PRIVATIZATION OF SOCIAL SECURITY: LESSONS FROM CHILE by Peter Diamond Presented by Agata Narożnik Ertem Ejder

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

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

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

Comparition Old SystemNew System System Financing PAYGOIndividual capitalization ManagementStatePrivate, competitive OptionsRigidMultiple (pension fund, contributions over legal minimum, type of fund (in multi-funds) Role of StateAdministrator, self- regulation Supervision, regulation, subsidiary BenefitsOld age pensionOld age pension, annuities, programmed withdrawals

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

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. The high cost of running a privatized social security system:

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.

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.

Source: Robert Holzmann Making Pension Reform Work: The Link to Labor and Financial Market Reforms World Bank, June 2007

Financing the Transition

Active workers that switched to the new system have received explicit government debt (recognition bonds) on account of past contributions. This financing decision has implied an increase in fiscal saving, with the decision to avoid debt financing implying an improvement in the primary fiscal balance of % of GDP each year in the 1980's.

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

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 political views 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. Contribution based systems make redistributions clearer.

Redistribution and Political Risk Chile did freeze the COLA for pensions received under the continuation of the old system in Since COLA's paid by private insurance companies do not directly affect the government budget, one would not expect to see the government freeze pensions paid under the new system at the time of some future budget squeeze.

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.

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.

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

Insurance The Chilean system has a maximum allowable rate of withdrawal from accumulated funds. The rate varies with age and recent interest earnings on the funds. Eligibility to tap retirement funds in either form is unrelated to whether individuals stop working. Only sufficient age are necessary to begin withdrawals. Funds are accumulated until retirement age is reached.

Conclusions PAYG is a replaceable system. Cost of running a privatized social 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.

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

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.

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.

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

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