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Pension
Reform: What an Ageing Europe Can Learn from Chile
By Kristian Niemietz
“Consider
the difference between a private attendant and a court servant. The latter
will put up with much more, for he has a pension to expect.” Otto
von Bismarck (1881)
“You
are absolutely right, general. If this reform is approved, a giant step
into the direction of reducing state power will have been made.” José
Piñera (1980)
For
decades, Chile’s PAYGO public pension system had appeared impossible to
reform. Benefits were determined by the political process but paid from a
common pool, so the formation of vested interests was heavily encouraged.
Early retirement privileges were a popular election promise. As a result,
the system became financially untenable. At the end of the 1970s, its
deficit increased up to 40% of its expenditures, or 3% of GDP, and
increasing rapidly.
Since the 1950s, there had been a broad political consensus that the
pension system was being excessively abused by pressure groups, had become
burdensome and bureaucratic, and that it paid low pensions to the bulk of
the elderly. These criticisms were repeated by governments from very
different political factions, be they conservative, Christian Democrat or
Socialist. They were also backed by the results of various expert
committees installed by these governments, but no coherent solution was
ever proposed. In 1973, out of political and economic chaos, a military
government emerged. Paradoxically, this government hesitantly accepted
advice from a group of classical liberal economists who were enthusiastic
about rolling back state power.
In
December 1978, José Piñera took over the Ministry of Labour and Social
Security. Initially he ended the most grotesque abuses of the PAYGO system
by standardising some key variables such as retirement age and inflation
adjustment. But Piñera feared these improvements would likely be reversed
by successors and therefore prepared steps to unhinge old age provision
from the political sphere once and for all.
The
creation of the AFP system.
José
Piñera proposed a radical reform entailing the creation of a fully
funded, defined contribution, pension system and announced it in his May 1st
1980 speech. But the resistance of assorted “social security experts”,
of diverse groups benefiting from the PAYGO system, and, unsurprisingly,
by members of the military, blocked it. On September 1980, the government
called for a referendum about a new Constitution that included a gradual
transition to democracy. The country viewed the referendum also as a poll
over the market liberal reforms. The positive result provided the needed
back-up. The referendum was accepted with a two thirds majority and Jose
Piñera seized the opportunity of the moment and put his reform plan back
on the agenda. This time, he got his way.
The
legislation which laid the foundation for the new pension system was
finally signed in November 4, 1980 and came into effect on May 1, 1981.
The managers of the workers individual retirement accounts would be new
companies, called the Administradoras
de Fondos de Pensiones, or AFPs.
They were to manage the
personalised savings accounts belonging exclusively to the affiliated
workers – not to the AFPs. The AFPs were prohibited from engaging in any
other commercial activities, and required to organise disability and life
insurance for their clients, via a group contract with a life insurer. A
highly technical regulatory watchdog, the Superintendencia
de AFP, was created.
It
was decided that nothing should change for those who had already retired,
while new entrants to the labour force had to join an AFP. Current
contributors were given a choice. They could either remain in the PAYGO
system under unchanged conditions, though the multitude of existing
pension regimes and institutions were merged into a single organization,
or they could switch to an AFP. In this case, their already accrued
entitlements were quantified by a standard formula and paid out to them in
the form of a “recognition bond”, due upon retirement. This recognized
the unfunded liability of the PAYGO.
The
transition phase had to confront many difficulties. A capitalisation
scheme requires sophisticated capital markets, or at least risk rating
agencies, bond custodians and an insurance sector, all of which were
underdeveloped in Chile. For the transition phase, a governmental risk
classifying committee was set up, and bonds custody was given to the
Central Bank. Both tasks have gradually been passed to the private sector.
The insurance sector was liberalised and oversight was tightened, so that
it could grow alongside the AFP system.
Today,
a Chilean employee, instead of paying the government a payroll tax,
has to deposit 10% of monthly gross earnings, up to an earnings
ceiling, into a personal retirement account run by an AFP of his or her
free choice. This contribution, as well as additional voluntary pension
savings up to the same ceiling (APV), is tax exempt. Currently, six AFPs
are competing in the market, each of which offers five types of pension
funds. These are arrayed by risk and return, A-Funds can contain up to 80%
of instruments with variable returns, B-Funds up to 60%, and so on,
E-Funds being composed exclusively of fixed-return assets. Workers aged
under 55 can choose any fund they wish, older workers become ineligible
for A-Funds and retirees for B-Funds. AFPs charge a wage-related fee which
pays administrative expenses and pays for disability and survivorship
insurance. A retiree can choose to retain his AFP account, purchase a
lifetime annuity from a life insurer, or combine both options. A
time-deferred combination, in the sense that a retiree chooses an annuity
that begins at some distanced future point of time and lives from his AFP
savings until then, could be interpreted as an insurance against surviving
one’s own retirement resources.
