The Success of Privatization of Social Security in Chile
Most discussions about Social Security in the U.S. include acknowledgment that it is financially troubled. Politicians, however, disagree on what to do about it.
Some believe that social security should be privatized which means management would be turned over to the private sector with some government oversight. They point to the country of Chile as a success story and model regarding how to run a program of old age and disability benefits in a more efficient manner.
Others believe that whatever changes are made should be done within the entirely governmental framework from which it has been working for many years. A look at the details of Chile’s privatized system can help Americans understand the debate.
Chile first established its original social security program in 1924, which was pay-as-you-go program like the U. S. currently has, both of which are based on the program begun in Germany in 1889. In Chile, by the late 1970’s, it had became apparent the program was in trouble as payouts began to be greater than the money paid in.
Some of this was due to under reporting of earnings by workers and employers. Another factor was that the system discouraged hiring because employers had to pay into the system for each of their employees as they do in the current U. S. program. Fewer employees naturally mean fewer payers into the system.
In 1981, Chile became the first country to privatize its retirement system. The government was able to change to the new system without a lot of controversy because voices of opposition to it were not as passionate as they are in the U. S.
The military government in power at that time expected the new program to do four things: switch the burden of retirement to the individual, decrease the government’s financial responsibilities, stimulate the economy, and promote higher employment. Although there is much debate as to how well the program succeeded in each of these areas, by most accounts the majority of Chileans seem to be pleased with the program.
When the new system was created, employees currently in the old system were given a choice whether to join it or remain in the old system. New entrants, however, were not given the opportunity to be in the old system. The old system will be gradually phased out after all the participants have stopped receiving benefits due either to death or a change in their circumstances.
Employees who had been paying in the old system and who switched to the new system were given credit for their accrued benefits in the old system. Jose Pinera, former secretary of labor and social security in Chile reported that 93% of Chilean workers chose the new system because they trusted the private sector and preferred market risk to political risk.
Under the new system, workers contribute 10% of their monthly earnings to a retirement account. They may choose to contribute more if they so desire. The required 10% is tax deferred but any additional voluntary contributions are taxed. This only applies to the first $22,000 of annual income.
An additional 3% of their earnings is collected for administrative fees. Workers also contribute 7% for health insurance. This is in comparison to 34% workers had to contribute in the old system. Workers who are self-employed are not required to participate in the system but may if they wish to.
Workers choose one of a number of government approved investment companies to manage their personal retirement accounts. These companies are subject to government regulation to prevent theft or fraud and to cap fees. These companies are also required to meet minimum return requirements. If the fund’s performance is lower than what is required, the company must make up the difference out of its own funds.
Workers are free to change companies at any time. This promotes competition among the companies to provide higher returns on investment, better customer service, and lower commissions. Workers receive a statement every three months that advises them of how much money has been accumulated in their individual account.
Furthermore, the workers can connect to computer terminals at the investment companies to figure out what the expected value of their future pension will be based on what they are contributing, or to determine how much they need to contribute in order to retire at a chosen age.
Books About the Social Security Debate
The employer contribution was eliminated under the new system, but the government required employers to increase employee pay by approximately the same percentage they would have been contributing to the government program to offset this. The worker’s account is not tied to the employer so the account is fully portable unlike in a traditional government or company pension plan (though not in the general social security provision).
The current retirement age in Chile is 65 for men and 60 for women. People who keep working after this are not required to contribute to the pension fund. Because this increases their net pay, many Chileans choose to keep working. This increases the economic productivity of the Chilean economy which also increases its wealth. In addition, if they keep working, it does not lower their benefits in any way. Workers can choose to retire at an earlier age as long as they have accrued a minimum amount.
Under the current U. S. system, workers must keep contributing if they keep working. They can also choose to begin receiving benefits at age 62 at a reduced rate. Both of these discourage work.
Disability benefits are also provided for in the new plan as with the previous public pension system. Workers who haven’t yet met the requirements for retirement benefits and who have lost at least 50 percent of their ability to work can receive payments if they have paid into the system for at least two years within the five years prior to acquiring the disability. Disabled workers are also allowed to keep any wages they are able to earn while disabled along with receiving benefits.
