Social Security Reform in Latin America

By Mitchell, Olivia S. | Federal Reserve Bank of St. Louis Review, March-April 1998 | Go to article overview

Social Security Reform in Latin America


Mitchell, Olivia S., Federal Reserve Bank of St. Louis Review


Latin America has seen a great deal of political and economic upheaval over the last hundred years. What happened in Chile in 1981, however, was a "quiet" revolution - one that dramatically changed the way people look at retirement programs around the world. In that year, the Chilean government pioneered the radical idea of completely overhauling the nation's then-bankrupt national social security reform program, replacing it with a privately managed, funded, defined-contribution pension system. Today, more than 15 years later, the Chilean pension fund "success story" has caught the attention of economists and policymakers everywhere.

To understand why Chile's restructuring of its social security system has caught the attention of its Latin American neighbors - and many other nations as well - it is useful to begin by asking what that country did and why. Next we summarize what other countries did, following in Chile's footsteps. Finally we offer a brief assessment of the Latin model for social security reform.(1)

WHAT THE CHILEAN SOCIAL REFORM ACCOMPLISHED

At the end of the 1970s, Chile's old-age retirement program was in disarray. Many "cajas" - publicly managed pension programs - were critically under-funded, placing the government in the unenviable position of either closing them down or radically restructuring them. In 1981, the government decided to terminate these old plans, instituting in their place a national two-tiered social security system.

Most widely discussed is the private pension tier in this new system, known as the AFP plan (Association of Pension Funds). This structure mandates that every (formal sector) worker pay 10 percent of earnings into a privately administered defined-contribution pension plan. System taxes are collected by a pension sales force of more than 19,000 agents; individual workers may designate a fund manager from among approximately 20 state-licensed and regulated fund managers who compete for the privilege of managing workers' investments. AFP sales agents hence devote substantial effort to trying to get workers to switch AFPs up to four times per year. Less well known, but also important, is the other tier in the Chilean national system, which takes the form of a government-supported old-age benefit promise. This is a floor or minimum benefit, payable by the government to workers whose private AFP pension is too small to generate a minimum payout.

Several financing techniques were needed to pay for the transition to this new system. The Chilean government was fortunate to have a budget surplus worth about 5 percent of GDP. In addition, benefit entitlements under the old plan were pared down, in part by raising the retirement ages and years of service required for full benefits. Finally, the government issued new debt in the form of "Recognition Bonds" to workers with accrued benefit promises under the old terminated system. These bonds were estimated at around 80 percent of GDP and will be paid down over the next 45 years or so.

Benefit payouts at retirement are determined by workers' accruals in their AFP accounts. These accumulations may be used to purchase an annuity from an insurance firm, or workers may take a "programmed withdrawal" akin to the minimum distributions computed by the United States Internal Revenue Service. (A retiree with a very large pension accrual might also be allowed to take a partial lump sum.) Should the retiree's benefit payment be too low, however, the government will instead provide him with a guaranteed minimum benefit - worth about three-quarters of the minimum wage, or one-quarter of the worker's average pay during the decade prior to retirement. In that event, his AFP amount is taxed 100 percent by the government.

One as-yet-unsettled issue is how large this minimum guarantee promise will end up being. Some analysts have opined that perhaps a majority of future retirees may be owed this minimum payout if investment performance and labor earnings fall below current projections. …

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