SOCIAL SECURITY REFORM

LUIS LARRAIN A.

I. INTRODUCTION

This chapter describes the primary characteristics of the so-called Social Security Reform implemented in Chile in 1980 in an effort to create a privately-administered individual capitalization system through institutions known as Pension Administration Funds (known by their Spanish acronym, AFPs). This reform covered solely old age pensions, disability and survival (widow and orphan) benefits, which, while representing the lion's share of Chilean social security, did not cover all of the services which fall into this category. In fact, the Provisional Health Care Institutions or ISAPRES -- which will be discussed in a separate chapter -- were designed in conjunction with the social security reform and are at times considered to be a part of the larger social security system even though they seek to resolve an almost entirely separate problem. A second area that is not covered in this chapter is the private participation in the social security system which arose through mutuals formed in Chile in the 1950's by businessmen and entrepreneurs in an effort deal with work-related and professional illness.

The first section, prior entering into a description of the reform process itself, provides an analysis of the status of Chile's social security industry as of 1980. The second section deals with the objectives taken into consideration in designing the new social security system. The thirrd section focuses on the measures taken vis-avis the old system and to a large extent addresses the issue of transition. Subsequently, the fourth portion of this chapter contains a description and conceptual analysis of the new system's key attributes, while the fifth section provides an overall assessment of the performance of the industry and of the private pension program based on 10 years worth of operational experience. The sisth and final section addresses the challenges the system will undoubtedly confront in the future.

1. PRINCIPAL CHARACTERISTICS OF THE "PAY AS YOU GO" SYSTEM

A distributive or "pay-as-you-go" pension system is one in which pension funds do not accumulate. Thus, active workers (in conjunction with employers and the government) finance the pensions of retired or inactive workers through obligatory contributions or premiums. That is to say, there is a sort of inter-generational commitment whereby active workers finance the benefits of retirees with the belief that future active workers will finance their own retirements. Although many of the old pension systems were not initially conceived in this fashion, in practice this is the way they have worked.

Under the old system, pension benefits and the obligations of active workers were established by law. Thus, there was no direct relationship between the amount a worker contributed during his/her active life and the pension he/she received. Therefore, there was no incentive for a worker to increase premiums in an effort to secure an enhanced pension. Moreover, such a worker might expect to receive benefits greater than the amount contributed during his or her lifetime if he or she belonged to a group capable of lobbying the government for increased benefits. On the other hand, such a worker could also be affected negatively by the system if he/she were unable to secure additional benefits.In Chile, this lack of a relationship between premiums and pensions received -- which served as an incentive to under-declare income and induced lobbying by certain groups for increased benefits (despite a lack of adequate financing for such increases) -- led to the breakdown of the system and spiraling costs as the government was increasingly called upon to make contributions to the system in order to ensure the ability to meet existing commitments.

I2. BRIEF DESCRIPTION OF PLANS AND BENEFITS

Despite the fact that one often refers to Chile's old pension system as a homogenous unit, the truth is that a number of plans were in operation at the time of the reform. These plans, totaling over 100 in 32 Social Security Funds or "Cajas" in existence in 1979, established a variety of retirement requirements, pension levels and mechanisms for calculating benefits for different groups of workers. The effects of this differentiation were most strongly felt among the poor (Social Security Service or SSS employees) whose premiums accounted for 65% of total in-put in 1979. Nonetheless, these employees did not have access to benefits provided to other workers such as pensions for years of service (which enabled some workers to retire as early as age 42). SSS employees, despite their work in fields requiring heavy manual labor, could retire only upon reaching the age of 65 and, moreover, received a smaller portion of their income at retirement than manual laborers belonging to other cajas. In the Bankers caja, as well as those of the Bank of Chile and the Bank of the State, employees could retire at age 55 (or earlier if they met the "years of service" requirements).

A second problem with the "pay-as-you-go" system was the lack of uniformity in the re-adjustability of benefits. At one end of the spectrum were the so-called "chaser" pensions, reserved for a select group of public employees and other small groups which received the same income as their colleagues still in active service. That is, each time the salary of an active worker in a given post was adjusted, the pension of the retired workers who had held that position in the past would receive an equivalent increase in their pension. The majority of pensions, however, were not hedged against the drop in purchasing power caused by inflation and occasionally legislation was passed to grant a general or partial readjustment.

In addition to the problem of indexation or "re-adjustability" of the benefits granted, the basis used for calculating pensions varied under different plans. These variations, aggravated by high inflation, caused significant differences in coverage. Some retirees saw their pensions calculated on the basis of income over the last year, others on that of the average for the last three years, and still others on the basis of the average over the last five years. In certain cases, only some of those years were adjusted for inflation. For example, in the case of those with five-year calculation periods, the first three years were adjusted for inflation, while the salaries over the latter two were not. Thus, two years of the triple-digit inflation that Chile faced at times reduced the real value of the pension to insignificant levels.

