José Piñera: Private Pensions Create Growth, Savings in Chile

December 6, 2004

Writing this week in the New York Times, José Piñera, co-chairman of Cato's Project on Social Security Choice, details the enormous success of the private pension system adopted in Chile in 1980. Piñera, who served as Chile's labor and social security secretary from 1978–1980, is considered to be the chief architect of Chile's reform, and he makes a convincing case for adopting similar reforms in the United States. Excerpts of his article follow.

"The Chilean retirement system was originally based on exactly the same principle that guides the United States' system. It originated in 19th century Prussia, where Bismarck created a pay-as-you-go-system. But such a defined-benefit system is not only hostage to demographic trends, it also has a fatal flaw: it destroys the link between individual contributions and benefits, or, in other words, between personal effort and reward.

"Chile's Social Security Reform Act of 1980 allowed current workers to opt out of the government-run pension system financed by a payroll tax and instead contribute to a personal retirement account. What determines those workers' retirement benefit is the amount of money accumulated in their personal account during their working years. Neither the workers nor the employers pay a payroll tax. Nor do these workers collect a government-financed benefit.

"Instead, 10 percent of their pretax wage is deposited monthly into a personal account. Workers may voluntarily contribute up to an additional 10 percent a month in pretax wages. The invested amounts grow tax-free, and the workers pay tax on this money only when they withdraw it for retirement.

"Upon retiring, workers may choose from three payout options: purchase a family annuity from a life insurance company, indexed to inflation; leave their funds in the personal account and make monthly withdrawals, subject to limits based on life expectancy (if a worker dies, the remaining funds form a part of his estate); or any combination of the previous two. In all cases, if the money exceeds the amount needed to provide a monthly benefit equal to 70 percent of the workers' most recent wages, then the workers can withdraw the surplus as a lump sum.

"A worker who has reached retirement age and has contributed for at least 20 years but whose accumulated fund is not enough to provide a 'minimum pension,' as defined by law, receives that amount from the government once funds in the personal account have been depleted. (Those without 20 years' contributions can apply for a welfare-type payment at a lower level.)

"Workers may choose any one of several competing private pension fund companies to manage their accounts. Those companies can engage in no other activities and are subject to strict supervision by a government agency. Older workers have to own mutual funds concentrated in short-term fixed-income securities, while young workers can have most of their funds in stocks. The law encourages a diversified portfolio, with no obligation to invest in government bonds or any other security.

"Each worker receives a statement from the manager every three months, and can keep track of the retirement capital at any moment. Workers with enough savings in their accounts to buy a 'sufficient' annuity (50 percent of their average salary, as long as it is 20 percent higher than the minimum pension) can stop contributing and begin withdrawing their money. But there is no obligation to stop working, at any age, nor is there an obligation to continue working or saving for retirement once a worker has met the 'sufficient' benefit threshold.

"…We set three basic policy rules for the transition to personal accounts: the government guaranteed retirees that their benefits would not be affected by the reform; everyone already in the work force could stay in the government system or move to the personal retirement account system (those who opted out were given a 'recognition bond' calculated to reflect the money the worker had already accrued); and all new workers were required to enter the personal account system.

"With this system, we ended the illusion that both the employer and the worker contribute to retirement. As economists know well, all the contributions are ultimately paid by workers, since employers take into account all labor costs in making their hiring and salary decisions. To protect the net wages of workers, we initially recategorized the employer's contribution as an additional gross wage.

"There was no 'economic' transition cost, because there is no harm to the gross domestic product from this reform (on the contrary, there is a huge benefit). A completely different issue is how to confront the 'cash flow' transition cost to the government of recognizing, and ultimately eliminating, the unfinanced Social Security liability. The implicit debt of the Chilean system in 1980 was about 80 percent of the G.D.P.

"We used five 'sources' to generate that cash flow: a) one-time long-term government bonds at market rates of interest so the cost was shared with future generations; b) a temporary residual payroll tax; c) privatization of state-owned companies, which increased efficiency, prevented corruption and spread ownership; d) a budget surplus deliberately created before the reform (for many years afterward, we were able to use the need to 'finance the transition' as a powerful argument to contain increases in government spending); e) increased tax revenues that resulted from the higher economic growth fueled by the personal retirement account system.

"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 (from the historic 3 percent to 7.2 percent a year) until the slowdown caused by the government's erroneous response to the Asian crisis.

"…When the system was inaugurated, one-fourth of the eligible work force signed up in the first month. Today 95 percent of covered workers participate. For Chileans, their retirement accounts represent real property rights. Indeed, the accounts, not risky government promises, are the primary sources of security for retirement, and the typical Chilean worker's main asset is not his used car or even his small house (probably still mortgaged) but the capital in his retirement account.

"Since they have a personal stake in the economy, workers cheer the stock market's surges rather than resenting them, and know that bad economic policies will harm retirement benefits. When workers feel that they themselves own a part of their country's wealth, they became participants and supporters of a free market and a free society."

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