The
results have been impressive. In the last 25 years, AFPs have earned
annual real returns of 10% on average. Financial market volatility has not
been a major problem because AFPs have continuously diversified their
portfolios. Gradually, the capital market has grown in size and diversity,
investment possibilities open to the AFPs have been liberalised, and AFPs
have made use of these opportunities. Neither the Mexican nor the
Argentine crises have been able to do serious harm to the pension funds,
and neither have turbulences in the pension market itself. The number of
AFPs had risen from 12 at the beginning to 21 in the mid-1990s and then
dropped back to 6, but workers accounts have not been affected.
Savings and Investment
Economic
theory suggests that moving to a funded pension scheme will permanently
raise the level of savings and investment. Indeed, each year, Chileans pay
about 4.6% of GDP into retirement savings accounts. But is that really a
net increase in the savings rate? Or has the introduction of pension
saving simply squeezed out other types of savings? Bennett et al (2001)
and Coronado (1997) have econometrically modelled private saving behaviour
in Chile, to examine whether a substantial offset has occurred. Neither
has found reliable evidence that it had. ‘Saving’ is not a monolithic
block, but serves specific purposes. It is unlikely that reserves intended
for, say, the purchase of a car, will be liquidated to be transferred to a
pension account. Corbo and Schmidt-Hebbel (2003) have shown that about
half of the new savings have translated into additional domestic
investment, thus enhancing economic growth.
A
commonly heard argument against a reform such as the Chilean one is that
it necessarily produces a transition deficit. One generation, it is
argued, pays twice. They must save for their own retirement, and support
the retirees of the old system through their taxes.
This
argument deserves a closer look. What is actually meant by “transition
deficit” is the process of transforming a debt hidden from government
accounts -the promises made to future retirees- into a visible debt. This
creation of public awareness is likely to exercise pressure upon political
decision makers to reduce spending and sell off assets. In this way, the
transition deficit might have an inbuilt self-containing mechanism.
While
that effect is, of course, not measurable, the Chilean case makes it at
least plausible to assume that it plays a significant role. In 1981, a
transitory tax on income of 3% was introduced, but it decreased
automatically by one percentage point each year and thus disappeared in
1984. There was also a global budget deficit in the five years following
the reform, but it was succeeded by twelve years of budget surpluses.
While it is unknown how taxes and debt would have behaved in absence of
pension reform, at least they have not generally increased. In contrast,
government expenditure contracted. Its share of GDP was 32% from 1974-84,
but 25% from 1985-99. The period from 1985-89 also experienced the
greatest wave of privatisations in the regions’ history, comprising
predominantly areas such as telecommunications and electricity. Government
assets worth 7% of Chilean GDP were sold off, more than twice the relative
scope of British privatisations in the Thatcher era.
A
Model for Economic Transformation
One
target of the process of privatisation in Chile was to spread property
ownership throughout society, in order to make the market reforms of the
previous years irreversible. A programme named Capitalismo
Laboral encouraged workers to purchase shares in their own company,
which turned 30,000 workers into co-owners of their own workplace. Another
programme named Capitalismo Popular
favoured small investors and turned 170,000 Chileans into shareholders.
But it was the sales to the AFPs, denominated Capitalismo
Institucional, which transformed 3 million workers into small-scale
capitalists. Thus, 18% of all privatised assets were directly purchased by
AFPs. Investment in the affected companies soared. Until 1990, the number
of telephone lines in use almost tripled, and energy production went up by
a third.
There
are reasons to assume that the way in which the pension reform was
designed had its share not only in encouraging these privatisations (as
explained above), but also in explaining its tremendous and lasting
success. The quality of Chile’s judicial institutions was still mediocre
even by Latin American standards in 1985. In the absence of sufficiently
developed legal institutions, privatisations are often vulnerable to abuse
and self-enrichment. The involvement of expert investors representing
millions of people might have been a strong check which enforced greater
transparency.
But
most of all, privatizing state-owned companies after the creation
of the AFP system established a nation of property owners, a stabilizing
factor in the new market economy. This idea can best be illustrated by
comparing Chile to Venezuela, which had for a long time been regarded as
Latin America’s success story. In recent years, exactly those sectors
privatised in Chile in the 1980s have been nationalised in Venezuela. Such
a roll back would be impossible in Chile, re-nationalisation of these
sectors would imply expropriating the retirement funds of millions of
workers.