A final characteristic of the old system, that become progressively onerous over time, was the tendency to take advantage of the initial stage of the system by creating new benefits, such as loans. Clearly, such activities drained needed funds from the social security cajas and jeopardized their financial capabilities for the long term. Despite the fact that the old system was designed to provide balanced support, the redistribution of income which resulted from the struggle for special legislation aimed at satisfying interest group demands was clearly regressive.

3. INSTITUTIONS

In 1979, there were 32 social security cajas which grouped together specific types of workers or productive categories. Employees could not select the caja of their choice, nor change cajas unless they shifted into a new line of work. In other words, each institution had a captive market and made no extra effort to provide quality service. The country's three largest cajas accounted for 90% of contributing affiliates (see Table 1).

Source: La Previsión en Chile Ayer y Hoy. Impacto de una Reforma; Hernán Cheyre V.,CEP.

The purpose of the cajas was to administer the funds collected through payroll deductions, pay pensions and provide other benefits. At the time of the reform, the revenue generated by a majority of the cajas was less than their expenditures. In order to bridge the gap and meet outstanding obligations, they turned to the State for financing. Thus, state contributions to the cajas rose by 13.8% between 1947 and 1980 (see Table 2).

Source: Gert Wagner, Universidad Católica de Chile, Instituto de Economía: Estudio de la Reforma Previsional: Previsión Social Chilena, Antiguo Sistema 1925-1980.

In general, the administration of the cajas was inefficient. The slight surpluses occasionally generated by some cajas were poorly invested in hapless efforts to provide instantaneous increases in benefits, such as subsidized mortgage rates (only 1% of EMPART contributors received this bonus benefit), acquisition of properties which could be rented by affiliates at subsidized rates as well as the acquisition of theaters, pharmacies, agricultural lands, etc. Such investments reflected no concern for ensuring adequate counterpart financing and thus the cajas were gradually diverted from their primary objective of granting pensions and fell prey to every imaginable vice inherent in statist and bureaucratic administration.

4. FINANCIAL SITUATION

A "pay as you go" system has essentially three forms of increasing its revenue: 1) Increase premium rates; 2) Increase State allotments; and 3) Decrease benefits. Changes in the ratio between active workers and retirees in Chile required, over a period of time and to varying degrees, the use of all three of these approaches.

In effect, the ageing of the Chilean population, as a result of increases in life expectancy and the incentives of the system itself, meant that there was a continual decrease in the number of active contributors financing the cost of benefits to each retire. Thus, while in 1955 there was an average of 12.2 active contributors for each retired worker, by 1979 that rate had dropped to just 2.5 active contributors per retiree (see Table 3).

Source: Estudio de la Reforma Previsional: Previsión Social Chilena, Antiguo Sistema 1925-1980; Instituto de Economía, PUC.

Moreover, as the ratio between active contributors and retirees fell, the resources generated by the former were insufficient to pay for the benefits of the latter. To make up the difference, State allotments were increased or pension levels were reduced. The growing contributions by the State can be seen in Table 4.

An additional form of confronting the problem of generating resources is to increase premium rates. From its inception in 1925 through 1937, the Social Security Service received 5% of wages. This premium had risen to 51.4% by 1975 and fell back to 33.5% in 1980, the year the Social Security Reform was implemented. In the Private Employees Fund (Caja de Empleados Particulares) the rate from 1924 to 1936 was 10%; by 1974 it had reached 64.7% and steadied at 41% in 1980.

In addition to the economic effects of such increases, the system had negative side effects. For example, if the obligatory rate of savings resulting from payroll deductions is greater than the rate a worker wishes to contribute, incentives for evading premiums emerge. This often results in workers under-declaring their taxable income.

Lastly, there is the option of decreasing pension benefits in order to confront financial difficulties in the pension system. The next section will discuss benefit levels in greater detail. Nonetheless, despite the utilization of the three approaches we have noted here: increased State contributions; increased premium rates; and decreased benefits, it is clear that the Chilean system could not have held on much longer. Each of these approaches had its limits. It is hard to imagine premium rates over 50% or decreases in already-low benefits. In fact, a study conducted by ODEPLAN (National Planning Office) projected the financial situation of the system for 50 years as of 1980. The results showed a deficit of 395 billion (1990 pesos) for the final year under study. It is important to note that this study took into consideration a series of reforms to the old system aimed at diminishing the impact of the future financial deficit. These reforms, which will be discussed in a moment, increased retirement requirements for the most privileged groups and significantly reduced the system's short-term financial difficulties.

5.BENEFIT LEVELS

In general, the level of benefits in real terms was extraordinarily varied under the old system. This resulted primarily from the adjustments provided under some plans (as we have seen, such readjustments were not automatic). Each caja established specific mechanisms for calculating initial pensions for its retirees at the time of their departure from the labor force. In order to compare the plans provided by different cajas, Chilean economist Hern‡n Cheyre estimated the maximum initial pension a contributor could hope to receive as a percentage of taxable income. Thus, a retiree from the SSS could expect to receive 60.8% of his/her salary as an old age pension, while EMPART employees could expect to receive 86.8% (see Table 5).

