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March/April 1998
The Lesson of Chilean Social Security: CAVEAT EMPTOR!

By David Langer

Many advocates for change in Social Security point to the privatized social security system in Chile as a model. Not so fast, says David Langer. The cure may be worse than the disease.

Chile's privatized social security system is being hailed in the United States as the role model for privatizing our own Old-Age, Survivors, and Disability Insurance (OASDI). Enthusiastic supporters propose dismantling a large portion of our defined-benefit oriented OASDI and establishing Chilean-type individual investment accounts for workers to allow them to accumulate retirement funds. Private market investments, they believe, will generate yields at such a level that benefits will greatly exceed those from OASDI. The promoters of Chile's privatized social security have been quite successful in selling the concept. Among the other countries adopting it are Argentina, Colombia, Peru, Mexico, Uruguay, Poland, and Kazakhstan.

It would follow that a study of Chile's program should lead to a profitable basis for reconsideration of OASDI. However, a reading of the literature leads to the startling discovery that Chile's program is not at all what the privatizers would ask us to adopt, and they would likely be embarrassed to do so. One learns that the program's expenses are exorbitant, workers have practically no choice of investments, it's highly regulated by Chile's government, and it has saddled the Chilean government with incalculable costs. Moreover, the vaunted high investment yields seem to have been calculated on a gross basis, before expenses, rather than on a net basis.

What are the salient features of Chile's privatized system, and what lessons can we derive that will be of use to us in considering privatization for the United States? First, let's examine why each country adopted the type of program it did.

Pinochet and Roosevelt
Chile's social security system was inaugurated in 1924. It wasn't possible to establish a single program to accommodate the country's diverse workers, so more than 36 programs were set up, based on industry and occupation. Differences in benefit formulas and contributions also existed, and coverage was a problem. Even though many workers and employers were able to avoid making contributions, workers were still able to receive benefits at retirement. An effort to use bonds to prefund benefits came to grief because of the rampant inflation that swept Chile in the mid-1970's. Restructuring was essential.

The Chilean dictator, Pinochet, appointed Jose Pi-era in 1981 to oversee the restructuring and, by 1983, the government adopted a privatized arrangement featuring individual investment accounts. Pi-era was then a 30-year-old Harvard University Ph.D. with little apparent background in social insurance programs. Given the dictatorship that existed, the public had virtually no input in the decision-making process.

It would appear that the key lesson to be learned from Chile is that when one looks past the glowing pro-motion and notes the drawbacks, then one must necessarily also examine closely the major privatization proposal being urged for adoption in the United States

In striking contrast, our Social Security system arose out of the collapse of the stock market in 1929 and the severe depression that followed. In setting up the system in 1935, President Franklin D. Roosevelt found it unthinkable to use the private securities markets as a basis and looked, therefore, to create economic security for the nation's retirees and workers without the use of such markets. He called on social insurance experts such as Arthur Altmeyer of Wisconsin, highly experienced in the design and operation of social insurance programs, to play a leading role.

The insurance industry recognized and supported the need for a basic national retirement program. Metropolitan Life actuary Reinhard Hohaus made a major contribution to understanding Social Security financing and later became the Met's chief actuary His noted analysis of the actuarial literature in 1936 concluded that pay-as-you-go should be the primary funding method. Key Aspects of Chile's System Now lets look at the key aspects of Chile's social security system.

Pension fund associations (AFPs). There are currently 13 privately run AFP's authorized to manage a private pension fund covering a group of workers. The original 12 in 1981 grew to 22 in 1993, but competition caused this to fall to 13. Investments now totaling around $30 billion are regulated by law, and about 28 percent is currently invested in equities, 42 percent in government bonds, 30 percent in Chilean financial institutions and companies, and a small amount in foreign securities.

Workers can choose only one AFP at a time, and there's no choice of investments within an AFP The AFP's have also largely come to invest in similar securities because they're penalized if performance falls by a certain amount below the average yield of all AFP's. Conversely, an AFP is required to build reserves when its yield exceeds such an average by a similar amount.

There is now a sizable sales force of about 20,000, up from 1,900 in 1981, converging on the 5.5 million covered workers (about one for each 275 workers).

Contributions. Workers must contribute 10 percent of pay (tax deductible) to their pension accounts up to about $22,000 and may voluntarily contribute and deduct up to 10 percent more. Another 2.5 percent to 3.7 percent is for death and disability insurance and for the administrative expenses of the AFP There's no employer contribution, but when the system was begun, wages were raised to a level more than necessary to cover the workers contribution—a wash for employers since they no longer had to contribute. Highly paid employees benefit most from the tax deduction and therefore have the most to gain from participating.

AFP expenses. AFP's incur expenses for advertising, sales, investment management, administration, and profit. A portion of the premiums for the insured death and disability benefits is also retained for insurer expenses and profits. Purchasers of insured annuities at retirement (about 40 percent of retirees) can buy only high-cost individual annuities and incur their added expense.

In addition, steep advisory fees of 3 percent to 5 percent are paid by many who need help in making the complex decisions of which retirement option to select and which insurer or AFP to deal with. Total expenses appear to be in the range of 15 percent to 20 percent of annual contributions. (OASDI's expense rate is under 1 percent.) The high expenses result partly from the high rate of workers transferring from one AFP to another. This maybe the result of the large sales force, its high commissions, and the inducements (cash, TVs, cellular phones, etc.) offered workers to switch.