Labour Market
s
PAYGO
systems and defined-contribution, funded, schemes differ substantially
with regard to their effects on labour markets. Social security
contributions in a defined-benefit system are mostly perceived as a tax,
and taxes on labour discourage work. The same is not true for pension
savings, because people pay them into their own accounts, which is, to
themselves.
There
is a second effect. In a transition country such as Chile, the labour
market (as in the economy as a whole) is usually divided into a formal and
an informal sector. Lacking legal security, these “extralegal sectors”
will tend to be less productive. Cutting taxes on formal employment will
lower incentives to tax-evading informal employment. Some people will
switch from the informal to the more productive formal sector, changing
the composition of the economy in favour of the latter. An AFP system can
thus increase employment and labour productivity at the same time.
Some
have argued that a PAYGO system, too, could be designed in such a way that
efforts and rewards are closely connected, so that people would perceive
their contribution rates as a quasi-investment and not as a tax. In that
case, there would not be a negative effect on labour market participation.
But the true reason why PAYGO contributions are not really distinguishable
from a tax is that their contributors do not acquire property rights,
which they could contractually enforce. Their entitlements are a mere
promise of a diffuse nature and will only be made concrete through the
political process.
Edwards
and Cox Edwards (2002) have found empirical evidence for a positive effect
of the pension reform on formal employment. They developed a model
simulation of Chile’s labour market, dissecting the components
determining its shape. Expanding this model, Corbo and Schmidt-Hebbel show
that the pension reform has increased formal employment by 3.2% under the
most pessimistic assumptions and by 7.6% under the most optimistic.
As
in Chile, an AFP system can be combined with a means-tested minimum safety
net, a much more efficient and transparent instrument to combat old-age
poverty than the redistribution inherent in a PAYGO formula. PAYGO systems
tend to redistribute large amounts of money, but the distributional net
effects are opaque. A tax transfer, in turn, can be a targeted instrument,
exclusively directed to the focus group of those who fall below a certain
income level.
In
Chile, there are two types of old-age income supplements, a minimum
pension guarantee for people who have contributed for at least 20 years
and still fall below a certain level, and a non-contributive assistance
pension that ensures subsistence to the poorest. Old age poverty has
fallen from 30% in the late 1980s to less than 10%, whilst both forms of
payments to the old poor cost about 0.5% of GDP combined. This is much
less than government subsidies to the old system pension system. Spending
efficiency could be even greater if these two instruments were integrated
into one.
Capital Markets
Financial
institutions represent a very special economic sector. The ability to
channel capital to those points of use where it is most productive is a
prime determinant of a nation’s productivity. Creating fully funded
pension systems can be expected to be a great stimulus for capital market
development. Demand for diverse long-run saving products increases, and
professional institutional investors come into play. Chile’s development
in the last quarter-century seems to confirm this intuition. Capital
markets have greatly expanded in size and diversity. In the early 80s,
banks were practically the only actors in Chile’s capital markets.
Today, a wide variety of institutions such as mutual funds, real estate
funds, infrastructure funds, and, of course, the AFPs themselves, have
emerged.
Alongside,
the nature of economic growth has changed. Economies grow if the amount of
labour or the amount of capital grows. But the most decisive long-run
source is so-called Total Factor Productivity (TFP), the efficiency in the
interplay of the two factors. TFP-growth has virtually been nonexistent in
the past, but became a major source of economic growth after the
mid-1980s. This is the major change that has occurred in recent Chilean
economic history.
A
good measure for the degree of capital market development is the Financial
Intermediation Ratio (FIR), the sum of the most relevant assets traded in
financial institutions. Corbo and Schmidt-Hebbel have found econometric
evidence that the pension reform has greatly raised FIR, and that FIR has
greatly raised TFP. An increase in TFP directly translates into an
increase in economic growth.
Would
it Work in Europe?
Not
all of the merits of the Chilean reform would equally apply to Europe.
Long-term real returns of 10% could not be achieved here. Promoting
savings and financial markets would be desirable, but as our economies are
already highly capitalised and our financial markets highly sophisticated,
the boost to growth would be much weaker than it was in Chile. At the same
time, the transition deficits would be a lot larger in Europe, both
because our PAYGO systems usually comprise the whole labour force, and
because they provide not only a minimum living standard but often fairly
high replacement rates.
