Advocates of privatizing Social Security point to the success of Chile. In 1981, Chile replaced its inefficient state-run pension program with a private system where workers fund their own retirements through compulsory private savings. The Chilean solution has captured the imagination of free-market believers the world over. But a closer look suggests that Chile is no model for the United States.
One problem is huge management fees. Up to 20 percent of worker contributions go to middlemen. A second failing is that only a little over half of Chilean workers make regular social security contributions. And even for those who do contribute Chile's new private system Provides little progressive redistribution of income. Chile has also benefited from fortuitous timing. Unsustainable high rates of return in both stocks and bonds have exaggerated its long-term success.
Even more fundamentally, the two systems are not comparable. Chile's old system was an administrative mess. Like many other Latin state-run pension systems, it was underfunded and failed to provide adequate coverage to most workers. Our system, by contrast, is well managed, clean, and nearly universal. In the U.S., privatization is far too radical a cure for what is essentially a modest actuarial shortfall.
THE PRIVATE GRAIL
In the Latin American context, privatization seemed a plausible remedy to the corruption and inefficiency of state-run systems, in nations not noted for clean and reliable government. In the Southern Cone of South America, aging populations and massive evasion by both employers and workers created a system disastrously out of balance. Surpluses had been wasted on bad investments; benefits were often inegalitarian and financed regressively; deficits were mounting; and management was inefficient. By the 1980s, ever fewer contributions were supporting more pensioners, and payroll taxes were among the highest in the world. Latin America's large informal sector left millions more with no coverage at all.
By the end of the 1980s (that "lost decade" of Latin American economic development), an era of crushing interest rates, negative growth, and fiscal calamity, there was broad support for pension reform, coupled with intense political conflict over the particulars. Reforms ranged from partial privatizations in Argentina and Uruguay, to an aborted privatization drive in Brazil, where reform is still underway. In recent years, Mexico, Peru, Bolivia, and Colombia have attempted variations on the theme.
Chile's plan, enacted during the Pinochet dictatorship, is the only case of total privatization. The Chilean approach reversed a 100-year global trend toward increased state sponsorship of social insurance. Most countries, including the United States, use a tripartite "pay-as-you-go" model, in which payroll taxes on workers and employers, supplemented by government contributions, fund current benefits. By contrast, in Chile's private plan workers are required to contribute 10 percent of their salaries to private investment accounts, whose funds are invested by private pension fund companies in closely regulated portfolios. Upon retirement, the accumulated capital can be used to purchase an annuity.
A MIDDLEMAN'S PARADISE
Seemingly, Chile's private system has achieved impressive average returns on investment. However, once commissions are factored in, the real return for individual workers is considerably lower. Nominally, the real annual return on investment between 1982 and 1995 averaged 12.7 percent. But a recent paper by World Bank economist Hemant Shah demonstrated that an individual's average rate of return over this period after paying commissions would have been 7.4 percent.
The real return after commissions over other periods of time is even lower. For example, although the average rate of return on funds from 1982 through 1986 was 15.9 percent, the real return after commissions was a mere 0. …