Chiles Bachelet Pushes Pension Reform, Threatening Private Funds

27 JUN 2014 - JASON MITCHELL

Nothing illustrated Chiles conversion to the cause of free-market economic liberalism in
the 1970s and 80s like the countrys funded, privately managed pension system.
Inspired by economist Milton Friedmans landmark book, Capitalism and Freedom, Jos
Piera, Labor and Pension minister during the dictatorship of then-president Augusto
Pinochet, introduced revolutionary reforms in 1981 that overhauled the countrys pay-
as-you-go social security system. As a result of those changes, workers are required to
contribute 10 percent of their salaries to 401(k)-style funds, known as administradoras
de fondos de pensiones, or AFPs, which invest the money in a variety of fixed-income
and equity securities at home and abroad (see also Chiles AFPs: A Lucrative Market
for Foreign Fund Managers). This system has allowed Chile to build up one of the
worlds biggest pools of retirement capital $162 billion, or 62 percent of gross
domestic product and has served as a model for more than 25 countries around the
world, from Colombia to India to Russia. Piera, whose brother Sebastin would later
serve as president, from 2010 until this March, was celebrated as the pension reform
pied piper by the Wall Street Journal.
Today the private pension system is at the center of a new inflection point in Chilean
politics. Michelle Bachelet, a Socialist Party politician who returned to the presidency in
March, is preparing to embark on the biggest revamp of the countrys pension system in
its 33-year history. Arguing that the system leaves too many Chileans without retirement
security and carries excessive costs, Bachelet wants to introduce a new, state-run AFP
to compete with the private pension funds. The recommendation has provoked a howl
of protests from existing pension fund managers, which include some of the biggest
names in global finance, and warnings from economists that Chile runs the risk of
stifling its economic dynamism with an increasingly powerful state.
I think a state-run AFP is a very bad idea, says Arturo Cifuentes, academic director at
the University of Chiles Center of Regulation and Macrofinancial Stability and president
of the committee that advises the government on the investment policy of the countrys
two sovereign wealth funds, which hold a total of $22.5 billion. What can the
government offer that the private investment funds do not?
Notwithstanding the critics, Bachelet seems determined to see her reform through. She
campaigned on a promise to reduce rising inequality in Chile and won a strong
mandate; her 62 percent of the vote in Decembers presidential run-off election was the
highest share of any presidential candidate since the country returned to democracy in
1989. After taking office on March 11, she gave her ministers 100 days to draw up
legislation to overhaul the pension system. They did so in June, and Bachelet sent a bill
to Congress that would establish a state-run AFP under the auspices of CORFO, the
Chilean economic development agency.
Our priority is to improve the system so that we are able to give people greater
opportunities in life, the president said. The plan is to introduce greater competition
and to cover those people like women, self-employed workers and others who live in
remote parts of the country.
Cifuentes acknowledges the political pressure for change. The proposed reform
reflects a cultural issue, he says. In the U.S. people do not expect the government to
intervene. However, increasingly in Latin America, people want the state to do more and
more things for them.
Chile has been drifting leftward since the restoration of democracy a generation ago,
but the new reform drive stands out because of the countrys recent history.
After leading a coup that overthrew Socialist president Salvador Allende in 1973,
Pinochet cut back the states role in the economy and made Chile a virtual testing
ground for liberal policies, many of them drafted or inspired by economists from the
University of Chicago, such as Friedman. Over the ensuing decades prosperity
blossomed: The country boasts the highest standard of living of any major Latin
American nation, with per capita GDP of $15,458 in 2012, according to World Bank
data. Growth has averaged 4 percent a year for the past five years, and inflation is
projected to be 3.5 percent this year. Unemployment stands at 6 percent, one of the
lowest rates in Latin America, and the government runs a modest structural budget
deficit of 0.98 percent of GDP, according to the International Monetary Fund.
Yet the fruits of that prosperity have not been widely shared. According to the World
Bank, Chiles Gini index, which measures the distribution of income on a scale of zero
to 100, with a higher number reflecting greater inequality, stood at 52.1 in 2009 (the
latest figure available), compared with 46.1 in Argentina and 36.3 in Uruguay. Of the 34
members of the Organization for Economic Cooperation and Development, Chile has
the biggest gap between rich and poor.