Another component of the new plan is the minimum benefit funded out of the government’s general revenues for low income earners who are unable to generate sufficient retirement funds on their own. This benefit guarantees minimum retirement benefits worth 75 percent of the poverty level or 25 percent of the worker’s average pay 10 years before retirement, whichever is higher.
Jose Pinera, the former Minister of Labor and Social Security in Chile and currently the co-chairman of the Cato Institute’s Project on Social Security Privatization, was responsible for the privatization of Chile’s social security system. He has written papers and given speeches regarding Chile’s current system all over the world. He explains that one of the problems with a pay-as-you-go system is that it removes the link between effort and reward whereas the privatization system restores it. He has said “Everyone tries to minimize what he puts into the system while trying to maximize through political pressure what he can get out of it. That’s why pay-as-you-go plans are going bankrupt all over the world.” He has further suggested that two other factors that make the situation more acute: decreasing global birth rates and medical advances that are lengthening life.
Many countries in addition to the U.S. are having the same problem with funding their own retirement programs as Chile did in the late 1970’s and have been investigating Chile’s new program. Even officials from China have gone to Chile to study its private pension program. It is widely acknowledged that Chile’s program has reinvigorated the country’s economy and enjoys widespread public support.
The success of Chile’s private pension program had led five other South American countries to reform their systems in the same manner. Argentina, Peru, Uruguay, Mexico, and Colombia all privatized their retirement programs in the 1990’s.
Benefits of Privatization of Social Security
As briefly mentioned above, the introduction of privatized social security has caused a tremendous upswing in Chile’s economy. The benefit levels to workers are also higher than under the old system. Because receiving benefits is based on age and accumulated benefits and not by withdrawal from the work force as in the U. S., workers are more motivated to continue working to increase their income instead of being penalized in benefits if they reach a certain income level.
Other benefits include employees being more in control of their prosperity and their future, less burden on the government coffers after the initial transition years, and it motivates workers in several other ways already mentioned in this article to keep working instead of being a disincentive to work like the U. S. social security system. When workers keep working it increases national income and expands the tax base.
Jose Pinera has stated that because full employment is encouraged under the new system, the Chilean economy has doubled. Jose Pinera also suggested that because government economic policy is so intertwined with returns on investment, it prompts the Chilean population to keep on top of the issues and be more involved in public policy. He further asserted that under a totally government run program, when government inflates the money, it essentially reduces benefits though the dollar amount may remain the same. Under a privatized system, the worker’s account will not suffer as much as much from inflation. He further adds that a private pension system eliminates all the political shenanigans and manipulation connected to a government program. Pinera has testified before the Senate regarding the benefits of the system. See the Youtube video below featuring Jose Pinera.
Supposed Disadvantages of Privatization
People who possess an innate distrust of the private sector and want the U. S. program to remain under the auspices of government have come up with supposed reasons to do so. Some contend that Chile’s original retirement program was much more complicated than the U. S. system which resulted in much government inefficiency. The implication is that the U. S. does not contain such inefficiency and works just fine. This is highly debatable. They also suggest that the U. S. economy is so much bigger and better than that of Chile that there is no need to take such a drastic step. This is also highly debatable.
Critics of the new system also maintain that many workers in Chile under report their income to reduce the amount of money they have to contribute. They seem to suggest that this means the workers might end up with insufficient retirement funds and will thus become a burden to the system. Proponents believe most workers would be motivated to ensure they have adequate funds for retirement. Knowing that the responsibility and the control are in their hands would tend to motivate people to worker harder.
However, if this issue turned out to be a persistent problem, Chile could amend the system to have the money taken out of worker’s pay before they receive it as is done in a traditional public program. The article by Barbara Kritzer (see below) stated that workers were underreporting their incomes on the old system anyway. Another rebuttal to this argument is the fact that the new system has a minimum retirement component already in place. If workers choose to under report their income and end up with insufficient retirement funds, they will still receive benefits from the government, albeit at a lower rate than they could receive by contributing sufficiently to the new system.
