Table 12 shows con-tributors and their average monthly salary bytype and gender.

The Government Will Face LargeFuture Costs

There is an element of moral hazard in thesystem that comes from the governmentÕs guar-antee of a minimum pension to all workers withat least 20 years of contributions. Low-incomeworkers have an incentive to make sporadiccontributions (provided they contribute to their

accounts for at least 20 years) if they know thatthe minimum pension will be higher than anypension they may obtain on their own. An easyway to reduce, if not eliminate, that moral haz-ard would be for the government to establish alink between the minimum guarantee and theyears of contributions to the system, asUniversity of California at Los Angeles econo-mist Sebastian Edwards has suggested.62 Thisreform would basically make the minimum pen-sion guarantee a function of years of contribu-tions. In other words, instead of having a singleminimum pension guarantee, the system couldhave a guaranteed minimum pension Òband.Ó

The Minimum Guaranteed Pension IsToo Low

ÒAs compared to what?Ó one might ask. Theminimum pension is about $121Ð$133 permonth. Although the dollar amount may seem

Table 11ChileÕs Labor Force

Type of Worker Number Percentage of Labor Force

Unemployed 434,450 7.50Employed 5,361,410 92.50

Self-employed 1,309,180 22.59Salaried 3,493,020 60.27Domestic 265,940 4.59

Unpaid relatives 133,500 2.30Employers 159,760 2.76Source: Instituto Nacional de Estadística, National Labor Survey, http://www.ine.cl/int91.htm.

Note: Chile has a population of 14,930,490 and a labor force of 5,795,860.

Table 12Contributors and Average Monthly Salary by Type and Gender

(as of December 1998)

Type and Gender Number of Contributors Average Monthly Salarya

Dependent 2,560,158 $556.51Male 1,645,334 594.15Female 907,837 490.30NA 6,987 294.54

Self-Employed 59,458 315.07Male 36,471 338.22Female 22,887 277.76NA 100 413.08

Total 2,619,616 551.03Male 1,681,805 588.60Female 930,724 485.08NA 7,087 296.21

Source: Superintendencia de Administradoras de Fondos de Pensiones, Boletín Estadístico, no. 148 (1999): 75.

Notes: NA = not available.a $1 = 474 Chilean pesos.

While thestock marketin Chile wasdown 25percent in1998, thepension fundswere downonly 1.1percent.

14

low by U.S. standards, we have to keep in mindthat per capita income in Chile, while high byLatin American standards, is not even a Þfth ofwhat it is in the United States.63 In relativeterms, that amount as a percentage of the mini-mum wage in Chile (71Ð78 percent) is about thesame as the beneÞts a low earner is obtainingunder the U.S. Social Security system, whichare equivalent to 76 percent of the minimumwage in the United States.64 Measured as a per-centage of the average wage in Chile, thatamount is equivalent to about 25 percent of thatwage. By comparison, the beneÞts that a lowearner is obtaining under the U.S. SocialSecurity system are equivalent to about 30 per-cent of average earnings in the United States.65

Furthermore, this minimum pension is set bycongress and is independent of the structuralcharacteristics of the private system. The levelof the minimum pension is automatically adjust-ed every time the cumulative increase in theconsumer price index reaches 15 percent.

Frequently Asked QuestionsCriticsÑand perhaps supporters, tooÑof pri-

vatization are concerned about a number ofother issues as well, such as the rates of returnunder the new system, whether workers can betrusted to invest their money wisely, andwhether the new system enjoys widespread sup-port. These are legitimate questions and satis-factory answers to them might help to convinceopponentsÑand reassure supportersÑthat pri-vatization can be politically and economicallyfeasible.

What Have Been the Actual Rates ofReturn on Chilean Pension SavingsAccounts?

Table 13 shows the real rates of return for thewhole system from its inception until May 1999.Those rates ranged from 29.7 percent in 1991 toÐ2.5 percent in 1995, the year of the Mexicanpeso crisis. In 1998 the pension funds experi-enced a negative return for the second time, asthey felt the effects of the Asian crisis, lowercommodity prices, and an economic downturnin Chile. Nevertheless, it is worth noting thatwhile the stock market in Chile was down 25percent in 1998, the pension funds were downonly 1.1 percent, which was probably due to theconservative (and regulated) nature of the funds.In the Þrst Þve months of 1999 the pension

funds have obtained a return of 9.7 percent, asthe Chilean economy and the stock market haverecovered from the lows they hit in 1998.66

Chilean authorities report that the averageannual yield has been 11 percent since the incep-tion of the system. The SAFP does not take intoaccount the commissions workers pay to theAFPs for the management of their savings anduses an arithmetic average (the sum of thereturns divided by the number of years) ratherthan a geometric average (the nth root of theproduct of n wealth relatives),67 which woulddetermine the internal rate of return.68 When Icomputed the geometric average, I obtained anannual average rate of return of 10.62 percent, aÞgure similar to the one given by the SAFP.69

Can the AFPs’ Historic Rates ofReturn Be Expected to Continue?

The level of returns will depend on the invest-ment decisions made by the fund managers andthe performance of the market. Of course, thosedecisions will be shaped to a large degree by the

Table 13Real Annual Rate of Return of ChileÕs

Private Pension System

Rate of ReturnYear (percent)

1981 12.61982 28.81983 21.31984 3.51985 13.41986 12.31987 5.41988 6.41989 6.91990 15.51991 29.71992 3.11993 16.21994 18.21995 Ð2.51996 3.51997 4.71998 Ð1.11999a 9.7Annual Average: 11.3

Sources: Superintendencia de Administradoras de Fondos de Pensiones,

Boletín Estadístico, no. 148 (1999): 339; and Superintendencia de

Administradoras de Fondos de Pensiones, Press release, May 1999,

http://www.safp.cl/prensa/may/pag2.html.a From January to May of 1999.

institutional framework under which the AFPsoperate. Therefore, the policies that the Chileangovernment follows with regard to both the pri-vate pension system and other sectors of theeconomy will heavily inßuence the performanceof the private pension system. If the governmentfollows market-friendly policies, then there isno reason to believe that the AFPs cannot con-tinue to obtain high rates of return, even if inter-est rates, stock market returns, and growth ratesin Chile approach (lower) international levels.70

Can People Be Trusted to Know Howor in What to Invest?

