PRIVATIZATION OF SOCIAL SECURITY: LESSONS FROM CHILE by Peter Diamond

1. PRIVATIZATION OF SOCIALSECURITY: LESSONS FROM CHILEby Peter Diamond Presented by Agata Narożnik Ertem Ejder

2. Outline: • The history of the Chilean Social Insurance Scheme • Key elements of Reform • Costs • Capital market • Regulation • Financing the Transition • Redistribution and Political Risk • Social risk and aggregate change • Insurance

3. The history of the Chilean Social Insurance Scheme • 1924 – begining of Social Insurence as pension benefits • 1938 - expanded to include preventive medicine services • 1953 - expanded to include child and unemployment benefit • included 35 Insurance Funds by 1973 and covered 75.9% of the labor force • 1970 - level of benefits fell, as the pay-as-you-go pension system was failing (decreased fertility rates and the lengthening of life expectency) • 1980 - 70% of those retired received minimum pension

4. Key elements of Chilean Reform • Goal: privatized mandatory savings plan • Emploees place 10% of monthly earnings in a savings account managed by system of private founds - an Administradora de Fondos de Pensiones (AFP) • Additional contribution covers premium for disability and dependant survival pension benefits, plus AFPs commission fees • Contributions paid to PSAs are solely paid by employees

5. Comparition

6. Administrative costs • High cost of running a privatizedsocial security system, higher than the "inefficient" system that it replaced • Valdes-Prieto (1993b) has estimated thatthe average administrative charge per effective affiliate while activeare U.S. $89.10 per year (for 1991) which is 2.94% of averagetaxable earnings

7. The high cost of running a privatizedsocial security system: • Economies of scale that come with a single compulsory system without choice. • The costs that arise from competitive attempts to attract more customers - advertising, salespersonnel and the like. • In actual markets demand is much less sensitive to price variation than in idealized competitive markets ->the greater costs associated with trying to attract more customers -> prices exceed marginal costs.

8. Capital market • The combination of a steady flow of contributions together with very high real rates of return (an average of 14.5% from July, 1981 to July, 1992) has meant a large accumulation of funds invested in the Chilean economy. • The high rates of return, and implied rapid accumulation, are the result of generally high rates of return in the Chilean economy, not particularly astute investment choices by private fund management.

10. Evolution of regulation of the markets • Evolution of regulation of the markets in which funds are invested results in a set of capital markets that function far better than they did before the reform. • Each AFP has a single fund. • There is regulation guaranteeing that no fund will do too much worse than the average of all funds. This creates an incentive for fund portfolios not to differ too much from the average fund.

11. Source: Robert Holzmann Making Pension Reform Work:The Link to Labor and Financial Market ReformsWorld Bank, June 2007

12. Financing the Transition

13. Financing the Transition • Active workers that switched to the new systemhave received explicitgovernmentdebt (recognition bonds) on account of past contributions. • This financing decision has implied an increase in fiscal saving, withthe decision to avoid debt financing implying an improvement in theprimary fiscal balance of 3.5 - 4% of GDP each year in the 1980's.

14. Financing the Transition • Before the start of the pension reform, the government built aprimary surplus of 5.5% of GDP with a view to avoiding debt financing of the reform.

16. Redistribution and Political Risk • Redistribution is always a source of political tension. • Intergenerational redistribution is particularly focused on social security. • There is a deep tension between politicalviews that concentrate on outcomes and political views that concentrate on changes in outcomes. "all property is theft“ and "all taxation is theft.“ • Benefit-based formulas make consumption patterns clearer than the contribution based systems do. • Contributionbased systems make redistributions clearer.

17. Redistribution and Political Risk • Chile did freeze the COLA for pensions received under the continuation of the oldsystem in 1985. Since COLA's paid by private insurance companiesdo not directly affect the government budget, one would not expectto see the government freeze pensions paid under the new system atthe time of some future budget squeeze.

18. Transition period difficulties addressed by government guarantees: • Recognition bonds: are to rise annually by rate of inflation plus 4%, • Minimum pension guaranteed to contributors of 20 years, • Life annuities guaranteed in event of a failure by the Life Assurance Company involved, • The Chilean Government has huge general revenue obligations extending for decades to come.

19. Social risk and aggregate change • The rate of growth of real wages, • the real rate of return, • mortality factors, • the growth of the labor force.

20. Social risk and aggregate change • The Chilean system is sensitive to interest rate andmortality changes since these affect the adequacy of retirementincome relative to prior earnings. • Pay-as-you-go systems have more concern with population factors.

22. Insurance • The Chilean system has a maximumallowable rate of withdrawal from accumulated funds. • The rate varies with age and recentinterest earnings on the funds. • Eligibility to tap retirement funds ineither form is unrelated to whether individuals stop working. Onlysufficient age are necessary to begin withdrawals. • Funds are accumulated until retirement age is reached.

23. Conclusions • PAYG is a replaceable system. • Cost of running a privatizedsocial security system are higher then the costs of previous system. • New system created a large accumulation of funds. • Regulations of the markets is a main factor, especially at the begining of the reform.

24. Conclusions • Countries choosing to privatize can do better by recognizing that theprivate market is an expensive institution so they can try to hold downthe cost of using the private market. • It requires hard work at regulation and political discipline to make such a reform that Chile did. • The majorbenefits of the Chilean approach are the insulation from political risk and the development of capital markets.

25. More conclusions • The first country to "privatize" its Social Security system was Chile. • Since the system started on May 1, 1981, the average real return on the personal accounts has been 10 percent a year. The pension funds have now accumulated resources equivalent to 70 percent of gross domestic product, a pool of savings that has helped finance economic growth and spurred the development of liquid long-term domestic capital market. By increasing savings and improving the functioning of both the capital and labor markets, the reform contributed to the doubling of the growth rate of the economy from 1985 to 1997.

26. Unlike traditional social security payments, benefits in Chile are based on personal investment accounts owned by workers. Chileans don't worry about whether the government will run out of money as baby boomers retire, because benefits are financed by their own assets, which have been accumulating in their own accounts, not by taxes paid by current workers. The funds are privately managed and therefore insulated from political interference.

27. The Success and Failure of the Privatization of Social Security in Chile • The system is young, and its performance in the next 10 to 20 years will be important in determining the long range success or failure. • The average rate of return on Chilean pension accounts in 1995 was -2.5 % which demonstrates the risk involved in having privatized pension plans, there will inevitably be some poor investments. The government can regulate the investments heavily to avoid such failures, but the risk is inherent in free markets

28. Thank you