Introduction
Old age social security schemes have been around since the beginning of the century. Mandatory old-age insurance introduced in Germany and this model known as the "Bismarkian model" became very popular in Latin America. Argentina, Brazil, Chile, Cuba, and Uruguay were the first ones to introduce the public pension schemes in the 1920s and 1930s. (Muller, 2000, 508) Latin American countries, due to the perceived success of the partially privatized social security system introduced in Chile in 1981 have introduced compulsory individually fully-funded (IFF) plans that compete with, substitute, or complement the public pay-as-you-go (PAYG) plans. The privatization of old-age security is a radical change in retirement plans, going against the welfare state. Privatization of social security is a transition from collective to individual provision and a transition from the state to the market as the main suppliers of retirement pensions. So far, it is unclear whether privatization of social security has been successful across the board in Latin America.
This paper is divided into five sections. The first section will examine
the problems with the old PAYG social security scheme. The second section
will discuss Chile's transition to a new IFF private pension scheme. The
third section will discuss the second generation Latin American social security
reforms. The fourth section will explore the results so far of the different
social security reforms. The final section will summarize the paper and
take a look into the future of social security privatization.
Previous Public Social Security Schemes in Latin America
Public pension schemes in Latin America had many flaws. There was a weak contribution-benefit link with large entitlement conditions and replacement rates. Because of this, contribution rates and state subsidies were elevated while evasion and underreporting of income increased. (Muller, 2000, 508) In some countries, the existing old-age security were fragmented and consisted of multiple funds with varying legislation and management, benefits and contribution rates. There was inequality between the different groups of insured and administration. The informal sector workers were very vulnerable because they were basically excluded from the existing social insurance schemes. (Muller, 2000, 508) In the 1980s with the economic crisis and the stabilization and adjustment plans that followed there was a decrease in the public resources for social policy when they were greatly needed. (Muller, 2000, 508) In many countries, the real value of the pension benefits was destroyed by inflation. In some, the public social security institutions defaulted on their pension liabilities and failed to pay retirement benefits. (Muller, 2000, 508)
Chile was the first Latin American country to privatize social security.
Before the privatization in 1981 under the Pinochet regime, Chile had more
than 30 separate pay-as-you-go systems based on occupation. Each of these
systems had different contribution rates, requirements for retirement, and
benefit levels. The number of contributors was very low because of the high
unemployment, the large quantity of informal employment, and the large amount
of evasion of contributions. About 93 percent of pensioners were receiving
the minimum benefit because the system was about to go bankrupt and could
not pay the benefits to those that were eligible. In 1980, the PAYGO system
was about 2.7 percent of the GDP of Chile. (Kritzer, 2000, 7)
The Case of Chile - IFF pension funds
Chile was the first Latin American country to privatize its pension system.
In 1981, with neoliberal ideologies and the Pinochet dictatorship, the PAYG
(pay-as-you-go) system was replaced by a multi-pillar system of private,
IFF (Individually fully-funded) pension funds. In the Chilean system, the
first tier is publicly run and pays out tax-financed social assistance pensions
to a limited number of elderly people with less than 20 years of contribution
(Muller, 2000, 509). The second tier consists of funded private pension
funds (AFPs) that have mandatory contributions paid to them by Chilean employees
and investing these funds. The third tier promotes voluntary savings for
old age, where workers may contribute an additional 10 percent of their
wages each month as a form of voluntary savings that are tax deductible.
This new private IFF system is required for new entrants to the labor market
and the PAYG scheme was to be phased out. People who were insured by the
old system could enter the new system or stay in the old, public one. Under
the new IFF system, all workers automatically have 10 percent of their wages
deposited by their employers each month in their own Pension Savings Account
(PSA). This percentage only applies to the first $22,000 of annual income
(Piñera, 1996, 157). Workers chose one of the private Pension Fund
Administration companies to manage his Pension Savings Account. Each AFP
operates the equivalent of a mutual fund with low-risk stocks and bonds.
Workers are free to change from one AFP to another. (Piñera, 1996,
157)
Employees that switched to the new privatized system received government-mandated
gross wage increases of 18 percent, which were about 11 percent net wage
increases (Kritzer, 2000, 7). The government issued "recognition bonds"
to cover the pension entitlements of the people switching from the old to
the new system (Muller, 2000, 509). These recognition bonds were indexed
for inflation and funded by general revenues (Kritzer, 2000, 7).