But
at the same time, the pressure from an ageing society is far greater in
Europe. While a rising life expectancy raises the cost of old-age
provision in any pension system, and while funded schemes are not fully
independent of demographics either, the adaptability of a funded scheme is
enormously greater. Two extreme thought experiments illustrate this point:
Ø
What
would happen if the entire young generation of a country decided to leave
it (and no immigrants would follow)? If it happened in Europe, the older
generation would be left to either work until their last day of life, or
to starve. If it happened in Chile, the retirees would have to transfer
the whole capital stock abroad, because there would be nobody left at home
to use it. Maybe people would
not be happy with it because they would presumably prefer to have their
old-age assets geographically close to them. But even in this extreme
case, old-age income would be provided by the returns of the investments
abroad.
Ø
What
would happen if a number of miraculous pharmaceutical innovations
(gradually) raised the average life expectancy to 100 years? In Europe,
fierce political battles over the distribution of the cost burden would
break out. Young entrants to the labour force would be unwilling to spend
the lion’s share of their income on sustaining the older generation,
retirees would be unwilling to see their living standards fall, and older
workers would be unwilling to see retirement age raised. As no government
would be likely to touch what voters regard as their deserved
“entitlements”, the adaptation would surely be delayed and the
additional cost financed by debt. If it happened in Chile, the additional
burden would be large too, but the adaptation process would be
entirely different. The price for the purchase of a lifetime annuity,
which represents an “exchange rate” between a stock of savings and a
life-long stream of income, would rise. This would act as a signal to all
workers, even if they would not actually purchase an annuity themselves.
Young people who would observe this rate continually worsening would see
an incentive to save a larger proportion of their wage for old-age. To
workers close to retirement age, additional working years would suddenly
seem relatively more attractive than at the old “exchange rate”. So
while people would certainly not be happy about having less money for
present consumption and working longer years, the adaptation process would
begin sooner, run more smoothly, and take account of differing
preferences. It would not involve political battles between different age
groups, as it would be obvious that the change was not the result of any
deliberate political decision. An arbitrary political decision process
would be replaced by a self-steering market mechanism.
Meanwhile,
if Europe adapted a Chilean-style reform, it could easily avoid most of
the difficulties that the Chilean reform had to face:
Ø
The
Chilean reform was a risky experiment in the sense that, as was explained,
capital markets and the institutional infrastructure had to be developed
in parallel. At the same time, many people had no experience with any type
of financial institutions. All of this would hardly play a role in Europe,
where fully developed capital markets, sophisticated regulatory
institutions and a high degree of financial literacy can simply be taken
for granted. Some countries even have complementary pension funds already
in place.
Ø
As there
is no noteworthy “informal sector” in Europe (moonlighting is not the
same thing), universal participation could easily be guaranteed. Even the
unemployed could be covered if a share of their benefits were transferred
to the recipients’ retirement account, immunising the system against
frictional imbalances in the labour market.
Ø
In 1980,
the share of government spending in Chilean GDP was about 27%. In many
European countries today, that share is almost twice as high. So there is
definitely room to finance the transition deficit, especially in those
countries with large public sectors.
So,
many of the positive economic side-effects of the Chilean reform would be
less pronounced in Europe. But so would the initial problems. After all,
the role of a pension system is not to boost the economy, but to provide a
reasonable and stable old-age living standard. In that regard, Europe
would need a Chilean-style reform far more desperately than Chile did.
Bismarck
vs Piñera? The importance of the framing of the debate for Pension Reform
Why,
then, is a Chile-type pension reform so difficult in (Western) Europe?
Political-economic decision models usually argue that a transition creates
winners and losers, but these models are unconvincing. Pension
privatisation can be a pure gain. The market interest rate is usually
higher than the indirect yield of a PAYGO system, the capital stock in an
economy with a funded scheme is permanently higher, and the transition
deficit partially offsets itself. In short, this reform creates the means
by which those who lose from it can be compensated. The trouble with these
models is that they reduce the decision process to a weighing of economic
variables, while any observer of everyday politics knows that social
policy issues are not debated in this way. They are more of a battle of
ideas. A historical retrospect is enlightening because it shows that they
have been so since their modern origin.
The
debates that accompanied the introduction of Otto von Bismarck’s welfare
state in the 1880s were not technical, but ethical in nature. Chancellor
Bismarck had spoken of “dividends from human tragedy” when
referring to private insurance. Social insurance issues should “from
the moral viewpoint not [be a] subject matter of speculation and a source
for the payout of dividends”. His premise was that government
action, aspiring to the “common good”, was ethically superior
to private actions driven by base motives.
