Chile’s Pension System: Once eulogised and a case for emulation is now under a crisis…

These stories are so common in economics. The moment you think certain economic policy or system or economy has become the gold standard, it just goes the other way. This is both beauty and frustrating part of the subject.

This is the case with Chilean pension system as well. It was once eulogised but is under a crisis. It moved to a defined contribution plan much earlier than other economies which continue to be burdened by defined benefit plans.

But it is these very DC plans which are biting now. Reasons are not political but labor markets, as Prof. Andrés Velasco suggests:

Defined-benefit pension plans are under pressure. Changing demographics spell trouble for so-called pay-as-you-go (PAYG) systems, in which contributions from current workers finance pensions. And record-low interest rates are putting pressure on funded systems, in which the return from earlier investments pays for retirement benefits. TheFinancial Times recently called this pensions crunch a “creeping social and political crisis.”

Defined-contribution, fully-funded systems are often lauded as the feasible alternative. Chile, which since 1981 has required citizens to save for retirement in individual accounts, managed by private administrators, is supposed to be the poster child in this regard. Yet hundreds of thousands of Chileans have taken to the streets to protest against low pensions. (The average monthly benefit paid by Chile’s private system is around $300, less than Chile’s minimum wage.)

Chile’s government, feeling the heat, has vowed to change the system that countries like Peru, Colombia, and Mexico have imitated, and that George W. Bush once described as a “great example” for Social Security reform in the United States. What is going on?

The blame lies partially with the labor market. Chile’s is more formal than that of its neighbors, but many people – especially women and the young – either have no job or work without a contract. High job rotation makes it difficult to contribute regularly. And it has proven difficult to enforce regulations requiring self-employed workers to put money aside in their own accounts.

Moreover, the legally mandated savings rate is only 10% of the monthly wage, and men and women can retire at 65 and 60, respectively – figures that are much lower than the OECD average. The result is that Chileans save too little for retirement. No wonder pensions are low.

But that is not the end of the story. Some of the same problems plaguing defined-benefit systems are also troubling defined-contribution, private-account systems like Chile’s. Take changes in life expectancy. A woman retiring at age 60 today can expect to reach 90. So a fund accumulated over 15 years of contributions (the average for Chilean women) must finance pensions for an expected 30 years. That combination could yield decent pensions only if the returns on savings were astronomical.

They are not. On the contrary, since the 2008-2009 global financial crisis, interest rates have been collapsing worldwide. Chile is no exception. This affects all funded pension systems, regardless of whether they are defined-benefit or defined-contribution schemes.

We just keep going in circles.

The crucial lesson is both policy pushers and public should take policies with a pinch of salt. The unintended or hidden consequences eventually take-over and the initial successes become cases for future problems..

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