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Chile: Chilean pensions under pressure

Chilean workers face an uncertain retirement future. Poor pension prospects have led to calls for nationalisation, says Carlo Svaluto Moreolo

At a glance

• The Chilean pension system continues to attract praise from many for its design.
• Replacement rates will be low owing to low contribution rates.
• Large swathes of Chilean workers have called for the nationalisation of the system.
• The debate is ongoing, but there are little signs of government action.

Many commentators have praised Chile as one of the earliest adopters of a more sustainable system of pension provision. In the early 1980s, the public pay-as-you-go (PAYG) system was replaced by a defined contribution (DC) system, based on individual accounts run by private pension funds. The adequacy of the system is now being questioned as it is feared it will deliver poor pension outcomes.

Concerns that meagre pension benefits will force people into poverty post-retirement have led Chilean workers to demand the nationalisation of the system. Throughout 2016, several mass demonstrations were held in Chile’s largest cities in support of the cause.

The movement spearheading the protests calls itself No más AFP, in reference to the Administradoras de Fondos de Pensiones (AFP), the country’s private pension funds.

The group laments the opacity of the system. Workers are allegedly promised adequate pension benefits, contrary to the evidence that, with the current mandatory contribution rates of 10% of salaries, pensions may be extremely low.   

No más AFP claims that, under the current system, on average Chilean workers will earn a replacement rate of 38%. Women will get an even worse deal, earning a pension just 28% of their salary before retirement.

The figures are consistent with the findings of the Organisation for Economic Co-operation and Development (OECD) 2015 Pension at a Glance report. The report, however, shows that low-income workers will get a replacement rate of about 70%,

The system falls short because it is fully private, according to the group. In a statement on its website, No más AFP points out that in the vast majority of developed countries, private pension systems are complementary to public ones, rather than being the only choice.

Stephanie payet

Another of No más AFP’s grievances concerns the structure of the system. There are six AFPs operating in the market, a number that the group says denotes insufficient competition and excessive concentration of market power.

Three of the six AFPs are managed by American firms (Principal Financial Group, Prudential Financial and MetLife). Two are managed by regional firms, BTG Pactual from Brazil and Grupo Sura, a Colombian conglomerate. A sixth one is privately-owned.

The solution proposed by No más AFP is a ‘tripartite’ pay-as-you-go (PAYG) system, financed by contributions by employers and employees and run by the state. Although a return to a pre-privatisation model seems far-fetched, the idea has intensified debate over the strength of the current system.

At present, Chilean workers face several issues in building their post-retirement future.

First, long-term market returns are under pressure. When the Chilean economy entered the club of developed markets, long-term financial market returns converged towards those in other high-income countries.

Unsurprisingly, disillusioned citizens have singled out the six AFPs as being part of the problem. While their role cannot be ignored, there is little evidence that they are responsible for a lack of prospects for future Chilean retirees.

The five-year average real return generated by the AFPs was 2.3% in 2015, according to the OECD’s 2016 Pension Markets in Focus. The 10-year average was 3%, but the figure takes into account the severely negative impact of the 2008 global financial crisis.

Interestingly, OECD data shows that, in terms of real returns, the funds performed below the OECD average over the five years to June 2005. The AFPs’ performance over the 10-year period was, instead, above the OECD average.

AFPs invest relatively conservatively. In 2015, according to the OECD, almost 40% was invested in equities, 59% in bonds and the rest in cash and other asset classes. The asset allocation framework was expanded to included more overseas investments by a fundamental reform of the pension system in 2008 .

Beyond financial market returns, there are more pressing structural challenges at play. The Chilean population, as a whole, is ageing fast. The economy is characterised by a high share of informal labour, which is not covered by the private pension system.

Chilean pensions under pressure figures 1 and 2

But the main problem is the low level of contributions. Employees pay a mandatory 10% of their salaries to an AFP of their choice. There is no contribution by employers. At retirement, workers can choose between having pension benefits paid out in instalments by AFPs, or accessing the annuity market.  

This fully private structure was designed by José Piñera, minister of labour and social security in the military government of Augusto Pinochet.

Piñera was a member of the so-called Chicago Boys, a group of economists employed by Pinochet, most of whom had trained at the University of Chicago under prominent free market economists such as Milton Friedman and Arnold Harberger.

Chilean pension funds asset allocation

Notably, the system lacks some of the key elements of the multi-pillar model advocated by the World Bank. However, the system’s design continues to attract praise.

Pablo Antolín-Nicolás, head of the private pension unit at the OECD, was quoted in Chilean press as saying that the system is among the best internationally, in terms of design.

Antolín-Nicolás, an internationally recognised pension expert, insisted that the issue is the low contribution rate. The OECD’s position is that it does not matter whether the system is public or private, as long as contribution rates are high enough. But the organisation recognises that a combined public-private system is more capable of withstanding shocks.

Stephanie Payet, an analyst at the OECD’s private pension unit, says: “Whether the system is public or private, to us it’s not the critical question. The critical question is how much you contribute. If you go back to a PAYG system and you contribute 10%, you will not be able to reach a 70% replacement rate. The government will have to raise money through debt, and this will not be sustainable.”

“The real issue is: Chilean workers contribute too little. You need to find a way to contribute more. Of course, it is difficult to ask people to raise their contribution significantly from one day to the next. But there are ways to do it. Many countries increased the contributions in steps, starting from a low base.”

The other key question, says Payet, is how the contribution is split. In most countries it is divided between employees and employers, whereas Chilean companies do not contribute to the mandatory DC system. “There is room for Chilean companies to contribute to pensions”, says Payet.

A further proposal, according to Payet, is linking increases in contributions to increases in salary levels. This ensures that contributions grow, while limiting the impact on take home pay.   

The Chilean government has said that, for the time being, there is no room within the state’s finances for public support to the pension system. However, the protests have reignited a debate on the creation of a state-backed AFP, a proposal previously advanced by Chilean president Michelle Bachelet.

A key lesson in DC pensions design learned by Chile is that ensuring coverage for those who fall out of the system should be a priority. Self-employed workers and the lowest earners face a particularly grim post-retirement future.

In 2008, the Bachelet government implemented a significant reform to fill some of the gaps in the system. Contributions by self-employed workers were made mandatory. The measure was implemented through automatic enrolment, with a possibility to opt out until 2015. The reform also strengthened pension provision for the poorest sections of society, through a tax-funded scheme.

But the crucial lesson from the Chilean experience is that the key ingredient for a successful DC system is getting contribution levels right. This is a sticking point in many countries. However, Chile is paying the price for being an early adopter of private pensions.

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