WELFARE & PENSIONS|
1: Save yourself!
Personal accounts for pension savings
The problem: bankrupt state pensions
How can you reform a pay-as-you-go state pension scheme which is effectively bankrupt due to poor design, politicization, lack of incentive, and corrupt administration?
The idea: personal savings accounts
A growing number of countries now allow people to transfer to an individuated system where they can contribute towards their own pensions, and employ professional fund managers to grow their savings for them.
Example: pioneering Piņera
Chile was one of several Latin American countries to face the problem of a pension system that could not meet its obligations and had been twisted far away from its original aims. Corruption, contribution evasion and the effects of inflation - which had risen to over 1000 per cent during the Allende regime - had utterly discredited the existing state system.
In 1981 the new (military) government - or at least its labour minister, the academic economist Dr Jose Piņera - decided that a radical new approach was needed. Employees and employers would no longer pay contributions to the state. Instead, individuals would set up a private savings account, the proceeds of which would be used for his or her pension and health care benefits.
In the transitional phase, employees were offered the choice of remaining in the existing system or switching - but the potential benefits that they could expect from the existing system were so poor that few chose to remain in the old system. Indeed, around 85 per cent of employees switched at the first possible opportunity because they perceived the new system to be much more secure, fair, and honest.
But nobody would have to write off their past contributions into the old system in order to make the change to the new. Each worker who opted into the new system was given a `recognition bond' - a rough actuarial equivalent of his or her accrued rights under the old scheme. This bond could be exchanged at retirement for an annuity, so people knew that they would get something back for what they had already paid in, whatever they chose.
Chile's reformed social security system operates on the principle of individual capitalization accounts. Each employee in the new plan has to make a tax-deductible minimum contribution of 10 per cent of salary (up to a ceiling) to an individual retirement savings account. Additional contributions of a further ten per cent would also be permitted, on a tax-deductible basis. And there were smaller compulsory contributions towards incapacity insurance, so that workers would not lose out if they had to stop working because of ill health.
Savers in the new plan would have the choice of who managed their savings. They would pay their contributions to private sector pension fund adminstration companies, known as AFPs (short for Administradoras de Fondos de Pensiones), and not the state. Each member would have a pass book showing his or her accumulated balance and the investment performance of the AFP.
For administrative convenience, employers collect the contributions from their employees, and pass them on to the employees' chosn AFP. The AFPs receive and invest employees' contributions, and there are strict rules on how these funds can be invested in order to shelter workers from too much investment risk. If someone's lifetime contributions do not amount to a decent-sized pensions, the state steps in to make up the pension to a set minimum.
The AFPs compete actively with each others for members. In recent years there has been some consolidation within the sector: originally there were around twenty AFPs, some of them run by trade unions, others by financial institutions, including foreign-based investment houses; but now there is just half that number.
Competition is fierce - some say too fierce - because savers are free to change to another AFP with only a few months' notice. Salespeople go out actively to recruit new business, using computer projections to show savers what they can expect to receive in terms of a pension if they change funds or increase or decrease their contributions.
Assessment: spreading over the world
The Chilean system does not so much get new money into the pensions system: rather, it ensures that the money that is contributed is better used. Instead of going into various government spending priorities, like the old tax contributions, it is now earmarked for each individual worker. Likewise, and unlike tax-funded system,s it is invested and grows. It goes into the Chilen economy, where it helps businesses to capitalize themselves, develop new products and markets, and increase employment and national wealth: so it has an all-round benefit.
The proof of the Chilean system is perhaps found in the number of countries that have adopted variants of it. Several countries in Latin America have now adopted the system, including Argentina, Colombia, Mexico and Peru; and it has followers further afield too, such as Poland and elsewhere in the transition economies of Europe. Variants of the individual-account idea, though not derived from the Chilean experience, can be found in countries such as Singapore and in the upper-tier pension system of the United Kingdom.
