PRIVATIZATION OF SOCIAL

SECURITY: LESSONS FROM CHILE

by Peter Diamond

Presented by
Agata Narożnik
Ertem Ejder
Outline:

 The history of the Chilean Social Insurance Scheme

 Key elements of Reform
 Costs
 Capital market
 Regulation
 Financing the Transition
 Redistribution and Political Risk
 Social risk and aggregate change
 Insurance
The history of the Chilean Social
Insurance Scheme
 1924 – begining of Social Insurence as pension
benefits
 1938 - expanded to include preventive medicine
services
 1953 - expanded to include child and unemployment
benefit
 included 35 Insurance Funds by 1973 and covered
75.9% of the labor force
 1970 - level of benefits fell, as the pay-as-you-go
pension system was failing (decreased fertility rates
and the lengthening of life expectency)
 1980 - 70% of those retired received minimum
pension
Key elements of Chilean Reform

 Goal: privatized mandatory savings plan

 Emploees place 10% of monthly earnings in
a savings account managed by system of
private founds - an Administradora de
Fondos de Pensiones (AFP)
 Additional contribution covers premium for
disability and dependant survival pension
benefits, plus AFPs commission fees
 Contributions paid to PSAs are solely paid by
employees
Comparition

Old System New System

System PAYGO Individual capitalization

Financing
Management State Private, competitive

Options Rigid Multiple (pension fund,

contributions over legal
minimum, type of fund (in
multi-funds)
Role of State Administrator, self- Supervision, regulation,
regulation subsidiary
Benefits Old age pension Old age pension, annuities,
programmed withdrawals
Administrative costs

 High cost of running a privatized social

security system, higher than the "inefficient"
system that it replaced
 Valdes-Prieto (1993b) has estimated that the
average administrative charge per effective
affiliate while active are U.S. $89.10 per year
(for 1991) which is 2.94% of average taxable
earnings
The high cost of running a privatized
social security system:
 Economies of scale that come with a single
compulsory system without choice.
 The costs that arise from competitive
attempts to attract more customers -
advertising, salespersonnel and the like.
 In actual markets demand is much less
sensitive to price variation than in idealized
competitive markets ->the greater costs
associated with trying to attract more
customers -> prices exceed marginal costs.
Capital market

 The combination of a steady flow of contributions

together with very high real rates of return (an
average of 14.5% from July, 1981 to July, 1992) has
meant a large accumulation of funds invested in the
Chilean economy.
 The high rates of return, and implied rapid
accumulation, are the result of generally high rates
of return in the Chilean economy, not particularly
astute investment choices by private fund
management.
70% $ 60.000

60% Fund (current USD)

% of GDP $ 50.000

50%
$ 40.000

40%

$ 30.000

30%

$ 20.000
20%

$ 10.000
10%

0% $0
1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003
Evolution of regulation of the markets

 Evolution of regulation of the markets in

which funds are invested results in a set of
capital markets that function far better than
they did before the reform.
 Each AFP has a single fund.
 There is regulation guaranteeing that no fund
will do too much worse than the average of
all funds. This creates an incentive for fund
portfolios not to differ too much from the
average fund.
 Evolution of Number of Countries with Second Pillars Domenican R.
Kosovo
35 Bulgaria India Nigeria Macedoni
Bolivia
Hong Kong Croatia Korea Slovakia a
31
El Salvador Estonia Lithuania 30
Netherlands Costa
30 Switzerland Argentina Hungary Rica
Russia
28
Australia Kahzastan
Latvia
Colombia
Denmark 25
25 23
Poland
Peru Sweden
Number of Countries

Uruguay
20 19
Mexico
17
16
15 14

Chile 10
10 9
8

5 4
3
1
0
1981 1985 1993 1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
Source: Robert Holzmann Making Pension Reform Work: The Link to Labor and Financial Market Reforms World Bank, June 2007
Financing the Transition
Financing the Transition

• Active workers that switched to the new

system have received explicit government
debt (recognition bonds) on account of past
contributions.
• This financing decision has implied an
increase in fiscal saving, with the decision to
avoid debt financing implying an
improvement in the primary fiscal balance of
3.5 - 4% of GDP each year in the 1980's.
Financing the Transition

 Before the start of the pension reform, the

government built a primary surplus of 5.5% of
GDP with a view to avoiding debt financing of
the reform.
Redistribution and Political Risk

• Redistribution is always a source of political tension.