Social unrest grew during Sebastin Pieras presidency, with university students
staging mass protests in 2011 over the cost of education. Bachelet rode that wave of
discontent to victory in December and now seeks to deliver on her promises.
THE PROPOSAL FOR A STATE-RUN pension plan is part of a wider package of
reforms. The president has promised that the state will pay tuition fees for the poorest
70 percent of university students by the end of her four-year term. Currently, students
and their families have to shoulder the bulk of those costs. She also has promised to
ramp up spending on health care and reduce income inequality. Overall, the
government wants to boost spending by some $10 billion, or nearly 4 percent of GDP. It
plans to finance the spending mainly by hiking corporate taxes to 25 percent from 20
percent over a four-year period and by abolishing a mechanism that allows companies
to defer indefinitely the payment of taxes on reinvested profits.
Although Chile has a very light tax load it stood at 18.6 percent of GDP in 2010,
compared with 26.1 percent in Argentina and 34.4 percent in Brazil, according to the
Heritage Foundation some analysts warn that the governments plan to boost
spending could put a damper on the economy. Although a fair trade-off from a
structural standpoint, it is already negatively affecting business confidence, says
Gustavo Canonero, chief economist for emerging markets at Deutsche Bank. This is
expected to be a major impediment for a rapid recovery this year and next, although
expansionary fiscal and monetary policy should be expected to come partly to the
rescue. In May and June students staged a new round of demonstrations that brought
tens of thousands of people into the streets to protest that the governments education
reforms lacked ambition and urgency.
Under the current pension system, workers must contribute 10 percent of their salaries
up to a ceiling of $3,152 a month, which makes the maximum required contribution
$315 a month. People can voluntarily add to their pension savings, contributing as much
as 30 percent of their salaries on a pretax basis. At retirement workers have a few
options for accessing their funds, but all involve some form of an annuity, either directly
from the AFP or through a life insurance company.
Its easy to see why so many countries have been keen to adopt the Chilean model.
Because the system is funded, it relieves the strain on public finances from social
security expenses. It helps foster the growth of savings that are crucial for economic
development. And the system is popular with many Chilean workers and retirees. The
AFPs have allowed the middle class people with secure, well-paying jobs who have
been contributing to the system for decades to build significant retirement savings.
According to figures from the Pensions Supervisor, the government agency that
regulates the industry, the average monthly pension payment received in January 2013
by nearly 1 million Chileans in the AFP system was about 179,000 Chilean pesos, or
$322.
The current solution is not perfect, but most people with steady jobs receive a pretty
good pension, says Axel Christensen, chief investment strategist for Latin America and
Iberia at BlackRock in Santiago. Its no surprise that if people have not contributed
regularly, their pension is not adequate.
For others, such as lower-paid employees, people in precarious occupations with spells
of unemployment and those in the informal sector, or black economy, the private
pension system provides much less, if any, retirement security. The informal sector
accounts for as much as 25 percent of Chiles economic output. Many workers in this
sector reach retirement age with no retirement account or with a balance thats too
small to provide an adequate income. Currently, 4.96 million Chileans, or slightly more
than 60 percent of the countrys labor force, are contributing to an AFP; an additional
4.62 million retirees in the system are drawing benefits.
The pension fund system has come in for growing criticism since the outbreak of the
global financial crisis in 200809, which dealt a blow to investor returns. AFPs are
required to offer five funds with different risk profiles, ranging from the very conservative
to the very risky; contributors can invest in as many as two of the five funds. Funds with
intermediate risk generated average annual returns of 5.25 percent between September
2002 and May of this year, but annualized returns were only 2.62 percent between June
2011 and this May, according to the Pensions Supervisor. Overall, the system produced
annualized returns of 8.7 percent between 1981 and 2013.
