The Latin American Experience with Private Pension Funds: Lessons for Eastern Europe

by Jean de Fougerolles

The latest trends in pension privatization in Latin America were the focus of a recent working retreat held outside Washington D.C. Participants at the meeting, which was organized by the Institute for EastWest Studies, included Central and Eastern European pension experts who are contemplating pension privatization in their countries. Participants agreed that present pension systems throughout the transition economies are unsustainable and that reform is both urgent and unavoidable. This article is based on the report that was issued after the meeting.

PAYGO System Unworkable

As the number of workers relative to the number of pensioners (system dependency ratio) declines throughout the world, it is becoming more difficult to keep the prevailing (pay-as-you-go (PAYGO) system alive. In the PAYGO system workers contribute to a pension fund that is drawn on by current retirees, with the expectation that their pensions will be paid in turn by tomorrow's workforce. There are two choices: pensions must be cut or already high payroll taxes must be increased. The first is probably politically unacceptable; the second would cause further misallocation in the labor market, increase tax avoidance, and create a disincentive to work and hire.

In 1980 the government of Chile replaced the bankrupt, government-financed PAYGO pension system with an innovative new structure: a privately administered, national system of mandatory retirement savings that guarantees a minimum pension to all eligible individuals (determined by means testing). Instead of paying a social security tax, employees deposit 10 percent of their monthly wages in an individual investment account bearing their name, at any one of twenty-one private pension funds. The money that accrues in the account during the employee's active career, along with the returns on the investments made by the pension funds, will be used to cover the employee's retirement benefits. As of March 1995 the twenty-one funds had 5 million affiliates and 3 million active contributors and were managing assets worth $23 billion, or half of Chile's gross domestic product (GDP). On retirement, the average participant receives a pension equivalent to 70 percent of his or her average annual salary for the ten previous years.

The pension funds are authorized only to invest these savings; they are prohibited from engaging in any other activities. To guarantee a diversified, low-risk portfolio and prevent theft, fraud, or mismanagement, strict government regulations apply, overseen by a special government agency. The funds are required to provide statements to contributors three times a year that disclose the last four monthly contributions paid by employers, the fund's financial performance, and the accumulated balance and rate of return on individual accounts. The government is the insurer of last resort, but individual pension savings are insulated from the budget, and cannot be used for any but their intended purpose.

Advantages of the Chilean System

The Chilean system creates a direct relationship between the size of contributions and the size of pension benefits, moving the system from a defined benefit structure to a defined contribution basis. There are several other advantages:

• Employers have less incentive to underreport salaries.
• Individual responsibility and discipline increases because the burden of maintaining an acceptable standard of living during retirement cannot be shifted to others.
• The system is equitable. It is not possible for certain groups of workers to receive extra benefits, as they did under the old plan.
• Because private pension funds must compete for contributors' money, they have strong incentives to perform well.
• Freed from government management, the pension system gains stability and independence, regardless of a change in government or political will.
• The system is popular with investors, who have a direct, visible stake in the economy, and has spawned a public coalition to support sound economic policies and eliminate inflation.

Argentina, Colombia, and Peru-whose pension systems also faced high dependency ratios and budgetary costs, exacerbated by inflation and high levels of evasion-recently adopted variations of the Chilean pension system. These countries have maintained government-managed PAYGO systems based on employer contributions while introducing privately managed and publicly regulated pension funds based on employee contributions. Employees were given the choice of either staying in the public system or switching to the private system. In Argentina, beginning in 1996, employees who have opted for the private system will not be able to switch back to the public system. Peru and Colombia, by contrast, allow employees to switch between the public and private systems at will-that may cause both countries problems.

The two-system approach taken by Argentina, Colombia, and Peru allows the public to diversify its risk through a combination of state and market coverage. Pensioners participating in the capitalized private funds will be relatively safe from any government austerity program aimed at slashing the PAYGO system. At the same time, the government-guaranteed base system will provide a hedge against uncertain investment returns in the private pension funds.

Argentina's twenty-six private pension funds, which are operating with 3.5 million affiliates and 2 million active contributors, have attracted $800 million and are expected to be managing $3 billion by the end of 1995. In Colombia there are currently nine companies with 1.2 million affiliates and $80 million in assets. Peru's six private pension funds manage $200 million.

Pension Reform in Eastern Europe

In Central and Eastern Europe, the establishment of private pension funds has not been accompanied by reform of the PAYGO system. Politicians have delayed reform because drastic cuts and reorientation of public expenditures are politically unpopular.

Private pension funds in Central and Eastern Europe are less significant than similar funds in Latin America. In Hungary and the Czech Republic participation in private funds is voluntary. Individuals are not allowed to redirect any of their pension contributions to private schemes, and high tax rates crowd out voluntary contributions to private funds. The Czech Republic operates a supplementary system of forty-one funds, which has 1 million participants and expects assets of $100 million by the end of 1995. Hungary's ninety-three funds have 165,000 affiliates, and $30 million in assets are forecast for the end of 1995. In Russia a presidential decree allowing the formation of private pension funds passed two years ago. But because there was no accompanying regulation, the system is threatened by fraud and public distrust.

The author is manager, Pensions Reform Project, Institute for East-West Studies. The conference report, "Pension Privatization in Latin America-Lessons for Central and Eastern Europe," is available by writing to the institute, 700 Broadway, New York, N.Y. 10003; tel. (212) 824-4100, fax (212) 824-4149.