UNIVERSITY OF BOHOL

PROFESSIONAL STUDIES

Chilean Pension System: What is at stake?

August 14, 2022

Assignment submitted to:

Dr. AMMON DENIS R. TIROL, DM, CPA
as partial fulfillment of the requirements in
BA 204 FINANCIAL MANAGEMENT
Summer AY 2021-2022

KEZIAH REVE B. RODRIGUEZ

MASTER OF SCIENCE IN BUSINESS ADMINISTRATION
 Chilean Pension System: What is at stake?

The entire world has been looking at Chile’s pension system for a lot of years. It’s defined
contribution system was quite influential when introduced and was taken as an example by other
countries. However, it is now delivering low replacement rates, as its parameters did not adapt
over time to changing demographics and global returns, while informality persists in the labor
market.

Reforming the current pension system was one of the biggest demands the leftist
demonstrators had during the 2019 protests. One of their biggest complaints against the system
is its low-paying pensions. Due to this, Chile became the first country to replace a traditional pay-
as-you-go (PAYG) system that offered a defined benefit with a fully funded pension system based
on a defined contribution that financed individual capital accounts managed by private fund
managers (AFPs).

The private pension system was established in 1981 with the goal of increasing the
country’s saving rate, developing its capital market, and easing the long-term pressure on its
budget. During the introduction of the system, switching was optional for the workers, completely
and strongly encouraged by a government publicity campaign – and it became compulsory for
new workers.

Over time, the funds have accumulated to an annual average of 7.8% in real terms in the
span of 40 years. However, for the majority, payouts have failed to provide a decent standard of
living. In response to its complaints, the government instituted another system that is known as
top-ups, which are subsidies for retirees with low retirement payouts. Without them, more than
half of Chile’s pensioners would be below the poverty line.

Since the start of the COVID-19 Pandemic, Chile’s congress submitted on three laws that
each allowed savers to pull 10% of their savings from their pension funds. The funds became the
chief of source of relief during the economic crisis caused by the pandemic. The government of
Chile did implement a series of packages for spending that grew steadily larger. However, critics
call them narrowly focused, difficult to apply for and slow to offset the lost income. The pension
withdrawals, on the other hand, are more than compensated for the decline in household buying
power and are not targeted nor focused, at all.

The congress of Chile – which acts independently, sidestep laws that give the head of the
state the sole prerogative over new spending proposals. Improving pensions was considered by
far the most urgent challenge facing the government. Now, lawmakers are debating a fourth
pension withdrawal, while the continuing discussion to ponder details as whether taxes will be
imposed on the money disbursed. The economy has recovered; gross domestic product has
grown 10.8% this year while inflation has reached 4.3%, according to Bloomberg.

In simple terms, pension funds in Chile are the biggest institutional investor, meaning that
draining money from them leaves less cash that can go elsewhere in the economy. To meet
payouts, fund managers must sell assets. Another withdrawal also would mean an injection of
billions into an economy that is already threatening to overheat, possibly requiring more rate hikes
and forcing yields up further.

Expectedly, for low-income workers, the monthly loss they can expect at retirement – after
government top-ups – is small compared to benefit of cash in hand now to pay down debt or
replace lost income. On the other hand, for those earning high salaries, there may be advantages
to withdrawing money from pension funds and putting it in voluntary savings accounts.

The pension system would have delivered good pensions for people contributing regularly,
if demographics and global events would have not changed since its foundation. The system has
also contributed to macroeconomic stability by channeling savings into domestic investment and
growth, and to developing domestic financial markets. The pension system’s initial focus on
efficiency has been gradually broadened to bring equity into the mix, addressing challenges for
people of the poverty sector or those that have not been able to contribute regularly.

The study conducted by International Monetary Fund has showed that comparing Chile’s
system with international data, it shows that expected replacement rates in Chile compare poorly
to other countries, which is mostly caused by low contribution rates. Problems such as this will
likely be compounded by the recent pension withdrawals which exhausted the pension accounts
of a large share of participants of the system.