Consolidation has reduced the number of AFPs from 32 in 1997 to just six today:
Provida, a subsidiary of New Yorkbased MetLife, with $45 billion in assets as of
November 2013, according to the Pensions Supervisor;
Habitat, which has $42.3 billion in assets and is run by the Chilean Chamber of
Construction;
Capital, a $33.5 billion-in-assets arm of Colombian financial services company Grupo
de Inversiones Suramericana;
Cuprum, with $33.4 billion in assets, part of Principal Financial Group, a Des Moines,
Iowabased financial services group;
Planvital, a $4.4 billion-in-assets unit of Assicurazioni Generali, Italys biggest insurer;
and
Modelo, a $1.9 billion fund run by Chilean investment firm Sociedad de Inversiones
Atlntico.
FOR BACHELET, PENSION reform represents one of the biggest pieces of unfinished
business from her first term in power, between 2006 and 2010. (Chiles constitution
prohibits presidents from serving consecutive terms.) Back then she managed to make
some changes, introducing a minimum pension currently, the equivalent of $160 a
month for all Chileans; making women eligible for a state-subsidized pension, known
as el bono por hijo, depending on their number of children; and providing subsidies to
match the pension contributions of low-income workers. But she failed in a 2008 bid to
launch a state-run AFP through a government bank, Banco del Estado de Chile. As
drafted, the proposal would have allowed all banks to set up pension funds. The AFP
industry lobbied heavily against the measure, and the government shelved it.
The new proposal is unlikely to meet a similar fate. Bachelets Socialist Party and its
center-left allies enjoy a solid majority in Congress. In addition, the government is
sidestepping the banking issue by proposing to set up the new AFP through
development agency CORFO. The new fund would use the nationwide branch network
of the Institute of Social Security, the public pension service for people who do not
belong to AFPs, to serve its members.
The government contends that existing AFPs charge high management fees and that
greater competition would help to bring them down. The funds charge an average
management fee of 1.48 percent, but actual rates vary widely. In May, for example,
Modelo charged the lowest fee to existing clients (0.77 percent), while AFP Planvital
charged the highest (2.36 percent), according to the Pensions Supervisor. All of the
pension fund managers also charge contributors 1 percent of their monthly pretax
earnings to buy disability insurance and insurance for surviving dependents.
The AFPs rebut the cost argument, pointing to another reform that Bachelet pushed
through in 2008. Under this measure the government puts out to tender the exclusive
right to sign up new entrants to the labor force over the following two years. The tender
is based solely on price, with the winner being the AFP that bids the lowest
management fee. Workers enrolled under this measure are obliged to stay with the fund
for at least two years.
The pension fund companies assert that this procedure increases competition and puts
downward pressure on fees, eliminating the need for a state-run rival. Modelo won the
first two tenders, in 2010 and 2012, with its 0.77 percent management fee. Planvital
won the latest tender, in January, by bidding a management fee of only 0.47 percent for
new contributors; it gains the right to sign up new entrants to the workforce beginning in
July. In addition, the firm announced it would extend the same low management fee to
existing contributors starting in July a drastic cut from the previous level of 2.36
percent.
Only announcing that a draft law to set up the AFP is being sent to Congress has led to
strong reductions in commissions, says Eugenio Rivera, economics program director at
Fundacin Chile 21, a left-leaning think tank that is close to the government.
Planvital CEO Alex Poblete says the tender system is more effective than a state
pension provider would be. A state-run AFP could not have lower fees, he says.
Under the tender system we automatically receive new members. The state-run AFP
would not have that advantage and would need a sales team.
Yet even with the tender system, competition appears to be sorely lacking in the
pension market. The biggest problem is inertia: By law, the AFPs must publish their fees
each quarter, and the Pensions Supervisors website provides tools for comparing costs
and simulating their impact on pensions, but few Chileans take advantage of this to
switch AFPs.
Most people do not even know the commissions they pay, says BlackRocks
Christensen. The big problem with the governments reform is that peoples
expectations are high. It takes a long time to see the results, and you cannot change
someones pension pot in four years.
Will a new AFP increase the willingness of contributors to change providers? Some
experts estimate that as many as 1 million participants in the current system, out of a
total of 9.58 million, could switch to a state-run AFP. But many industry executives
dismiss such forecasts as wild guesses.
