Chile's private pension system, part I

I first saw a reference to Chile's pension reform when I was reading a critical analysis of Romania's own implementation of such a system (though, as I would find out, there are many underlying differences between the two). It said there that Chile is the first country where people have begun collecting the actual pensions, after retirement. I'm not sure whether this also means that Chile was the first to actually implement the private pension system reform, but it does make for an interesting case (if pensions are your thing, that is).

My first lecture (hence the 'part I' in the title) was The Sucess of Chile's Privatized Social Security. I think it is (it doesn't say anywhere, but it looks and sounds like one) the transcript of a speech which José Piñera gave at the CATO Institute. At the time of publication, José Piñera was the co-chairman of the Cato Institute's Project on Social Security Privatization. But the text itself relates to his activities as Minister of Labour in Chile at the time of the privatisation.

First and foremost, the reform was made in 1981. The idea is similar to what is going on in many countries around the world, including Romania - the state is transferring a part of the burden of paying pension annuities to citizens who have recently retired from the workforce to the private system, where they are managed in the context of open markets and capitalism. The hope (and, in most cases, reality) is that this responsibility will be handled more efficiently by private administrators.

The main difference, however, between Chile and Romania in terms of the pension system is that Chile is now almost 100% privatised, in that it has outsourced all responsibility of pension handling to what they call AFPs (Spanish for Pension Fund Administrators - there were 20 of them in 1995), and the only pension related activities that the state still has are managing the pension funds for the minor part of the population which has chosen not to entrust their finances to the private sector. [Note: the text for this article was published in 1995; odds are that since that time the state has finalised all pension-related activities]

New workers have to go into the new private system because the old system is bankrupt. Thus, the old system will inevitably die on the day that the last person who entered that system passes away. On that day the government will have no pension system whatsoever. The private system is not a complementary system; it is a replacement that we believe is more efficient.

This fundamental difference naturally raises the following question : why has Romania not followed suit and made a decission for complete privatisation? As you may know, Romania is planning to switch 6% of worker's taxable salaries toward the private sector (this will effectively happen starting with February of March 2008, when the percentage will be only 2% and gradually rise to 6% in 8 years, making the reform complete in 2016), and to keep the remaining 3.5% state-managed. To my mind, there are a number of possible answers for this question:

• The state does not yet fully trust the private system and thus chooses to keep a backup fund (the 3.5%) just in case (although, it must be said, there is a backup fund for the private pension administrators as well)
• Romania cannot cover the budget deficit of a full privatisation
• The decision was made to adopt the multi-pylon system, as advised by the World Bank
  

The first option is truly laughable and I sincerely hope it's not the case. As for the second and the third, it might be the case that they both have a grain of truth.

Whichever the case, there are two points to be made about possible pitfalls in the Romanian design:

• Firstly, the cost of privatisation will be very large as it is, for the following reason (I'm not sure it will surpass the estimated cost of the full version of the privatisation, but I'm almost sure the difference is not worth the trouble of partial privatisation unless there are additional benefits): the state will have to manage two concurrent, complementary systems instead of one. First, there's the state-managed pension fund, which will diminish, but not disappear - the costs for running it will most likely stay the same. Then, there's the new web of institutions and departments created specifically to manage the transfer of money from employers and other contributors to the private pension administrators, to keep an eye on the latter and to devise regulations for the new system. There will be a need for hundreds of new state emplyees, new information systems and hardware (not only IT), etc. Add to this the drop in GDP and you suddenly start to wonder if it's worth the effort (because budgetary burdens will be reflected on the economy as a whole and thus on the working class as well). For this to make any sense, the benefits must be substantial. However, the prospects are not good in that direction.
• Secondly, the inflexible nature of the reform is likely to induce a lack of competition between the private pension administrators. By inflexibility I mean that the percentage of the monthly wage set aside for private pension is fixed by the state. This will not create uniformity among contributors, but what it will do is decrease interest in the development of administrator's assets, since there isn't much one can do, apart from switching between administrators (which is likely to be perceived as a radical move and therefore attempted relatively seldom). This will in turn generate a lack of competition, due to low migration of the clients between administrators. And low competition, apart from generating weak financial results, also opens up the possibility for administrators getting away with poor services, lack of professionalism and even attempts to fraud.
  

However biased the article may be (the man was the minister of labour at the time of the switch and also an active promoter of the idea), the privatisation of the pension system in Chile is nevertheless a success story.

Today we have 20 AFPs. In 14 years no AFP has gone bankrupt.
[...]
After 14 years and because of compound interest, the system is paying old-age pensions that are 40 to 50 percent higher than those paid under the old system. (In the case of disability and survivor pensions, another privatized insurance, pensions are 70 to 100 percent higher than under the old system.) We are extremely happy.
[...]
Pension reform has contributed strongly to an increase in the rate of economic growth. Before the 1970s Chile had a real growth rate of 3.5 percent. For the last 10 years we have been growing at the rate of 7 percent, double our historic rate. That is the most powerful means of eliminating poverty because growth increases employment and wages. Several experts have attributed the doubling of the growth rate to the private pension system.
[...]
But on the whole, I can tell you that it has been a success beyond all our dreams.

As for the same thing happening in Romania, I have my doubts. More in part II.