One of the greatest objections to a private sys-tem of individual retirement accounts is thatpoorer workers lack the knowledge and skills toinvest wisely and that, as a result, that systemwill only beneÞt those who are already well off.The Chilean experience shows that that objec-tion is wrongheaded. While it is probably truethat low-income workers lack vast knowledgeof Þnancial markets and investment strategies(and may lack the time to learn about those sub-jects, given that their time is occupied with making ends meet), the advantage of the free-enterprise system is that they do not have to beÞnancial experts to beneÞt from investing in theÞnancial markets. Indeed, workers can hireÞrms that have expertise in the management ofretirement portfolios (in the case of Chile thatexpertise is provided by the AFPs) in the sameway millions of Americans hire investmentÞrms to manage their mutual funds.71 The claimthat one has to be a Þnancial expert to proÞtfrom a system of individual retirement accountsis as farfetched as saying that one has to be agourmet cook to enjoy a good meal or evenavoid going hungry.

What Are Employers’ Responsibilities,and Is There Fraud in the New System?

The law establishes very clearly deÞnedresponsibilities for each and all of the playersinvolved in the private pension system. Theresponsibility of employers is to withhold con-tributions from their employeesÕ salaries andsend those contributions to the AFP with whichthose employees are affiliated. If those contribu-tions are not deposited in the workerÕs accountwithin a month, the employer is subject topenalties and interest equal to at least the AFPindustryÕs real average return over the previous

12 months plus 20 percent of that average.72 It isperhaps for that reason that contributions inarrears are not common. In fact, in 1997, the lastyear for which such Þgures appear to be avail-able, those contributions amounted to 0.53 per-cent of total assets.

The penalties imposed by the Super-intendency of AFPs on AFPs that violate therules of the game are severe. The nature of theviolation and the amount of the penalty are list-ed in the SAFPÕs bimonthly statistical bulletin.Again, the systemÕs transparency may helpexplain why violations are rare. For instance, inall of 1998 there were only 19 violations in thewhole AFP industry, fewer than 2 per month onaverage. The most common violation wasexceeding the investment limits set by theCentral Bank of Chile (4 instances), followed bydelays in the adjudication of pension beneÞtsdue to Òadministrative disorderÓ (3 instances).The only case of fraud was one in which 17workers were granted early retirement withoutmeeting the criteria for that type of pension.73

Why Does the Employee Pay the EntireContribution and the EmployerNothing?

When the new system was implemented inChile, gross wages were redeÞned to includemost of the employerÕs contribution to socialsecurity. For those workers who moved to thenew system, net wages increased by an averageof 12.6 percent.74 (At the same time, total laborcosts for employers decreased because contribu-tion rates under the new system were signiÞ-cantly lower than under the old one.) Grosswages were redeÞned because, from an eco-nomic perspective, the worker is likely to bearthe full burden of the payroll tax because theaggregate supply of labor is highly inelastic.Therefore, employers take into account the costsof labor, including payroll taxes, when settingsalaries. Breaking down the contribution into anemployer part and an employee part would haveallowed the political manipulation of those ratesand would have made the new system less trans-parent and more politicized.

How Many AFPs Are There?

As of May 1999 there were 8 AFPs. The sys-tem began with 12, reached a high of 23, and hasgradually consolidated over the last Þve years tothe present number. Most of the consolidation

If thegovernmentfollowsmarket-friendlypolicies, thereis no reason tobelieve thatthe AFPscannotcontinue toobtain highrates ofreturn.

15

has occurred through mergers. There have been,however, three AFPs closed down by the gov-ernment for not meeting the minimum capitalrequirements (Table 14). In terms of concentra-tion, the three largest AFPs controlled almost 74percent of all accounts, 70 percent of activeaccounts, and about 62 percent of total assets atthe end of 1998.

Are the AFPs Forced to BuyGovernment Bonds?

No. There has never been a requirement toinvest in government bonds of any kind sincethe system started in 1981. In other countriesthat have followed the Chilean example, such asMexico, the government requires that the pen-sion fund managers invest a minimum percent-age of workersÕ savings in governmentinstruments.75 That has never been the case in

Chile, because the requirement to invest in gov-ernment instruments is not consistent with thenotion of pension privatization. However, it istrue that in Chile the AFPs were not allowed toinvest in equity until 1985, when the AFPs wereallowed to invest up to 30 percent of workersÕsavings in shares of formerly state-owned enter-prises that had been recently privatized. Furtherliberalization of the investment rules occurred in1990, when the AFPs were allowed to investabroad and in common stock of corporations.The general tendency has been to relax theinvestment rules and to raise the investmentceilings (so as to make those ceilings unimpor-tant) as the AFPs have gained experience. Table15 shows how the AFPs have invested workersÕsavings over the years.

Why Is Each AFP Allowed to ManageOnly One Fund?

In a country with no experience in the man-agement of long-term savings, those in chargeof the reform thought that it would be best bothfor the regulatory agency and for the fund man-agers if each AFP managed only one fund.Again, this regulation was meant to be transito-ry. There are now bills in the Chilean congressto change the law and allow the AFPs to managea second fund, although the second fund wouldhave to be a Þxed-income fund. Ideally, it wouldbe best if the AFPs were allowed to offer fundswith different combinations of risk and return,so as to accommodate individualsÕ different tol-erances for risk.