I cant see the state-run AFPs foundation as a real economic event its more
political, says Pedro Daobeitia, head of the global client group for Latin America at
Deutsche Asset Management. The government says it wants to increase competition. I
have hardly ever seen improved competition come from the state at least, that has
not happened in Europe. Planvitals Poblete echoes that view. Its hard to believe that
many people will just switch to the state AFP, he says. It will be starting from zero. It
will have no track record.
A new, state-run AFP may be only the first of a number of changes to the Chilean
pension system. The government has appointed a commission led by David Bravo,
an economics professor at the University of Chile, and including some of the worlds
leading economists and pension experts to consider an array of other reforms, such
as extending the retirement age, increasing the contribution rate and improving the
systems coverage. The commission is due to deliver a report to the government by
January.
Launching a state AFP will make it easier to have a debate about other reforms, such
as improving the contribution rate, says Rivera. It will help to create a better climate to
discuss general reform of the pension system.
The Chilean system already ranks as one of the better pension programs on the planet.
It won a B grade in last years Melbourne Mercer Global Pension Index, meaning it has
a sound structure with many good features but still has some room for improvement.
Other countries whose retirement systems earned a B grade included Canada, Sweden,
Switzerland and the U.K. Only Australia, Denmark and the Netherlands received an A
rating (see Top Danish Pension Fund ATP Is Making Headway in the UK Market).
Melbourne Mercer says Chile could improve its rating by raising the level of mandatory
contributions to increase retiree benefits, requiring employers to make contributions,
raising retirement ages and continuing to review the minimum pension for the poorest
pensioners.
Critics of the governments proposal for a state-run AFP say it would do nothing to
address those fundamental issues. There is no technical or logical reason why the
state-run AFP should be set up, says Poblete.
One of the reasons for discontent with the current system is a perception that it has
failed to deliver the level of benefits its founders promised. When the system was
launched in the early 1980s, officials predicted that AFP plans would provide retirees
with income equal to 70 percent of their working salaries a ratio known as the
replacement rate. The actual rate for workers on average earnings in 2013 was 41.9
percent, according to the OECD. Though higher than the U.K. and U.S. replacement
rates of 32.6 percent and 38.3 percent, respectively, that was below the OECD average
of 54.4 percent.
One of the main reasons Chile has a lower replacement rate is because employees
contribute only 10 percent of their salaries to their AFPs. By comparison, the average
contribution rate for private pension systems in OECD countries is almost 20 percent.
The Chilean system does offer pretty good value for money overall, says Rafael
Rofman, a social protection specialist at the World Bank who is based in Buenos Aires.
The benefits may be lower, but that is mostly because contributions are significantly
lower. In many ways this is a political decision.
Rofman adds, The Brazilian pension system has very good coverage, but public
pensions in that country amount to around 10 percent of GDP. In Chile the government
spends very little on pensions, up to 2 percent of GDP.
The graying of Chiles population is increasing the urgency around the issue of
contribution rates. According to the countrys census, there were 2.4 million Chileans
aged 60 or older, or 14 percent of the population, in 2012, up from 11 percent in 2002.
Life expectancy is 30 percent higher than it was 30 years ago. The individual account
balances that Chileans have built up must now be spread over many more years,
resulting in lower retirement incomes.
Pension and actuarial experts say contributions would have to rise to 15 to 16 percent
of salaries to give a meaningful boost to retirement income, but such a shift would either
eat into workers current income or cause a significant rise in labor costs.
Fundacin Chile 21s Rivera says employers should be forced to contribute an
additional 3 to 6 percent, but other experts argue that this would only encourage
employers to hire people on an informal basis.
It might be politically challenging, but the surest way of improving pensions is by
extending the retirement age and increasing the contribution rate, says Jaime de la
Barra, a partner at Compass Group, a Latin American investment adviser with offices
throughout the region.
As with most countries, there is no single, simple solution to Chiles pension dilemma.
Bachelet never promised that a state-run AFP would be a panacea. Instead, the country
will need a menu of options. Increasing contributions and raising the retirement age
would enhance retirement security and help ease complaints from private pension fund
managers about the new competition. That could bolster Chiles vaunted pension model
for a new generation.