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Case Study: The Chilean

Individual Capitalization
Eduardo Fajnzylber
Special Studies Unit
United Nations Economic Commission for
Latin America and the Caribbean (ECLAC)

prepared for the
World Bank Core Course on Pensions
November 7-18, 2005, Washington D.C.

Structure of the Presentation

The Chilean Pension Reform (1980)

Contributions and fees
Pension calculation
The Pension Fund Administrators (AFPs)


Transition Costs
Macroeconomic effects
Participation and coverage
Projected pensions
Demand for AFP services
Supply of AFP services

What have we learned in the first 25 years since the reform?

Current debate in Chile
Lessons for countries considering individual capitalization reforms
Useful links


ƒ New workers must enter the funded system (the old system is “closed” to new entry) Index . ► Transition generation: ƒ Older workers could choose to stay on their previous system or switch to the new one. Note: no democratic debate and armed forces special regime still in place. with increasing financing problems ► The 1980 reform introduced a unique compulsory fully funded scheme. based on defined contribution individual capitalization accounts. managed by private sector specialized firms.The Chilean Pension Reform (1980) ► Prior to the reform: multiple defined benefits systems.

5% under the new one.The Chilean Pension Reform (1980) ► Acknowledging previous contributions: ƒ Workers who stay on the old system receive their pensions under the old rules. ƒ Contributions from workers who switch to the new one are converted into a “recognition bond” which is paid by the government at retirement. most workers decided to switch to the new system (or were compelled to do so by their employers) Index . ► Contribution rate ƒ The contribution rate was lowered from an average 20% of taxable income under the old system to about 12. ƒ Under these rules.

2.The Individual Capitalization scheme Contributions and fees ► 1.5% of taxable income AFPs charge an additional commission to pay for disability and survivor’s insurance= on average 1% of taxable income Index . Total deduction ~ 12. 3.000 income ceiling) broken down as follow: Contributions from dependent workers are deposited on individual accounts (participation from self-employed workers is voluntary)= 10% of taxable income These funds are invested on financial instruments by specialized Pension Fund Administrators (AFPs).5% of taxable income (with a US$2. who charge an administrative fee= on average 1.

programmed withdrawal. No restrictions on continued work after retirement. paid after the funds are exhausted) guaranteed by the State (SG). workers can choose to exchange the accumulated funds (including recognition bonds) for a pension stream (annuity . On each case. If sufficient funds are accumulated. individuals have access to an early retirement (before the minimum age). No minimum number of contributions but if the worker has contributed for at least 20 years.The Individual Capitalization scheme Pension calculation ► ► ► ► ► At any time after a minimum age (60 women. or a combination of both). 65 men). the benefits are actuarially calculated. he/she has access to a Minimum Pension (MP around 2/3 of the minimum wage. based on accumulated funds and age-gender specific life expectancy. Index .

Collect social security contributions Deposit them in the personal account of each member Invest the resources Take out insurance policy to finance disability and survivorship pensions ƒ Calculate and pay pension benefits (programmed withdrawal) ƒ ƒ ƒ ƒ ► ► Commissions are fixed by each AFP (without price regulation) and are uniform for all members. differentiated by the proportion of their portfolio invested in equities (Fund A must have between 40% and 80% of its portfolio invested in equities …Fund E cannot invest in this type of assets).The Individual Capitalization scheme Pension Fund Administrators (AFPs) ► Public limited companies. whose exclusive purpose is the management of a Pension Fund. Since 2002. and administering the services and benefits stipulated in the law. Index . each AFP is required to offer 5 different funds.

Securities Custody. ► Conflicts of interests: tighter limits on related firms. a 1% Obligatory Reserve belonging to the AFP. ► Investment abroad: to meet growing demand for financial assets and risk diversification. commission structure. Valuation of Instruments. Subject to special regulations and an overall investment limit (currently 30% of all funds invested by a single AFP) ► Others (see Chapter IV. Authorized Markets. SAFP 2003): Eligible Instruments. etc. AFP Obligatory Reserve invested in same portfolio as pension funds. This seems to generate some heard behavior on the investment portfolios of different AFPs (some AFPs replicate the portfolios of the leader firms).The Individual Capitalization scheme Regulations ► Risk management is ensured through a complex set of 97 different investment limits. Information for members. structured by instruments and issuers ► A relative Minimum Yield for each type of fund (industry average minus X) is guaranteed by a Yield Fluctuation Reserve. voting rules in boards of companies. Risk Rating. and a State Guarantee. etc. Index .

Increased coverage (3)Æ Competition should trigger high returns on contributions and low administrative fees Index .What have we learned in the first 25 years since the reform? ► Chilean reform involved three main changes to the structure of the system 1) Pay-As-You-Go Æ Individual accounts 2) Defined Benefits (DB) Æ Defined Contributions (DC) 3) Public management Æ Private management ► These changes can have multiple effects on the economy (1)Æ Fiscal cost of transition (1)Æ Financial sector development. savings and growth (2)Æ Formalization of the labor force.

which must be paid at the moment of retirement ► ► This costs should disappear around 2040 This deficit adds up to the cost of non-contributory pensions and the payment of the Minimum Pensions (MP) guaranteed by the State (SG). Index . that generate the transition cost to the new system (3. two things happen. The difference between the pensions that are still being paid and the (lower) contributions to the old system is the operational deficit ƒ Contributions made to the old system are acknowledged by Recognition Bonds.9% of Chilean GDP for the first 30 years) ƒ Their contributions to the old system are no longer received.What have we learned? High Transition Cost ► As workers switch to new system.