What Kind of Support Does the PrivateSystem Enjoy among Workers?

The biggest indication of support for the newsystem is the fact that more than 95 percent ofChilean workers have left the old governmentsystem since the inception of the private system;one-fourth of the labor force switched in the Þrstmonth of operation of the new system.

Critics of the new system may argue that thelow participation rates of self-employed work-ers are an indication of the systemÕs lack of pop-ularity. That criticism, however, fails to take intoaccount several factors. First, by participating inthe private pension system, a self-employedworker is revealing information to the govern-

16

Table 14History of ChileÕs AFP Industry, 1981Ð99

Year Event

1981 ChileÕs private pension system is launched. Twelve AFPs begin opera-tions: Alameda, San Cristobal, Cuprum, El Libertador, Habitat, Invierta,Magister, Planvital, Provida, Concordia, Santa Mar�a, and Summa.

1985 Alameda and San Cristobal merge creating Uni�n.1986 Protecci�n is created.1988 Futuro is created.1990 Bannuestra is created.1991 Bannuestra is liquidated for not meeting the minimum capital require-

ments.1992 Six more AFPs are created: Banguardia, Bansander, Fomenta, Laboral,

Previpan, and Qualitas.1993 Three more AFPs are created: Aporta, Genera, and Valora. In addition,

Invierta and Planvital merge creating Planvital.1994 Armoniza is created. Laboral is liquidated for not meeting the mini-

mum capital requirements.1995 Provida and El Libertador merge creating Provida; Santa Mar�a and

Banguardia also merge creating Santa Mar�a; and Valora, Qualitas, andPrevipan merge creating Valora. Finally, Genera is liquidated for notmeeting the minimum capital requirements.

1996 Magister and Futuro merge to create Magister; Planvital and Concordiamerge to create Planvital; and Armoniza and Valora merge to createQualitas.

1998 Fomenta and Aporta merge to create Aporta; Magister and Qualitas merge to create Magister; Provida and Uni�n merge to create Provida; and Summa and Bansander merge to create Summa Bansander.

1999 Provida and Protecci�n merge to create Provida.1999 As of May 1999, there are eight AFPs: Aporta, Cuprum, Habitat,

Magister, Planvital, Provida, Santa Mar�a, and Summa Bansander.Source: Superintendencia de Administradoras de Fondos de Pensiones, various publications and Web site postings.

ment about his income that he may want to keepprivate for income-tax reasons. Second, wealthyself-employed workers have other means of pro-viding for their own retirement, including self-insurance and access to Þnancial instrumentsthat may offer a better combination of risk andreturn. Finally, some self-employed workershave an incentive to make only enough contri-butions to qualify for the minimum guaranteeprovided by the state to those with at least 20years of contributions, but not to contribute reg-ularly.

It is also worth noting that in the 1990s therehave been two center-left democratically electedgovernments in Chile that have not consideredgoing back to the old system or moving awayfrom the principles on which the private systemwas founded, not even in 1995 when the privatesystem experienced negative returns for the Þrsttime.76

How Do Average Retirement Benefits ofthe New System Compare with Those ofthe Old?

Ultimately, the success of the Chilean privatepension system will be measured more by theresults it provides than by more abstract issuessuch as equity, fairness, or whether it is moreconsistent with the principles of a free societythan a government-run pay-as-you-go system.For that reason it is important to determinewhether pensions under the new system havebeen higher than under the old system. We mustalso keep in mind that the goal of the reform wasto provide pensions that were equivalent to 70percent of a workerÕs Þnal salary. Has the newsystem been successful on both counts? In 1995Chilean economists Sergio Baeza and Ra�lB�rger conducted the most extensive study todate of the quality of pensions under the newprivate system.77 Baeza and B�rger looked atover 4,000 new retirees and the amounts of theirpensions. On average, those pensions were

Table 15Pension Funds Portfolio DiversiÞcation, 1981Ð98

(as a percentage of total assets, December of each year)

Total Portfolio

Bonds and Stocks Other Fixed-Income Securities

Non- Total Non- Total Cash andYear Chilean Chilean Stocks Government Corporate Chilean Bonds Othersa Equivalents

1981 0.00 0.00 0.00 28.10 71.90 0.00 100.00 0.00 0.001982 0.00 0.00 0.00 26.00 74.00 0.00 100.00 0.00 0.001983 0.00 0.00 0.00 44.50 55.60 0.00 100.00 0.00 0.001984 0.00 0.00 0.00 42.10 57.50 0.00 99.60 0.00 0.501985 0.00 0.00 0.00 42.40 57.10 0.00 99.50 0.00 0.501986 3.80 0.00 3.80 46.60 49.50 0.00 96.10 0.00 0.101987 6.20 0.00 6.20 41.40 52.00 0.00 93.40 0.00 0.401988 8.10 0.00 8.10 35.40 56.50 0.00 91.90 0.00 0.001989 10.10 0.00 10.10 41.60 48.30 0.00 89.90 0.00 0.001990 11.30 0.00 11.30 44.10 44.60 0.00 88.70 0.00 0.101991 23.80 0.00 23.80 38.30 37.70 0.00 76.00 0.00 0.101992 24.00 0.00 24.00 40.90 34.80 0.00 75.70 0.20 0.101993 31.80 0.00 31.80 39.30 27.90 0.60 67.80 0.30 0.101994 32.10 0.00 32.10 39.70 26.40 0.90 67.00 0.90 0.001995 29.40 0.00 29.40 39.40 28.40 0.20 68.00 2.60 0.101996 26.00 0.01 26.01 42.10 28.32 0.53 70.95 3.00 0.001997 23.40 0.03 23.43 39.60 32.64 1.22 73.46 3.10 0.101998 14.90 0.00 14.90 40.96 35.44 5.63 82.03 2.88 0.19Sources: Superintendencia de Administradoras de Fondos de Pensiones, Evolución del Sistema Chileno de Pensiones, no. 3 (1998): 63; and Superintendencia de Administradoras de Fondos de Pensiones,

Press release, December 1998, http://www.safp.cl/prensa/dic/pag4.html.