In July 1997, a new privately administered pension programme was created in Mexico, with the active participation of retirement fund administration companies, known as Administradoras de Fondos de Retiro or AFOREs. Individuals have their own capitalized accounts and the AFOREs invest their pension contributions (6.5 per cent of salary) together with a contribution from government.
In Argentina, President Menem's government implemented fundamental changes to the Social Security system. In July 1994 the Integrated Pension System was introduced covering retirement, death and disability benefits. As a result, employees now have the opportunity to join a private scheme and have their personal contribution (11 per cent of pensionable earnings) directed to an individual capitalization account, run by an authorized pension fund administrator (AFJP). As a result, all employees are now encouraged to select a private insurer for their pension provision.
Argentinian employers' contributions (currently an average of 11.2 per cent of pensionable earnings) are allocated to the state social security system. At retirement, employees receive a pension based on the value of their private account, plus compensatory payments from the state social security system. Employees can make additional voluntary contributions to their AFJB accounts. Such contributions are tax deductible.
For its part, Chile's experiment has proved an immense success. Six out of seven workers who have retired since 1981 have received pensions well in excess of the government subsidized minimum. The system is simple, spreads wealth to ordinary workers and links benefits to contributions.
The main criticism in Chile is that fierce competition between AFPs has led to excessive spending on marketing and advertising. However, this trend is not an inherent weakness of a capitalization-account system, but depends upon the financial incentive structures that circumscribe the plan. In Chile the costs and activities of the AFPs were closely regulated, but the nature of the regulation prompted them to spend large amounts on marketing: a less regulated system would have worked more rationally.
Certainly, the Chilean government wanted to encourage competition by enabling people to switch pension fund managers at short notice: on the other hand, it is hard to generate real returns on savings unless people stick with their investments for a lengthy period and do not keep changing them. Again, capitalization-account systems can in principle deal with this and encourage people to invest for the long term.
It is probable that Chilean pension savers also received a lower return than they might have come to them in a less regulated system, because of regulation to prevent AFPs investing overseas. This may have been partly a protectionist measure, but was justified on the grounds that Chile's fledgling capital markets might take too deep a risk by entering into foreign markets. However, these restrictions have since been eased.
The pensions which Chileans can now expect to have when they retire depend not on their politicians, but on their own contribution records and the investment success of their savings. Some people argue that this is highly risky when investment markets, particularly those of a country so dependent on commodities as Chile, are volatile. However, the government finances out of which state-funded pension schemes are paid are based on just the same volatile foundations, and savers face the political risks of them as well.
It may be wise, therefore, for countries thinking of a Chilean-style system of individual pension accounts to try to make sure that savers are not exposed to too great a degree of risk. Chile attempted to limit risk by outlawing fund investments in various risky assets. However, this kind of restriction may not be necessary in countries whose financial services sector have greater world markets experience than those of Chile in the 1980s. And such restrictions are generally to be avoided anyway on the grounds of free trade and competition.
But by far the greatest risk for most investors is the threat of inflation; and this of course is firmly in the hands of governments. It would seem wise, therefore, to link any introduction of funded personal accounts with the creation of an anti-inflation contract such as those prevailing in New Zealand and (to a more limited extend) the United Kingdom (see the chapter Cash Controls).
For further information:
- Adam Smith Institute (1996) Singapore v. Chile: Competing Models for Welfare Reform Download PDF (170kb), Adam Smith Institute (London) www.adamsmith.org.
- Rodriguez, L Jacobo (1999) Social Security Privatization: Cato Institute (Washington).
- International Benefits Guidelines, published annually by William M Mercer, the employee benefits and actuarial firm.
- Butler, Eamonn and Pirie, Madsen (1983) The Future of Pensions: Adam Smith Institute (London) www.adamsmith.org.
- For practical explanations of the Chilean system and views on it, see Butler, Eamonn and Young, Matthew: A Fund for Life Download PDF (113kb): Adam Smith Institute (London) www.adamsmith.org.
- Willman, John et al (1996) Over to You: The Transition to Funded Fortune Accounts Download PDF (67kb): Adam Smith Institute (London) www.adamsmith.org.