Additionally, it has been projected that self-funded pensions would fall by an average of
21% due to three rounds of withdrawals as of August of 2021 but this decline will trigger an
increase in the government supplement associated with solidarity pillar, rescuing in a lower
decline in total pensions by 7%. The increase in government supplements will lead to a gradual
increase in fiscal costs relative to current levels. Further rounds of withdrawals would accentuate
economic numbers.

To add more points, the reform agenda will increase contribution rates, the retirement age,
and that improves the contribution density that would strengthen the system by improving the
completeness of the pensions. Reforms that tackle multiple parameters could achieve similar
results with more gradual changes, could have a broader impact across cohorts compared to
reforms that focus on a single parameter of the system, and could ease the political economy of
reform. It is worth pointing that the contribution density is not a policy parameter but increasing it
will require implementing policies (labor market, structural and fiscal) that encourage labor market
participation and boost job creation in the formal sector.

One way to open fiscal space to enhance the solidarity component of the Chilean Pension
System would be to strengthen the self-funded portion of the pension. The increasing expected
replacement rate would imply less people in need of the public solidarity pillar at current
parameters. For example, the combination of measures will entail a reduction in the fiscal cost of
the system by 0.8% of GDP in 2060. Such fiscal space could be used to strengthen the solidarity
component of pension in a targeted way.

The system is still in a transition phase, the old PAYG system and the new capital system
coexist, and this will continue until the benefits paid to the pensioners that remain the old system
cease (which is forecasted to be by 2045). The transition from a pay-as-you-go system to a fully
funded one has major fiscal implications. In term of flows, the government faced a sharp decline
in its income due to contributions that moved to the new system, while it fully funds pensions in
the old system. The fiscal implications depend essentially on the sources of funds used to finance
the reform.

The domestic savings impact of pension reforms such as the Chilean depends essentially
on the way they are financed. The transition to a funded system that is not debt financed means
an increase in taxes on current generations to finance the deficit of the old system and an increase
in the stock of capital for the benefit of future generations. This is a risky decision which in this
case seems to have gone well thanks to the capital gains that were mentioned in the previous
section. In a more stable economy with mature financial markets, there is no room for this kind of
compensation.

The accumulation of pension funds and their investment in financial markets has
contributed to the development of important economic sectors. This influence was most decisive
in the housing market since the availability of long-term savings gave support to a private market
for mortgage bonds. In 1996, 17.9% of the pension fund’s portfolio was invested in mortgage
bonds. In the Chilean housing market, it means that two out of every three houses’ purchases
have been financed by pension savings.

As the economy and real wages grow, the value of minimum pensions is becoming less
acceptable and political pressures to raise the value of the minimum pension are rising steadily.
Of course, this has a big fiscal impact in the short term, and this has been a factor to deter these
pressures, but it is also a big danger for public finances in the future as it brings more people
below the line of the fiscal guarantee.

Finally, the final fiscal risk. This is the relatively low level of contributions as compared to
affiliations. This means that many people "passed through" the system at one point or another of
their working life but will not have enough funds to finance a decent pension and will not qualify
for a minimum pension under the fiscal guarantee (20 years of contributions is one of the
requirements). This means that in the next 10 to 20 years, the Chilean government will face
mounting pressures to relax the constraints to get access to minimum pensions.
References
Pienknagura, S., & Evans, C. (2021, September). Assessing Chile's Pension System:
Challenges and Reform Options. Retrieved from International Monetary Fund:
https://www.imf.org/en/Publications/WP/Issues/2021/09/09/Assessing-Chile-s-Pension-
System-Challenges-and-Reform-Options-465415

Boyd, S. (2021, October). How Chile’s Pension System Became a Covid Piggy Bank. Retrieved
from Bloomberg: https://www.bloomberg.com/news/articles/2021-10-29/how-chile-s-
pension-system-became-a-covid-piggy-bank-quicktake

Chile plans to reform controversial pension program next year. (2022, March). Retrieved from
Reuters: https://www.reuters.com/world/americas/chile-plans-reform-controversial-
pension-program-next-year-2022-03-22/

Llano, J. (2022 , February). Chilean pension system: what is at stake? Retrieved from Latin
America Policy Journal: https://lapj.hkspublications.org/what-is-going-on-with-chile-and-
the-pension-system/