Note: Percentages may not add to 100 due to rounding.a Shares of closed-end mutual funds.

17

equivalent to 78 percent of the retireesÕ averagesalary over the last 10 years of their workinglives. For those workers choosing early retire-ment, the average pension was equivalent to 81percent of their average salary. If the lump-sumbeneÞts are taken into account, the average pen-sion of retirees in the Baeza and B�rger sampleincreases to 84 percent of salary.

Another good indication that pensions underthe new system are adequate is the number ofworkers who are choosing early retirement. Asstated above, to qualify for early retirement, aworker must have enough funds accumulated inhis account to obtain a pension that is at leastequal to 50 percent of his average salary duringthe last 10 years of his working life and at least110 percent of the minimum pension guaranteedby the government. As shown on Table 6, since1994 more workers have been choosing theearly-retirement option than the old-age retire-ment option.

The Genesis Investment Management studyfound that, between 1993 and 1995, old-agepensions under the new system were between 51percent and 57 percent higher than pensionspaid under the old system.78 Disability pensionswere between 69 percent and 82 percent higherthan under the old system. Of course, theGenesis comparison does not include earlyretirement pensions, which usually provide thehighest beneÞts, because the government-runsystem does not give workers that choice. And,in all cases, contributions under the private sys-tem are much lower than they were under theold one, which shows beyond any doubt that thenew system is on the whole much more efficientthan the old one.

Challenges for the FutureChileÕs private pension system has been very

successful since it was implemented 18 yearsago. The reform was revolutionary in nature butvery prudent in implementation. Some restric-tions that the architects of the new systembelieved made sense at the beginning in a coun-try with little experience with the private man-agement of long-term savings have clearlybecome outdated and may negatively affect theperformance of the system in the future. Chileanauthorities should act with the same boldnessthey exhibited 18 years ago. They should takespeciÞc steps:

¥ Approve the commission-liberalization billintroduced in June 1997, which would allowmanagers to offer different combinations ofprice and quality of service, introduce greaterprice competition, and possibly reduceadministrative costs to the beneÞt of all work-ers. Beyond that, the restrictions introduced in1987 should be lifted as well so that AFPsmay charge commissions on inactive accountsas well as a percentage of assets under man-agement.

¥ Let other Þnancial institutions enter the AFPindustry. The resulting synergies would lowerthe prices of the services being provided and,thus, beneÞt consumers.

¥ Eliminate the minimum return guarantee, or,at the very least, lengthen the investment peri-od over which it is computed.

¥ Further liberalize the investment rules, so thatworkers with different tolerances for risk canchoose funds that are suited to their prefer-ences.

¥ Let AFPs manage more than one fund.79 Onesimple way to do that would be to allow theAFPs to offer a short menu of funds that rangefrom very low risk to high risk.80 That couldreduce administrative costs if workers wereallowed to invest in more than one fund with-in the same AFP. This adjustment would alsoallow workers to make prudent changes to therisk proÞle of their portfolios as they get older.For instance, they could invest all the manda-tory savings in a low-risk fund and the volun-tary savings in a riskier fund. Or they couldinvest in higher-risk funds in their early work-ing years and then transfer their savings tomore conservative funds as they approachedretirement. Allowing the AFPs to managemore than one fund would contribute to loweradministrative costs, if rotation of workersamong the AFPs were less frequent (as shouldbe expected).

¥ As Latin American markets become moreintegrated, expand consumer sovereignty byallowing workers to choose among the sys-tems in Latin America that have been priva-tized, which would put an immediate (andvery effective) check on excessive regula-tions.81

¥ Give workers the option of personally admin-istering their pension savings accounts.82

¥ Reduce the moral hazard created by the gov-ernment safety net by linking the minimumpension to the number of years (months)workers contribute.

¥ Adjust contribution rates in such a way thatworkers have to contribute only that percent-age of their incomes that will allow them to

Between 1993and 1995,old-agepensions werebetween 51and 57percent higherthan pensionsunder the oldsystem.

18

purchase an annuity equal to the minimumpension.83 In other words, if a high-incomeworker can obtain an annuity equal to theminimum pension by contributing only 1 per-cent of his income, he should be able to do soand decide for himself how to allocate the restof his resources between present and futureconsumption.

ConclusionAfter 18 years, ChileÕs private pension sys-

tem has been, by any measure, an astoundingsuccess. Chilean workers are retiring with betterand more secure pensions. This reformÑalongwith other free-market reforms, such as privati-zation of state-owned enterprises, trade liberal-ization, labor reform, and tax reductionÑhascontributed to the extraordinary performance ofthe Chilean economy over the last 14 years, aperiod during which it has been growing at anaverage annual rate of almost 7 percent. Thesavings rate has increased from about 10 percentin the late 1970s to over 25 percent today.84

The Chilean pension reform has also con-tributed positively to the functioning of the labormarket. As Edwards has stated, ÒBy reducingthe total rate of payroll taxes, it has reduced thecost of labor and, thus, has encouraged job creation . . . [and] by relying on a capitalizationsystem, it has greatly reducedÑif not eliminat-edÑthe labor tax component of the retirementsystem.Ó85 Indeed, the unemployment rate inChile has decreased from about 15 percent in themid-1970s to approximately 5 percent, on aver-age, in the 1990s.