When retiring, a worker may chose between two general payout options. Retiring
in this system has a different meaning; a covered worker can retire whenever
as long as the worker is over the minimum amount and does not have to retire
from the workforce to retire from the pension account (Piñera, 1996,
159). A retiree may use the capital in his PSA to purchase an annuity from
any private insurance company, which would provide a constant monthly income
for life that is indexed to inflation. The second option that a retiree
has is leaving the funds in the PSA and making programmed withdrawals with
limits based upon life expectancy of the retiree and dependents in the household
(Piñera, 1996, 160). Pensions in Chile are protected from inflation
because they are denominated in monetary units that are adjusted to inflation
monthly by the consumer price index (Kritzer, 2000, 8). The amount of the
pension is based on the individual's contribution plus interest minus the
administration fees. Pensions are usually paid by the AFPs at the retirement
age of 60 for women and 65 for men. In the pension plan, people that meet
a minimum of 20 years, but do not receive the minimum pension level are
entitled to the minimum pension from the state budget (Muller, 2000, 509).
The PSA system also includes insurance against premature death and disability.
Each AFP provides this service to its clients by taking out group life and
disability coverage from private life insurance companies, which is an additional
contribution of 2.9 percent of worker salary (Piñera, 1996, 159).
The PSA system's goal is to eliminate the unfunded pension liabilities that
many countries face with the pay-as-you-go system. The PSA for Chile should
allow for individual preferences to become individual decisions that will
produce desired outcomes; whereas, the PAYG scheme did not allow for personal
preferences (Piñera, 1996, 158). Supporters of the Chilean model
say that a switch to a private, funded plan increases long-term saving,
investment and economic growth. These supporters claim that restricting
public involvement in old-age security reduces private spending (Muller,
2000, 509). Therefore, they are implying that private savings will increase.
The Chilean model has spurred pension reform all over the world.
Second Generation Reforms
Private mandatory pension provision is now established in many Latin American countries, and although there are no identical replications, variations of the Chilean model have been implemented in Argentina, Bolivia, Colombia, El Salvador, Mexico, Peru and Uruguay (Muller, 2000, 509). They include an introduction of a mandatory private pension fund that competes with, substitutes or complements the PAYG plan.
Structural pension reforms in Latin America are divided into three main
groups. The first group is the substitutive model, which is where the former
public system is closed down and is replaced by the private IFF system.
This reform was made in Chile, Bolivia, El Salvador and Mexico. The second
type is the parallel model, which is where the private IFF system is an
alternative to the public system and the two systems compete. This reform
was made in Peru and Colombia. The third type is the mixed model, which
is where the private IFF part complements a reformed public system. Examples
are Argentina and Uruguay. The reforms in all countries, except Chile, were
made in the midd-1990s. (Muller, 2000, 511)
Costa Rica introduced voluntary individual accounts in 1995 as supplements
to the PAYG system, and in 1999 Cost Rica passed a law requiring individual
accounts that would be funded with a percentage of the employer's severance
pay contribution (Kritzer, 2000, 3).
Results of Latin American Social Security Privatization
There are several positive aspects of privatizing social security, especially for Chile. The full or partial shifts to funding (private IFF) have led to a quick increase in retirement capital in countries with coverage. Among younger age groups, acceptance of the private schemes is high (Muller, 2000, 511). In addition, the new systems also had high real rates of return (Muller, 2000, 512). However, the two decades of pension privatization in Latin America present some discouraging empirical lessons as well.
The high transition costs result in the transitional generations paying
double because they have to pay for their own retirement plans and the current
pension plan that goes to the elderly. In Chile, Colombia, Peru, and El
Salvador, the government issued "recognition bonds" to cover acquired
pension entitlements of those switching to the funded partially privatized
system, which created strain on the public budget (Muller, 2000, 512). Argentina
and Bolivia used compensatory pension arrangements put less cash flow pressure
on the government budget (Muller, 2000, 512).
The Chilean model change did not result in reduced public spending or increased
national savings in the short or medium run (Muller, 2000, 512). In the
first ten years of the new Chilean system, there was a pension deficit due
to the reform of 4.0 percent of GNP per year. This pension deficit was beyond
the extra personal savings stemming from the pension reform, which was 2.4
percent of GNP per year. According to economic forecasts, the pension deficit
due to reform will disappear in 2020, which is 40 years after the Chilean
pension reform started (Muller, 2000, 512). Therefore, the transition between
the old and new system, which is a very long process, creates economic losses
due to such high transition costs. Chile was in a fiscal surplus when it
introduced the pension reform, whereas countries that followed introduced
reform in unfavorable circumstances. The Argentine case shows that governments
use their benefits of a partial shift to private funding in order to cover
their transition costs (Muller, 2000, 512).