• Intergenerational redistribution is particularly
focused on social security.
• There is a deep tension between political views that
concentrate on outcomes and political views that
concentrate on changes in outcomes.
"all property is theft“ and "all taxation is theft.“
• Benefit-based formulas make consumption patterns
clearer than the contribution based systems do.
• Contribution based systems make redistributions
clearer.
Redistribution and Political Risk

 Chile did freeze the COLA for pensions

received under the continuation of the old
system in 1985. Since COLA's paid by
private insurance companies do not directly
affect the government budget, one would not
expect to see the government freeze
pensions paid under the new system at the
time of some future budget squeeze.
Transition period difficulties
addressed by government guarantees:
 Recognition bonds: are to rise annually by
rate of inflation plus 4%,
 Minimum pension guaranteed to contributors
of 20 years,
 Life annuities guaranteed in event of a failure
by the Life Assurance Company involved,
 The Chilean Government has huge general
revenue obligations extending for decades to
come.
Social risk and aggregate change

 The rate of growth of real wages,

 the real rate of return,
 mortality factors,
 the growth of the labor force.
Social risk and aggregate change

 The Chilean system is sensitive to interest

rate and mortality changes since these affect
the adequacy of retirement income relative to
prior earnings.
 Pay-as-you-go systems have more concern
with population factors.
Insurance

• The Chilean system has a maximum allowable

rate of withdrawal from accumulated funds.
• The rate varies with age and recent interest
earnings on the funds.
• Eligibility to tap retirement funds in either form is
unrelated to whether individuals stop working.
Only sufficient age are necessary to begin
withdrawals.
• Funds are accumulated until retirement age is
reached.
Conclusions

 PAYG is a replaceable system.

 Cost of running a privatized social security
system are higher then the costs of previous
system.
 New system created a large accumulation of
funds.
 Regulations of the markets is a main factor,
especially at the begining of the reform.
Conclusions
 Countries choosing to privatize can do better
by recognizing that the private market is an
expensive institution so they can try to hold
down the cost of using the private market.
 It requires hard work at regulation and
political discipline to make such a reform that
Chile did.
 The major benefits of the Chilean approach
are the insulation from political risk and the
development of capital markets.
More conclusions
 The first country to "privatize" its Social Security system
was Chile.
 Since the system started on May 1, 1981, the average
real return on the personal accounts has been 10
percent a year. The pension funds have now
accumulated resources equivalent to 70 percent of gross
domestic product, a pool of savings that has helped
finance economic growth and spurred the development
of liquid long-term domestic capital market. By
increasing savings and improving the functioning of both
the capital and labor markets, the reform contributed to
the doubling of the growth rate of the economy from
1985 to 1997.
 Unlike traditional social security payments,
benefits in Chile are based on personal
investment accounts owned by workers.
Chileans don't worry about whether the
government will run out of money as baby
boomers retire, because benefits are
financed by their own assets, which have
been accumulating in their own accounts, not
by taxes paid by current workers. The funds
are privately managed and therefore
insulated from political interference.
The Success and Failure of the
Privatization of Social Security in
Chile
 The system is young, and its performance in the next 10
to 20 years will be important in determining the long
range success or failure.
 The average rate of return on Chilean pension accounts
in 1995 was -2.5 % which demonstrates the risk involved
in having privatized pension plans, there will inevitably
be some poor investments. The government can
regulate the investments heavily to avoid such failures,
but the risk is inherent in free markets
Thank you