More important, however, are the culturaleffects the reform has had on Chilean society.Chilean workers, through their pensionaccounts, have become owners of the means ofproduction in Chile and, consequently, havegrown much more attached to the free marketand to a free society.86 This has had the effect ofreducing class conßicts, which in turn has pro-moted political stability and helped to depoliti-cize the Chilean economy. Pensions today donot depend on the governmentÕs ability to taxfuture generations of workers, nor are they asource of election-time demagoguery. To thecontrary, pensions depend on a workerÕs ownefforts, with the satisfaction and dignity that thatproduces. As political analyst Mark Klugmannstated in testimony to the U.S. Senate in 1997,ÒTouching the pension savings accounts of the

workers is, indeed, the third rail of Chilean pol-itics.Ó87

All the ingredients for successÑindividualchoice, clearly deÞned property rights in contri-butions, and private administration of accountsÑare already present in the Chilean system. IfChilean authorities address the systemÕs short-comings with boldness, we should expectChileÕs private pension system to be even moresuccessful in its adulthood than it has been dur-ing its infancy and adolescence. And unlike apay-as-you-go system, a fully funded individualcapitalization system can anticipate fewer prob-lems as it matures.

The Chileanpensionreform hascontributedpositively tothe function-ing of thelabor market.

19

Notes1 Comprehensive studies of the Chilean reform includeSuperintendencia de Administradoras de Fondos dePensiones, El Sistema Chileno de Pensiones, 4th ed.(Santiago: SAFP, 1998); Sebastian Edwards, ÒThe ChileanPension Reform: A Pioneering Program,Ó in PrivatizingSocial Security, ed. M. Feldstein (Chicago: University ofChicago Press, 1998), pp. 33Ð62; Jos� Pi�era,ÒEmpowering Workers: The Privatization of SocialSecurity in Chile,Ó CatoÕs Letter no. 10, Cato Institute,Washington, 1996; Sergio Baeza and FranciscoMargozzini, eds., Quince A�os Despu�s: Una Mirada alSistema Privado de Pensiones (Santiago: Centro deEstudios P�blicos, 1995); Dimitri Vittas, Strengths andWeaknesses of the Chilean Pension System (Washington:World Bank, 1995); Peter Diamond and Salvador Vald�s-Prieto, ÒSocial Security Reforms,Ó in The ChileanEconomy: Policy Lessons and Challenges, ed. B.Bosworth, R. Dornbusch, and R. Lab�n (Washington:Brookings Institution, 1994), pp. 257Ð328; and GenesisInvestment Management Limited, AFP: The ChileanPrivate Pension System 1980Ð2010 (London: GenesisInvestment Management, 1996).

2 By artiÞcially increasing the price of labor, payroll taxeslead to the substitution of capital for labor.

3 For general overviews of those reforms and the similari-ties and differences between the new systems, see, forinstance, Monika Queisser, ÒThe Second-GenerationPension Reforms in Latin America,Ó Ageing WorkingPaper 5.4, Organization for Economic Co-Operation andDevelopment, Paris, 1998; and Salomon Smith Barney,Private Pension Funds in Latin America: 1997 Update(New York: Salomon Smith Barney, December 1997).Feldstein contains case studies of the Mexican andArgentinean reforms, in addition to the study by Edwardson the Chilean reform. L. Jacobo Rodr�guez, ÒIn Praise andCriticism of MexicoÕs Pension Reform,Ó Cato InstitutePolicy Analysis no. 340, April 14, 1999, contains a list ofcomprehensive studies of the Mexican reform.

4 As is the case in most Latin American and West Europeannations, in addition to pensions, the Chilean social securitysystem covered health care services, disability and unem-ployment insurance, and other so-called social services.Thus, when talking about contribution rates for social secu-rity, it is important to distinguish between rates for thewhole system and rates for the pension portion of the sys-tem. In this paper, Òcontribution ratesÓ under the old sys-tem refer to the pension portion only.

5 In reality those funds were never capitalized, becausecapital markets did not exist in Chile at the time.

6 Quoted in Genesis Investment Management, p. 6.

7 See Superintendencia de Administradoras de Fondos dePensiones, El Sistema Chileno de Pensiones, p. 27.

8 The complete text of D.L. 3,500 can be found athttp://www.safp.cl. Article 34 of the reform law states thatcontributions and the returns earned on them are the work-ersÕ property and cannot be conÞscated under any circum-stances.

9 See Jos� Pi�era, El Cascabel al Gato (Santiago: EditorialZig-Zag, 1991), p. 172.

10 The actual cap is 60 Unidades de Fomento per month.The UF is ChileÕs indexed unit of account. At the end ofDecember 1998, 1 UF was equivalent to 14,685.39 Chileanpesos. $1 = 474 Chilean pesos. Thus, UF 1 = $30.98, andUF 60 = $1,858.80. Yearly income to which the contribu-tion rate of 10 percent is applicable is then equivalent to$22,305.60.

11 This option is especially beneÞcial to workers who wantto retire early (i.e., before the age of 65 for men and 60 forwomen) or with higher pensions.

12 Workers are free to withdraw money from thoseaccounts up to four times per year. If the money withdrawnis not transferred to a pension savings account, the workerhas to pay taxes on the amount withdrawn. At the end ofAugust 1998, there were 978,022 Voluntary SavingsAccounts with an accumulated balance of 74.3 millionChilean pesos.