The new pension fund had an oligopolistic structure. In Chile, Uruguay and
Peru over two-thirds of the insured are affiliated with the three major
funds. The administrative efficiency of the private pension fund schemes
has been troublesome for every country that has made privatization reforms.
The administrative costs of the Chilean funds are 15 to 30 percent of annual
contributions due to excessive marketing costs (Muller, 2000, 512). These
high costs have persisted in Chile almost twenty years after pension privatization
was initiated.
The assumption that transition to a private IFF scheme would decrease contribution
evasion has not been confirmed. There is a large gap between affiliates
and contributors in all Latin American reform countries. This results in
an increase in risk of old-age poverty. About 50 percent of account holders
fail to regularly contribute to the pension funds, especially the ones with
low incomes (Muller, 2000, 513). It is likely that lower-income workers
will realize that they should just count on the minimum pension rather than
what they will accumulate so they will only contribute enough to get the
credit for the coverage. Because administrative fees are charged only on
contributions, the workers that are making the contributions are paying
to maintain the inactive accounts of those who are not making regular contributions.
This will significantly lower their PSAs (Kritzer, 2000, 13).
Insufficient coverage is a problem that existed before the new private schemes
and was not solved with the new Latin American privatization schemes. In
Chile, at the most, 75 percent of the labor force is actually in the pension
system (Myers, 1996, 212). In the less developed countries, such as Bolivia,
Colombia, El Salvador and Peru, over three-fourths of the population were
not covered by pre-reform social security, especially the poor receiving
salaries informally and the people from rural areas. This low level of coverage
is not going to increase with pension privatization because the labor market
and affordability problems will remain unchanged (Muller, 2000, 513). The
situation of the poor might actually become worse because the high transition
costs involved in pension privatization could result in using public funds
to consolidate the old-age scheme of a minority when these funds should
be going to public assistance, primary health care, and other programs (Muller,
2000, 513).
Women usually receive smaller pension than men for several reasons. Women
receive benefits based upon their own earnings, which are generally lower
than the earnings of men. In addition, using gender-specific mortality rates
to calculate life expectancy produces a lower annuity because women generally
live longer than men. Therefore, in order for a woman to receive the same
pension as a man with the same salary, she would have to retire later than
the man (Kritzer, 2000, 13). As of March of 1999, about 50 percent of all
pensioners under the privatized system had retired early, 86 percent of
them being men (Kritzer, 2000, 3).
The new pension scheme was supposed to make future old-age benefits more
secure, but the Latin American experience shows that the PAYG risks are
traded for other risks in the transition from public to the funded scheme.
In an IFF scheme, the amount of future old-age benefits is dependent on
rates of return of the pension assets. The investment risk therefore is
the burden of the insured. Inflation may decrease the real amount of accumulated
pension capital. This risk cannot be insured in a private pension fund scheme.
CPI-indexed securities could solve this problem, but they are not being
used in any of the second-generation countries (Muller, 2000, 513). Chile
is the only country that accounted for inflation through their adjusted
currency.
Another risk with the new pension scheme is the lack of investment opportunity.
Pension funds are supposed to invest accumulated pension capital on the
local financial market in order to close the "savings gap" because
people are believed to reduce their private spending and save more. Therefore,
their investments are needed in the local financial market. In order to
achieve this, restrictive portfolio regulation was implemented. Crises in
South East Asia, Rusia and Brazil show that local capital markets, especially
for developing countries, are sensitive to major financial market crashes
around the world. The Mexican Tequila crisis for instance created losses
in the Chilean pension funds in 1995. (Muller, 2000, 513)
Conclusion
In Chile, the system's planners assume that the 10 percent contributions will provide adequate pensions of between 50 and 70 percent of the final salary of the contributors. This theory is based entirely on the assumption that there will be a 7 percent real rate of return. There have been high rates of return up until now, but over the long run it might not be realistic to expect over 7 percent real rates of return (Myers, 1996, 213). Therefore, it is too early to say that the Chilean system is a great success. Those who have retired by 1999, rely mainly on recognition bonds as a large portion of their pension.
Except for Chile, the new private pension schemes in Latin America have
been set up very recently. It is too early for a good evaluation of their
performance. Questions about social security reform will remain unanswered
until the first generation of retirees is able to use their IFF pensions.
Early experience with the mandatory private schemes shows that private pension
funds do not necessarily guarantee efficiency and competition. Even with
privatization, there are problems of coverage, evasion, and payment delays.
Pension privatization is an expensive strategy, both politically and fiscally,
due to the transition costs that result from the shift to private funding.
Because of the high transition costs, there is also no guarantee for a net
growth in national savings. Therefore, privatization is not necessarily
a success for old-age social security.
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