No
less founded in ethical value judgements were the arguments of the
adversaries of Bismarck’s welfare state, led by the Reichstag deputies
Eugen Richter and Ludwig Bamberger. Since the late 1840s, numerous mutual
self-help initiatives were emerging in the German states, on a voluntary
and decentralised basis, covering a number of risks such as accidents or
illness. They were organised as cooperatives or were run by labour unions,
and provided an alternative to commercial insurances. Richter and
Bamberger feared that compulsory monopoly insurances would bleed these
voluntary initiatives to death - and assumed that this was even intended
by Bismarck. In some of these associations, people developed a spirit of
loyalty and personal belonging. According to his critics, it was
Bismarck’s very intention to weaken this culture of social
self-organisation, for being out of reach of government control, and
replace it with a culture of state-dependency. Workers should be bribed
into projecting the mentioned loyalty upon the state instead. Ludwig
Bamberger asked whether “human individuality, self-determination, the
free initiative of the responsible citizen” were to be replaced by
“the supervision of the police and the caring hand of the state“.
Eugen Richter indicted that workers should “learn to regard
themselves as state pensioners”, in order to “develop the
sentiment of dependency” typical for these.
In
this view, the welfare state does not appear as a humanitarian
institution, but as an instrument of power and control. Detmar Doering
(2006) finds proof for this perspective in the fact that the welfare
monopolies of the 1880s did not cover those risks for which voluntary
insurance mechanisms were indeed underdeveloped, such as unemployment.
Instead, they covered –surprisingly- those areas where private
initiatives were already relatively advanced. Richter and Bamberger
embraced the voluntary alternatives because of their spirit of
independence and self-determination. For the specific issue of old old-age
provision, the alternative they held against Bismarck’s monopoly was “everything
which is appropriate to facilitate and boost savings, capital
accumulation, land acquisition and homestead” (Richter).
A
hundred years later, though in a totally different historical environment,
the arguments of then Labour Minister Jose Piñera sounded astonishingly
similar to those of Richter and Bamberger. Piñera had never spoken of the
pension project in mere economic terms, and never made high capital
returns his principal point. When publicly announcing the reform on
November 6th, 1980, he said it would “drastically widen
the margins of individual liberty”, that “an enormous source of
state power and discretion” would be eliminated, and that it made
“every worker an owner”. Richter and Bamberger would have been
delighted.
State-run
PAYGO might, in many countries, perform in a mediocre fashion or worse,
but in (Western) Europe it seems Bismarck and his heirs have won the
battle on moral terms. Friedrich Hayek had once said that “the
ultimate decision about what is accepted as right and wrong will be made
not by individual human wisdom but by the disappearance of the groups that
have adhered to the “wrong” beliefs”. This is exactly what has
happened. At least in continental Europe, positions such as those of Eugen
Richter and Ludwig Bamberger have simply disappeared. Concerning old-age
provision, criticism of PAYGO systems’ vulnerability to demographic
change and of their high payroll tax burden may be heard. But Bismarck’s
concept of a virtuous, all-benevolent government is still the unchallenged
implicit premise behind social policy debates. Practical issues must also
play a large role, for example, public fears that funded pensions were
“unstable” need to be addressed.
But
anyone who tries to win a debate which is primarily of an ideological
nature with technical arguments only has lost right from the start.
Supporters of private funded solutions must not abandon the realm of moral
arguments to their competitors. Like Richter, Bamberger and Piñera, they
must emphasize the differences of principle that distinguish a mechanism
based on individual property accumulation, secured by enforceable
contracts and independent of personal discretion, from a system based on
dependence on political bodies, all of whose variables are and can only be
decided in the sphere of political power.
It
is sometimes said that European systems are run by the government, while
the Chilean and similar ones were ‘run by the private sector’.
This is a superficial perception. A mechanism of private savings accounts
is not really run by anybody; it simply runs and steers itself. Europe
needs to be reminded that this is the only form of provision fit for a
society of free citizens.
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Kristian Niemietz is Research Officer for Health and Welfare at the
Stockholm Network, Diplom-Volkswirt
(M.Sc. in Economics) of Humboldt University, and author of the book “Die
kapitalgedeckte Altersvorsorge am Beispiel Chile” (Diplomica Verlag,
2008)
(Note:
A longer version of this essay was published by the Stockholm Network on
September 2007. It can be reviewed here: http://www.stockholm-network.org/downloads/publications/Chile24Sep_3.pdf).
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