Naysayers also assert that low income workers would not be able to accumulate enough for retirement. They add that the new system does not allow for redistribution of income as did the old system. In other words, money from the rich could not be siphoned to support the poorer workers. Not all would agree this is a bad thing. Many economists maintain that redistributing wealth is a drag on the economy as a whole because it creates a disincentive to work hard to both the recipients and the contributors.
Opponents of the plan also suggest that women would be worse off because they would have inadequate retirement funds since they often take off work for extended periods to give birth and raise children. On the other hand, they say, public systems compensate for social and economic circumstances of women. However, under Chile’s new system, widows receive both their own pension benefits as well as survivor benefits, unlike in the U. S. where widows must choose one or the other.
Both of the objections in the two paragraphs above can be countered by pointing to minimum retirement benefit provided by the government which was mentioned above. Apparently the writers of the articles that voiced these objections are not aware of the minimum public retirement benefit of the plan.
The detractors also warn that in an economic turndown the investment rates might diminish significantly to an unacceptable level. Reports have instead indicated an improvement in the economy with the introduction of privatization of retirement funds. In addition, Jose Pinera has been quoted as stating that over a 40-year period, a diversified portfolio will have low risk and a positive rate of return. He further pointed out that when the government runs the system, it can cut benefits at any time.
The critics point out that the management fees of the investment firms that manage the worker accounts range from 16 to 20 percent of contributions. The management fees cover employee salaries at the firm as well as marketing since the various firms are hugely competitive. They argue that this practically wipes out any gains on the contributions. However, in reports written by Jose Pinera, the Chilean official responsible for setting up the program, on the growth in Chile’s economy and in the retirement funds of the workers suggest an entirely different picture. The issue should not be so much the rate of return as to whether the accumulation of funds at retirement is equal to or exceeds what they would have received from the government at retirement.
Probably the most significant issue in the switch from a public system to a privatized system is the huge transition costs. Since there would be no more workers paying into the public system, the government would have to fund the benefits for workers who remain in the old system. In addition, the funds already accrued by workers who have switched to the new system would have to be supplied by the government.
Anticipating the transition costs, the Chilean government raised money in advance of the change by selling some government assets to the private sector. In addition, the government was running a surplus at the time, instead of in a deficit like the U. S. is today. The transition was also helped by the fact that at the time the ratio of workers to retirees was 9 to 1, whereas in the U. S. today the ratio is 3 to 1.
Chile additionally funded the transition by cutting public spending (which may or may not be a good thing depending on your point of view), raising taxes, and selling bonds (i. e. increasing debt). The spending cuts included social, health, and education programs. The Chilean government instituted a value-added tax several years prior to the transition in order to help fund it. This is a tax on every step of production in consumer goods which significantly increases the final cost to the consumer. 40 percent of the government costs in the new system are obtained by selling bonds to the investment companies that manage the workers’ private accounts.
Detractors of privatization also say that Chile had to reduce benefits to workers in the system change but what they are referring to is an increase in the retirement age. This sounds bad until you realize that prior to the transition, the retirement age in Chile ranged from age 44 to 65. At the transition the retirement age was changed to an across-the-board age of 65 for men and 60 for women. This does not sound bad at all when you think that the U. S. retirement age to receive social security is currently 67 and expected to increase to 69 or 70 in the near future. The Chilean Government did have to make some reductions in other types of pensions which may have been excessive to begin with. Once the transition is complete in approximately 2050, the cost to the government will be eased considerably.
The arguments against privatization are considerably weaker than those in favor of it. The case made against privatization appeals to individuals who like to see things controlled by a higher entity (i.e. government) to a substantial degree rather than letting individual citizens maintain more control and responsibility over their lives. The article by Steve Idemoto (see below) keeps repeating itself as if the author thinks that repetition will make the arguments against privatization seem more plausible.
Final judgment on Chile’s privatized social security system will have to be reserved until the time when a significant number of people on the new system have reached retirement and have begun receiving benefits. As the system is at this point not quite 30 years old, this is not yet the case.
Much of the information contained in the above article was obtained from the three PDF files indicated below and are available online.
PDF Documents Online Which Examine Privatization of Social Security
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