The Chilean Pension System: A Renewed View Guillermo Larrain Rios Superintendent of Pension Funds, President of AIOS Washington, February 2005

Chilean Pension Funds have grown steadily and impressively

Macroeconomic impact of pension funds: analytics The Corbo/Schmidt-Hebbel model Pension Reform Labour Market Financial Developmt SavingInvestment TFP Total employ- ment Formalization Public financing of transition Growth Note these causalities!

Macroeconomic impact of pension funds: estimates

Three general considerations about the Chilean model 1) Demographics –The old Chilean PAYG system was in crisis: 32 regimes, regressive, underfunded –The AFP model started before the current demographic transition appeared –From an actuarial point of view, DC systems are better prepared to adapt to the new demographic paradigm than DB systems for the simple reason than in the latter benefits are defined according to the dynamic of politics not of demographics and, obviously, they need not coincide

Three general considerations about the Chilean model 2) Transitional costs –New workers to new system; strong incentives to older workers: real wage increased for workers and employers´ contribution ceased. –Fiscal deficit, persistent and long lasting –Expenditure cuts in other areas to accommodate it. –Specific political situation of Chile

S DtDt D t +D FP S’ 3) Complementary reforms and markets: Pension reform is not a miracle. WSJ (dec 22, 04) “True entitlement reform, in other words, would be more than just an adjustment to the federal fiscal situation. IT WOULD REFORM DEMOCRACY AND EVEN THE CHARACTER OF THE ELECTORATE ITSELF" p F Three general considerations about the Chilean model

Some institutional requisites for diversification  Fixed income:  Mortgage.  Corporate.  Variable Income  Corporate culture, accountability  Corporate governance  Minority shareholder´s rights 1.Inflation protection (Macro stability) 2.Investment opportunities 3.Contracts: stable judicial framework 4.Tax distortions minimized. 5.Risk classification… etc… 6. etc…

Exogenous problems: Labour Markets Lifetime employment is over, job rotation, frequent unemployment episodes. This does not affect people equally: employability differ according to education, economic sector, family linkages etc… Poorer workers, more exposed to uncertainties. Important characteristic of the labor market : its duality.

Exogenous problems: Labour Markets – natural reluctance of many workers to contribute for pensions – proliferation of formal self employed workers: require savings to be liquid in case of need while pension assets are extremely illiquid

Exogenous problems: women, a special case Start working later Earn less (for same skills), Retire earlier Live longer Chile has lowest female participation rates, slow change in this

Exogenous problems: Life expectancy For given savings, now must finance more years Consequence: pensions are smaller Two contradictions: people live longer… –and retires earlier –and feel better: old age jobs!

Endogenous problems: accumulation and disbursement Accumulation phase: a)AFP (P2) b)Voluntary (P3) Disbursement phase: a)LIC b)AFP P1: Solidarity through State

Endogenous problems: competition and concentration Two design problems impact competition: –Inelasticity of demand: mostly explained by the mandatory character of the product sold. The pension market is artificial, there is no spontaneous demand for it and that´s why people do not pay much attention to relevant variables in this market specially while they are young. –Economies of scale: typical in financial sectors but more present here due to the necessary exclusive nature of the commercial firm that distribute pensions.

Reforming the reform 1: Multifondos At the beginning there was only one portfolio Strict regulation on limits Minimum relative return

Reforming the reform 1: Multifondos Herd behaviour appeared (more than elsewhere) Two opposing views on that: –minimize likelihood of individual errors of judgement: safety element. –as portfolios do not vary, nor do returns. AFPs offered only one portfolio, very similar to each other. From the perspective of the affiliate: –the benefit of being informed was smaller compared to the cost of doing it. The management of pension savings started to look more as a commodity inducing further indifference. –People received statements but it was useless: desinformation 93% declared they did not know the price 56% declared ignorance of the balance of their personal accounts 54% of men and 64% of women declared that they have never changed from one AFP to another

Reforming the reform 1: Multifondos

Herd amplified 5 times.

Reforming the reform 2: The Scomp

Summary Chile has a succesful pension system. In spite of that, I requires reform in three areas: –Coverage: independent workers, first pillar –Industrial organization: diminish barriers to entry –Investment regime

The Chilean Pension System: A Renewed View Guillermo Larrain Rios Superintendent of Pension Funds, President of AIOS Washington, February 2005