13 No data are available on the average number of low-income workers who have voluntary accounts.

14 Other changes introduced in 1997 included the require-ment to produce an ID card and the most recent statementof account. An indirect effect of those changes has been toincrease sales agentsÕ commissions, since transfers are nowless frequent and more valuable to the AFPs.

15 The minimum capital required to create an AFP is 5,000UF. If an AFP has 5,000 affiliates, the minimum increasesto 10,000 UF; if it has 7,500 affiliates, the minimumincreases to 15,000 UF; and when an AFP reaches 10,000affiliates, the minimum capital requirement increases to20,000 UF.

16 Although the passbook may have become obsolete in theinformation age, it has been one of the powerful symbolsof the new system. The passbook has been the equivalentof a property title, which has made it easier for workers tounderstand that the money in those accounts is their prop-erty.

17 There is now a bill before the Chilean congress thatwould increase the percentage from 110 percent of theminimum pension to 150 percent.

18 This option is ideal for workers who are about to retire ata time when the value of their accounts is down.

19 For instance, if the industryÕs average return for the pre-ceding 12 months is 10 percent and an AFP has a return of17 percent, then the Òexcess returnsÓ are 2 percentagepoints (10 percent plus 50 percent of the average return,which is 5 percent, equals 15 percent, which is the thresh-old in this case). If, on the other hand, the industryÕs aver-age return is 2 percent and an AFP has a return of 4.5percent, then the Òexcess returnsÓ are .5 percentage points(2 percent plus two percentage points equals 4 percent,which is the threshold in this case, since it is higher than 2percent plus 50 percent of the average, 1 percent, whichwould be equal to 3 percent).

20 Roberto Fuentes, ÒEvoluci�n y Resultados del Sistema,Óin Baeza and Margozzini, p. 95.

20

21 Pi�era, ÒEmpowering Workers,Ó p. 5.

22 Information from the Office of the Chief Actuary, SocialSecurity Administration, http://www.ssa.gov/OACT/COLA/IllusAvg.html.

23 Per capita GNP was $4,860 in Chile and $28,020 in theUnited States in 1996. World Bank, World DevelopmentIndicators 1998, CD-ROM (Washington: World Bank,1998).

24 Advocates include Nobel laureates Milton Friedman andGary Becker, Harvard economist Robert Barro, andFederal Reserve Board chairman Alan Greenspan.Opponents include former Social Security commissionerRobert Ball, Brookings Institution economists HenryAaron and Robert Reischauer, and MIT professor PeterDiamond.

25 Presumably, workers would also switch often from onecompany to another if there were greater variance inadministrative costs or, more important, returns.

26 In a letter to Harvard economist Martin Feldstein, Jos�Pi�era stated that his only regret with respect to the way thereform was implemented was that some restrictions thatwere meant to be temporary have no sunset provisions andthat, because of the success of the new system, politicianstoday are afraid to eliminate such restrictions. The letter isdated February 10, 1998. I thank Pi�era for giving meaccess to his letter Þle.

27 As of the writing of this paper, no legislative action hadbeen taken on this bill.

28 Jos� Pi�era recently proposed the elimination of thereturn band along with a series of other measures intendedto increase the control each worker has over his accountand reduce government regulation of commissions andinvestments as a way to celebrate the 18th anniversary ofthe system. See Jos� Pi�era, ÒPrivate Pensions in Chile:New Frontiers,Ó http://www.pensionreform.org/articles/new_frontiers.html.

29 Those strategies appear to be affected by the minimumreturn guarantee.

30 2.7/(10 + 2.7) = 0.2126, or 21.26 percent.

31 Commissions are also overstated in the case of workerswho receive gifts or outright lump sums from sales agentsas an enticement to transfer from one AFP to another.

32 Ra�l Bustos Castillo, ÒReforma a los Sistemas dePensiones: Peligros de los Programas Opcionales enAm�rica Latina,Ó in Baeza and Margozzini, pp. 230Ð31.

33 Congressional Budget Office, ÒSocial SecurityPrivatization: Experiences Abroad,Ó January 1999, sec. 2,p. 7.

34 Ibid., sec. 3, p. 11.

35 Salvador Vald�s, ÒLas Comisiones de las AFPs ÀCaras oBaratas?Ó Estudios P�blicos 73 (Summer 1999): 255Ð91.

36 Allowing banks and other Þnancial institutions to enterthe AFP industry might present potential conßicts of inter-est. In principle, so long as those institutions competeunder the same rules as other market participants, they

should be allowed to administer the pension savingsaccounts of Chilean workers. It is likely that in a marketenvironment banks would have to develop effective sepa-rations between their bank functions and their administra-tive functions to attract and protect workersÕ investments.Furthermore, the banks might invest in instruments of ahigher quality to allay any fears about the safety of theinvestments.

37 See, for instance, CB Capitales, ÒReforma al SistemaPrevisional,Ó Informe Econ�mico, no. 8 (December 1997),http://www.cb.cl/trust/informes/economico/inf8/indice.htm. See also Pi�era, ÒPrivate Pensions in Chile.Ó

38 The issue of the commission structure has generated avast literature in Chile. See, for instance, Salvador Vald�s,ÒComisiones de AFPs: M�s Libertad y MenosRegulaciones,Ó Econom�a y Sociedad, JanuaryÐMarch1997, pp. 24Ð26; Salvador Vald�s, ÒLibertad de Preciospara las AFP: A�n InsuÞciente,Ó Estudios P�blicos 68(Spring 1997): 127Ð47; Jos� de Gregorio, ÒPropuesta deFlexibilizaci�n de las Comisiones de las AFP: Un Avancepara Corregir las IneÞciencias,Ó Estudios P�blicos 68(Spring 1997): 97Ð110; and Alvaro Donoso, ÒLos Riesgospara la Econom�a Chilena del Proyecto que ModiÞca laEstructura de las Comisiones de las AFP,Ó EstudiosP�blicos 68 (Spring 1997): 111Ð26.