Government civil pension deficits during transition period Transition Cost of the Chilean Reform. (1980-2010) 6% Non contributory pensions Minimum Pensions 4% Recognition bonds 3% 2% Operational deficit from the old system = Pensions paid Contributions received 1% 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 0% 1981 Government deficit as % of GDP 5% Index .

2004). macro stability and other reforms to the financial sector seem to be required for the macro effects to take place. ► Experience from other reformed countries suggest the importance of other factors to be present: sustainable financing of the transition costs.49 % points of growth between 1980-2001. Index . Corbo y Schmidt Hebbel.What have we learned? Macroeconomic effects ► Important impacts. in terms of financial development. savings and growth have been attributed to the Chilean pension reform (0.

implying low replacement rates. especially for women (designers expected an average 80% density) Never contributors Permanent contributors Source: Berstein et al (2005) Index . and much lower than predicted (50%). Lifetime density of contributions is heterogeneous.What have we learned? Participation and coverage ► ► Participation in the system has stagnated at around 58% of the labor force or 63% of the active workers. due to low participation among self-employed and workers in small firms.

suggesting that about half the population will not be able to finance a Minimum Pension (MP) AND will not have access to the State Guarantee (SG) Above MP SG Below MP. based on administrative longitudinal data. without SG Source: Berstein et al (2005) Index .What have we learned? Projected pensions ► First projections are being made.

retirement age and pension type. In practice. Most choices are driven by default options (type of fund) or the action of salesmen and gifts (choice of AFP) Index . AFP. surveys show little financial literacy and understanding on how the system works. ► Econometric studies show little response to relevant variables (price and returns). type of Fund.What have we learned? Demand for AFP services ► The system is based on a number of choices: choice of system.

Demand for AFP services Sensitivity to salesmen Number of salesmen Number of AFP switches Source: Berstein and Ruiz (2004) Index .

Demand for AFP services Importance of default options Fund type choices by age and Income level Fund E (less risky) Default options Fund D Fund C Fund B Lower tercile Medium tercile Higher tercile Fund A (riskier) 20-24 25-29 30-34 35-39 40-44 45-49 50-54 55-59 60-54 >=65 Age group Index .

In absence of price sensitivity. these costs tend to translated into higher commissions.What have we learned? Supply of AFP services ► Evidence suggests presence of important economies of scale in the production of AFP services (probably because of high fixed costs) ► Marketing costs (especially salesmen) can take up a large share of total costs. ► Tendency towards concentration of industry ► No entry in last 9 years. Valdés and Marinovic. 2005) Index . despite high return on assets (on average 53% per year between 1999 and 2003.

Scale and average costs Average Cost (thousand $) Number of contributors per AFP Source: Mastrángelo (1999) Index .

Increased Concentration of the AFP Industry 25 90% 78% 21 79% 79% 80% 79% 80% 74% 20 67% 64% 62% 60% 59% 61% 65% 66% 67% 69% 19 69% 69% 70% 61% Share of 3 largest 16 57% 15 14 13 12 12 12 12 12 13 13 13 60% 50% 13 12 11 40% 10 Share of 3 largest 20 Number of AFPs 78% 9 8 8 30% 7 7 7 6 Number of AFPs 5 20% 10% 0% 0 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Index .

aggregating contributors and auctioning their membership to the lowest commission? ƒ Simplify investment limits. increase investment abroad? Index .Current debate in Chile ► Pension reform is currently an important issue among presidential candidates (December 2005) ► Reform debate around 3 areas ƒ How to increase coverage? ► Attract self-employed workers through incentives? ► Expand non-contributory pensions ƒ How to increase competition? ► Let local banks create AFPs? ► Increase demand sensitivity.

without transition costs and preserving PAYG structure ► Defined contributions do not solve coverage problems. Index . ƒ Transition can be smoothed through mixed systems (Costa Rica. and other reforms to the financial sector.Lessons for countries considering individual capitalization reforms ► Careful consideration of transition costs. macro stability. importance of non contributory pillars ► Consider separation of operative functions from investment functions (see Swedish PPM model) ► Macro effects require adequate financing of transition costs. Uruguay) ƒ Defined contributions can be introduced through notional accounts. ► Social Protection Survey http://www.Useful links about the Chilean AFP system ► ECLAC Special Studies Index . Chilean Superintendency of AFPs (SAFP) http://www.html ► SAFP Research Department Working Papers Series: ► “The Chilean Pension System”. Development Financing Series: http://www.

Case Study: The Chilean Individual Capitalization System Eduardo Fajnzylber Special Studies Unit United Nations Economic Commission for Latin America and the Caribbean (ECLAC) prepared for the World Bank Core Course on Pensions November 7-18. Washington D. 2005.C. .