Chiles's success at privatizing public pension funds is encouraging other Latin American countries to follow its lead
Until 1994, Chile was the only country that had fully replaced a dominant public pay-as-you-go pension scheme with a two-pillar system in which the public and private sectors share responsibility. The system combines a private, competitively managed mandatory saving scheme with a publicly managed minimum pension guarantee.
Under the new scheme, workers choose from a small number of authorized pension fund management companies and can transfer their accounts from one company to another. To protect the safety and profitability of the workers' investments, the Chilean government has imposed strict regulations.
Chile's system also includes state guarantees: a social assistance benefit of about 12% of the average wage will be paid to old people not covered by the mandatory saving plan, and a minimum pension of about 22--25% of the average wage is guaranteed to workers who have contributed to the mandatory saving plan for at least 20 years.
Chile replaced its public pension system because of widespread evasion, unsustainably high contribution rates, and an inequitable benefit structure. For similar reasons, other Latin American countries are following Chile's lead.[1]
Latin America's pension schemes became seriously underfunded during the 1960s and 1970s, and the situation became critical during the debt and fiscal crises of the 1980s. By the end of the decade, falling real pensions, increasing evasion, large social security deficits, and depleted reserves had irreparably damaged the credibility of traditional schemes. Such crises coincided with a general debate over the role of government, a push toward privatization, and a strong desire to build domestic capital markets. By the start of the 1990s, the movement to privatize pensions gained momentum in Latin America, urged on by Chile's success.
In 1992, governments in Argentina and Peru proposed reforms that effectively privatized a large share of pension programs. Before making the transition, both countries were running enormous pension deficits, with implicit social security debts of about two-thirds of GDP. Colombia, too, is about to introduce a privatized pension system, though its current scheme has no pension deficit and has a much smaller social security debt because of lower coverage. All three countries have chosen schemes similar to Chile's and have largely adopted Chile's regulatory structure. Some of Chile's pension companies are moving into these new markets. Bolivia is on the verge of adopting similar reforms, and Mexico has also instituted a small compulsory saving scheme.
As in Chile, in Argentina, Colombia, and Peru current workers are given a choice between remaining in the old social security system and transferring to the new privatized system. If most workers under the age of 40 transfer, the assets of the new private pension companies are projected to grow to 10--20% of GDP over the next decade. Workers who switch will receive recognition bonds or pensions based on years of service under the old system as a payoff of the social security debt.
All three countries reformed their public pension plans before introducing the new private structure. Argentina raised retirement age by five years and eligibility from 15 to 30 years of service and lowered the pensionable wage base. Colombia increased the eligibility period and the contribution rate for workers who remained in the old system. That encouraged workers to choose the privatized pillar and reduced the social security debt owed to those who switched.
But the new schemes differ from Chile's in important respects, a consequence of their unique political climates and institutions. Argentina includes both a flat benefit and a higher minimum pension guarantee as part of its new system. All eligible workers receive, besides their pension from the second funded pillar, a flat benefit from the public pillar equal to about 25% of the average covered wage. Additionally, the state guarantees workers at least 40% of the average covered wage under the combined pillars. So long as underreporting does not cut the average covered wage, this guarantee is much larger than Chile's. But Argentina's 30-year eligibility period excludes many workers, including most women.
Colombia, like Chile, offers a minimum pension guarantee to redistribute to the lifetime poor and to insure workers against severe investment failure. But Peru's new system has no public pillar. The only backup is social assistance. While many workers may be reluctant to assume the full investment risk of the new system, they must compare this risk with that of the old system, which is also substantial.
The new Latin American schemes are welcome reforms, but design and planning flaws may create problems in the medium term.
First, it is difficult to calculate the value of the old social security entitlements. In Peru, a lack of reliable records forced officials to accept the sworn statement of workers to establish their past contributions---a method obviously subject to abuse. In Colombia, the formula for calculating the recognition bond is so complex that it may be impossible to implement uniformly. In Argentina, the index that will be used to revalue past earnings and contributions has not yet been specified. Calculations of old entitlements may be subject to political pressures that increase the fiscal costs of the transition or, conversely, that leave retirees with smaller pensions than they expected.
Second, continuation of the old system gives rise to problems. In Chile, new entrants to the labor force must join the privatized pension scheme. Other reformers in Latin America allow workers to choose between the new and the old systems. In Colombia and Peru, workers can switch back and forth, a freedom that introduces incentive problems, uncertainty, and higher administrative costs for the entire old age system.
Third, it is questionable whether governments' regulatory capacity and the domestic capital markets can run a mandatory saving plan. In Chile, the planning process took several years. An elaborate system of government regulations and guarantees was constructed, and a legal framework was developed that permitted trading of a full range of indexed bonds and other indexed financial instruments. For the first few years, most pension funds were invested in bank and government debt as financial regulations were modernized. Today, investments are much more diversified. In contrast, Peru has few people trained to be potential pension regulators or administrators. The short supply of government bonds and the absence of a secondary market for public debt raise questions about where the new pension funds can be invested. Colombia's new legislation does not specify investment restrictions. And in Argentina, stock market capitalization is low, so the entry of large new funds may bid up prices sharply until new issues enter the market. Imperfections in domestic capital markets can be avoided through international diversification, but all these countries, including Chile, limit that option. If the new private pension companies fail to operate prudently and to earn good returns during their first few years, the new system may be irrevocably discredited.
The general distrust of government institutions and the more specific distrust of social security arrangements make it likely that an increasing number of Latin American workers will trade public promises for accounts with private pension schemes. Whether these new systems ultimately succeed depends on a host of design and implementation details, and early indications are that these will differ from one country to another.