39 The unfairness does not come from the fact that someworkers are paying more than others for the same type ofservice. In a free-market economy sellers should be able toprice discriminate if they wish to in order to capture theconsumerÕs surplus. The problem here is that the govern-ment is mandating price discrimination.

40 See Vald�s, ÒComisiones de AFPs,Ó p. 25.

41 Critics of privatization often point to the giving of toast-ers and other consumer goods as incentives to switch fromone AFP to another as proof of the excesses of the Chileansystem. Retail banks in the United States engage in similarpractices on college campuses without any negative effectson the banking system or consumers. Of course, thosepractices have decreased as the banking industry has beenderegulated and banks in the United States have foundother ways of competing with each other, such as offeringbetter interest rates or lower fees.

42 Entry fees (or a part thereof) are usually given back bysales agents as a rebate to their customers as an enticementto switch from one AFP to another. Exit fees are notallowed by law in an effort to promote competition.

43 The bill also includes other measures that relate to theway commissions are charged. By Òtime commitment,Ó Imean an agreement between a worker and an AFP where-by the worker would agree to stay with the AFP for a num-ber of months (not to exceed 36 months) and the AFPwould agree to maintain the same commission structure forthe duration of the agreement. Again, as of the writing ofthis paper, no legislative action had been taken.

44 There has been a corresponding decrease in the numberof sales agents. There were almost 18,000 sales agents atthe end of 1997 and 6,380 at the end of 1998.

45 Before the U.S. airline industry was deregulated, airlinescompeted on service, rather than on price. That service

21

might be thought of as the equivalent of Òwasteful admin-istrative costsÓ in the absence of price competition.

46 See Milton Friedman, ÒSocial Security Chimeras,Ó NewYork Times, January 9, 1999. See also Milton and RoseFriedman, Free to Choose (New York: Harcourt BraceJovanovich, 1990), p. 124.

47 The value of the recognition bonds was computed bymultiplying 80 percent of the workerÕs average salary(indexed for inßation) in the 12 months before mid-1979by the number of years the worker had contributed to thesystem (up to a maximum of 35 years) and multiplying thatresult by an annuity factor of 10.35 for men and 11.36 forwomen.

48 This cost is projected to reach a peak of 1.06 percent ofGDP in 2005.

49 As of January 1999, the government had supplemented19,715 pensions, including 6,050 old-age pensions, in itsrole as Þnancial guarantor of last resort in the new privatesystem. Superintendency of Pension Funds Administrators,http://www.safp.cl.

50 Since the system is only 18 years old, the only workerswho are eligible for the government safety net are thosewho contributed to the old system as well. Today, they arethe only workers who could have made contributions formore than 20 years.

51 That tax was still lower than the payroll tax of the oldsystem. In fact, the total contribution to the new systemplus the tax was also lower than payroll taxes under the oldsystem.

52 The Þnancing of a transition from a pay-as-you-go sys-tem to a fully funded individual capitalization one is a com-plex issue, and the Þscal resources of each country have tobe taken into account.

53 Hern�n Cheyre, La Previsi�n Ayer y Hoy, 2d ed.(Santiago: Centro de Estudios P�blicos, 1991).

54 See ÒEl 44,17% de los AÞliados al Sistema de PensionesNo Cotiza Regularmente,Ó El Diario (Santiago), June 4,1998.

55 At the end of 1998 the number of females with a pensionsavings account was close to 2.5 million and the number offemales in the workforce was only about 2 million, whichmeans that about 500,000 females have left the workforcein recent years. Those women, however, have pension sav-ings accounts and their accumulated savings are earningreturns.

56 At the end of 1998, there were 156,782 self-employedworkers with pension savings accounts, and 59,458 ofthem contributed to their accounts in December 1998.

57 Critics of the Chilean reform often refer to the fact thatthe armed forces, which ruled Chile at the time the reformwas implemented, are not required to participate in the pri-vate system. In Chile the armed forces and police forces arecovered by a separate government-run retirement program,as they are in most countries. That system is performingpoorly in comparison with the private pension system.

58 I assumed that unemployed workers were evenly distrib-uted between the dependent and self-employed sectors. So,if the total unemployment rate was 7.5 percent, then 74.6percent of those unemployed workers (or 5.6 percent of thetotal labor force) were dependent workers.

59 The AFPs identiÞed 2,560,158 of those contributors, andtheir contributions were promptly credited to their respec-tive pension savings accounts. In addition, 236,024 contri-butions were made in that month on behalf of workerswhom the AFPs were unable to identify. The AFPs invest-ed those contributions in the pension funds they managebut did not credit them to the accounts of individual work-ers. Once those workers are identiÞed, the AFPs will cred-it their accounts. There were also 42,317 ÒpassiveÓcontributions. See Superintendencia de Administradoras deFondos de Pensiones, Bolet�n Estad�stico, no. 148 (1999):71.

60 Klaus Schmidt-Hebbel, ÒLatin AmericaÕs PensionRevolution: A Review of Approaches and Experience,ÓPaper presented at the World BankÕs ABCDE Conference,April 28Ð30, 1999, Washington, pp. 10Ð11.

61 The calculation was as follows: 2,897,957/5,361,410 =54.05 percent. To that Þgure, we must add the number ofself-employed workers who were contributing to the sys-tem (59,458, or 1.1 percent of the total employed laborforce) and the percentage covered by state-run systems, 6percent. When those Þgures are added up, we obtain a totalcoverage of 61.15 percent of the total employed laborforce.