Chile's costs. Chile's government pays for the transition from the old to the new system (beyond the workers' contributions it collects), providing each worker who transferred to the new one a recognition bond equal to the value of the generously computed accrued benefit. It also pays the current benefits of people who retired under the old system.


In addition, there's the cost of the new minimum benefit, which is expected to apply to perhaps 35 percent of workers who qualify as a result of low earnings, underreporting of wages, and evasion of payment. The government also maintains two bureaucracies, one for the old system and one for the new. The need for general revenues is expected to be substantial for a long time to come.

Investment yield. From 1981 to 1994, the yields ranged from 4 percent to 30 percent. The average was around 12.6 percent, but it became minus 2.5 percent in 1995 and 3.5 percent in 1996, pulling down the average to about 11 percent. This appears to be gross yield, however, which doesn't fully reflect the high expenses. Take the 3.5 percent yield for 1996, for example, and assume a first-year expense of 10 percent. Then the actual account at the end of the year, if $1,000 were put in at the beginning, would be $932 ($1,000 minus the $100 expense plus $32 of interest) for a net yield of minus 6.8 percent. The widely publicized average yield of 12.6 percent from 1981 to 1994 may thus be several percentage points lower after expenses. What Can We Learn From Chile? The discovery of Chilean social security's undesirable characteristics comes as quite a surprise, of course, in light of the intensely favorable publicity the system has received here and abroad. The privatization proponents have apparently not burdened the public with the negative aspects of the system: the outlandish expenses, the lack of choice workers have in investments, the less-than-awesome investment yields, and the government's extensive regulatory role and potentially staggering financial obligations.

It would appear that the key lesson to be learned from Chile is that when one looks past the glowing promotion and notes the drawbacks, then one must necessarily also examine closely the major privatization proposal being urged for adoption in the United States. This is the 5-percent Personal Security Account (PSA) that was presented to the Social Security Advisory Council, under which 5 percent of each workers 6.2-percent OASDI contribution will be placed in an individual account. The workers will have a virtually unlimited choice of where to invest their funds. One now needs to inquire: Does the 5-percent PSA proposal have drawbacks, too, that aren't being fully disclosed? Consider the following items that fall into that category:

Cost to privatize. Employers and workers will need to pay an additional combined contribution of 1.52 percent of taxable payroll until 2070. The Treasury would have to borrow amounts each year to pay the benefits that would otherwise have been paid by the workers' 5-percent contribution, which will now go into the individual accounts. The supporters of the 5-percent PSA proposal estimate the total of the borrowing will ultimately reach a peak of $10 trillion and descend thereafter to zero by 2070. Assuming an interest rate of 6 percent, the dollar amount of interest to be added to the federal budget in the peak year to be paid from general tax revenues will thus be around $600 billion. Other significant expenses will include the start-up costs for the government and the employers to effect such a radical change, e.g., laws, regulations, forms, procedures, and education. Operating expenses. The expenses to be paid to the financial companies administering the privatized portion of OASDI would, of course, be in addition to OASDI' s current expenses. This second layer would be 1 percent or more of invested assets. However, 1 percent of assets will come to equal 15 percent to 20 percent of the annual contributions in about 20 years and will keep increasing thereafter. A substantial yield will be needed to offset this.

The income to the managers. I estimate that for the period 1998 to 2010, the entities that will manage the privatization operations, many of which are also in the forefront of the promotion of privatization, will receive about $240 billion for investment management fees, commissions, administrative fees, and profits.

Future yields. While workers will be buying securities on the private markets with their 5 percent of taxable payroll (initially over $160 billion annually) the government will now need to sell Treasury securities on the public markets, since it will no longer have OASDI's surplus automatically available for borrowing. Such public sales will likely drive up interest rates, which will both raise federal operating costs (and taxes) and, possibly, dampen stock prices. The high yields projected for the PSA accounts (a pure 7 percent) may therefore not materialize.

(Note: A future average yield of 7 percent would require a gross domestic product annual increase rate of about 3.5 percent, while the OASDI board of trustees used an average GDP growth of only 1.4 percent for its 75-year projections. If the trustees had also assumed 3.5 percent, there would likely not be a projected future financial shortfall. Conversely, if the projections for the 5-percent PSA were based only on 1.4 percent GDP growth, then the 7-percent yield would be more like 5 percent, and the proposal's projected benefits would look more like OASDI's.)

Federal underwriting. In the event of a stock calamity in the fashion of 1929, the privatization groups tell us that the government, not they, will assume the responsibility of payments to retirees of specified minimum amounts. This will, of course, require that federal borrowing be repaid by the public. In addition, the purchasing power of retirees will be cut at a bad time for the economy Workers in desperate need because of lost jobs or pay cuts cannot be expected to take kindly to a sharp reduction in their nest eggs and will likely make demands on the government for restitution.

Opportunities for fraud. The financial media have stories practically every day about scams being perpetrated on even highly sophisticated investors. Will the scamming of workers and their beneficiaries become a major growth industry? The lesson from Chile may well be summed up in two words: Caveat emptor.

Reprinted, courtesy of Contingencies, the magazine of the American Academy of Actuaries. March/April 1998


© 2001 DAVID LANGER COMPANY, INC.