62 See Edwards, p. 47.

63 Per capita GNP was $4,860 in Chile and $28,020 in theUnited States in 1996. World Bank.

64 BeneÞts under Social Security for a low earner are, onaverage, $565 per month, or $6,780 per year. The mini-mum wage is $5.15, or $8,910 per year (using a 34.6-hourworkweek, the average weekly hours for a U.S. workeraccording to the Bureau of Labor Statistics, and 50 weeksof work per year), and $6,780/$8,910 = 76.09 percent. See Bureau of Labor Statistics, http://www.bls.gov.eag.table.html.

65 In December 1998 average earnings in the United Stateswere $12.98 per hour. Assuming that the average workerworks 1,730 hours per year, that comes to $22,455 per year,and $6,780/$22,455 = 30.19 percent. See Bureau of LaborStatistics, http://www.bls.gov.eag.table.html.

66 See Superintendencia de Administradoras de Fondos de Pensiones, Press release, hhtp://www.safp.cl/prensa/1999/may/page2.html.

67 A wealth relative can be deÞned as a value equal to oneplus the periodic rate of return of an investment. That valueis used to link returns in computing the geometric average.

68 The internal rate of return can be deÞned as a compoundinterest rate at which the net present value of cash inßowsfrom a project is equal to the net present value of cash outlays.

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69 My calculation is not entirely correct, because I assumethat the composition of the portfolio does not changethroughout the investment period (which is not true) and Ido not take into account the administrative costs net of thelife and disability insurance premiums because of the diffi-culties of converting a charge on contributions to a chargeon assets under management (see the section on adminis-trative costs above).

70 The reform was undertaken assuming that if the realreturn on investments was 4 percent, on average, thereplacement rateÑor pension beneÞtsÑwould be 70 per-cent of the average salary during the last 10 years of aworking life.

71 This is basically an application of the principle of thedivision of labor. As Adam Smith showed more than 200years ago, the division of labor, which is determined by theextent of the market, allows individuals to specialize inthose activities at which they enjoy a comparative advan-tage and pay someone else who has a comparative advan-tage in other activities to perform those activities for them.See Adam Smith, An Inquiry into the Causes and Nature ofthe Wealth of Nations (New York: Modern Library, 1937),pp. 17Ð21.

72 See Superintendencia de Administradoras de Fondos dePensiones, El Sistema Chileno de Pensiones, p. 103.

73 See Superintendencia de Administradoras de Fondos dePensiones, Bolet�n Estad�stico, no. 146 (1998): 12Ð15.

74 See Superintendencia de Administradoras de Fondos dePensiones, El Sistema Chileno de Pensiones, p. 38, n.13.

75 For a criticism of this measure, see Rodr�guez, p. 8.

76 In an interview with The Economist, Jos� Pi�era com-plained about the reluctance of the present government tointroduce changes to the pension system. ÒThe paradox,ÓPi�era said, Òis that all those who designed the system wantit liberalized, whereas those who originally opposed itwonÕt touch it. They have become more Catholic than thePope.Ó ÒFrom Chile, with a Pinch of Salt.Ó The Economist,October 24, 1998.

77 Sergio Baeza and Ra�l B�rger, ÒCalidad de lasPensiones del Sistema Privado Chileno,Ó in Baeza andMargozzini, pp. 165Ð75.

78 Genesis Investment Management, p. 22.

79 Chilean authorities are now contemplating the possibili-ty of allowing each AFP to manage a second fund made upof Þxed-income instruments only.

80 The City of San Diego, which allows its workers to optout of Social Security and participate instead in fully fund-ed privately managed retirement plans, introduced in 1996the option of putting savings into Þve different plans thatoffer different combinations of risk and return. For moreinformation on this issue, see, for instance, Carrie Lips,ÒState and Local Government Retirement Programs:Lessons in Alternatives to Social Security,Ó Cato InstituteSocial Security Paper no. 16, March 17, 1999, pp. 6Ð8.

81 The biggest question about this proposal is which regu-latory agency would be responsible for providing the min-imum pension guarantee, the one in the workerÕs countryof origin or the one in the country in which the pensionfund administration company is based. One easy solutionwould be to disqualify workers from other countries for theminimum pension guarantee. If those workers still wantedprivate pension fund administration companies from othercountries to manage their retirement savings, they shouldnot be prevented from doing so. Of course, this is a pro-posal that could not be implemented in the short term.However, it merits consideration and could possibly beimplemented in the medium to long term (5Ð15 years),once all the technical aspects have been discussed thor-oughly. The proposal would also put a check on the con-centration of decisionmaking about the allocation ofresources in Chile. Because the AFPs have become thelargest institutional investors in Chile, there is a growingconcern that the minimum return guarantees will lead theAFPs to favor investments that make it easier for them tocomply with those regulations even if more proÞtable orsound investment opportunities are available.

82 See Pi�era, ÒPrivate Pensions in Chile.Ó

83 See CB Capitales.

84 It is not clear that the reform has actually increased theprivate savings rate. What is clear is that public savingshave increased since the 1970s and stand at about 5 percentof GDP today. If the transition to a fully funded system istax Þnanced, as ChileÕs was, there can be a signiÞcantincrease in savings. Klaus Schmidt-Hebbel, has estimatedthe effect of the pension reform on the aggregate increasein the savings rate to be 3.8 percent of GDP. See Schmidt-Hebbel, p. 20.

85 See Edwards, p. 54.

86 See Carlos Alberto Montaner, ÒAccionistas del MundoUn�os!Ó Newsweek en Espa�ol, May 13, 1998.

87 Mark Klugmann, ÒPolitical and Social Effects in Chile ofThat CountryÕs Pension System,Ó Testimony before theSubcommittee on Securities of the Senate Committee onBanking, Housing and Urban Affairs, June 25, 1997.

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