Source: La Previsión en Chile Ayer y Hoy. Impacto de una Reforma, Hernán Cheyre V., CEP

The lack of indexation made real pensions fluctuate wildly as can be seen in Chart 1. The uncertainty created by such cases worked against contributors.

Evolution of old Age PensionsReal Averages(in 1989 pesos)

The social security system also established maximum pensions. In 1960 the maximum was 8 monthly salaries -- equal to 334,786 pesos (1989 currency) while in 1980 the maximum was 50 monthly salaries -- equal to 220,452 1989 pesos.

The situation in 1980, prior to the social security reform, meant that 70% of retirees were receiving pensions equal to or less than the minimum old age pension of approximately US$30 per month.

6.EFFECTS OF THE SOCIAL SECURITY SYSTEM ON THE ECONOMY

The lack of a relationship between premiums and pension received, coupled with insecurity and the complexity of calculating pensions led premiums to be widely perceived as a tax. The difference between what a contributor was willing to put into the system based on the benefits he or she expected to receive and what he or she was actually required to contribute was technically equivalent to an "implicit tax" on work (given that premiums were calculated on the basis of pay). This "tax" made hiring more expensive, reduced employment and reduced liquid pay.

Redistribution of income under this system occurred among fairly homogeneous workers belonging to a single caja. Thus, the redistribution was horizontal; that is, among people with similar income levels. Therefore, the structures and institutions in use under the old system did nothing to redistribute pension funds toward the poorest retirees (between different cajas). Moreover, as has been noted, such workers faced discrimination in terms of retirement requirements, the method of calculating pensions as well as a lack of re-adjustability. The primary redistribution was inter-generational, whereby some workers gained from increased rates and benefits, while others were clearly ravaged by the system.

One cannot say a priori that the presence of a pension system will affect overall savings, yet it is clear that if a person is required to contribute more toward his or her retirement than he or she would pay voluntarily, there will be an increase in obligatory savings. However, in these cases, obligatory savings may replace voluntary savings in the same amount. In a "pay as you go" system the so-called "stock" of capital is not affected since no accumulation of reserves is required given that active contributors finance the pensions of retired or "passive" workers.

III.REFORM OBJECTIVES

1. OVERCOMING FINANCIAL BANKRUPTCY

As noted earlier, the "pay as you go" system, given the evolution of expenditures, revenue and fiscal support, would have gone bankrupt sooner or later. Such an occurrence would have required State expenditures for social security equal to the total level of fiscal spending estimated for the year 2000. Clearly, the distributive approach was unsustainable and Chile's social security system was in dire need of reform.

At the time of the reform, the fiscal deficit was growing as a result of commitments to the social security system. Within this context, it is interesting to compare a projection for the Chilean deficit had the social security reform not been implemented with a similar projection with the reform in place. In accordance with the aforementioned ODEPLAN study on the financial perspectives of the social security system over a 50-year period, a surplus of $65 billion 1990 pesos was projected for 1981, while a deficit of $395 billion was foreseen for the year 2031. With the reform, however, a 1981 deficit of 261 billion 1990 pesos was expected to plummet to 7 billion by 2031.

From this data it is clear that the shift from a "pay as you go" system to a capitalization system would imposes a high initial financial cost on the State (which no longer receives active contributor input and must continue to pay out the pensions of those who retired under the old system). In the long run however, the situation is reversed and becomes good business for the State. The reason for this is clear: the "pay as you go" system has a financial projection of a growing deficit. With the reform, even though revenue drops because premiums by active workers move to capitalization, the State benefits by not contracting additional obligations with those workers who, in the future, will finance their own pensions.

2.DEREGULATION, NEUTRALITY AND THE SUBSIDIARY ROLE OF THE STATE

Although the State has an obligation to oversee pension systems -- given that it imposes an obligatory level of contributions on workers -- this does not mean that the State must provide the services associated with this type of activity directly. The concept of the subsidiary role for the State which served as a guideline for the economic and social reforms in Chile was also used in designing a new pension system. The reform implemented in 1981 sought to introduce the administration of individually capitalized pension funds in private hands. This created a new industry in Chile and allowed private administrators greater freedom and maneuverability in terms of account management. Nonetheless, the responsibility of the State to oversee and regulate the new-born industry remained intact and a so-called Superintendency was created for this purpose.

Moreover, the concept of the redistribution of income was reformulated. The system was no longer expected to redistribute income (as the benefits received are closely tied to the funds accumulated in each individual account). Rather, programs aimed at assisting the poor, including direct subsidies, were devised. The old system had resulted in a complex system of taxes and subsidies in which it was not clear who benefitted and who was dispossessed. Thus, under the new system, the only linkage between income redistribution and the pension system is the minimum pension established by the State. It is important to note, however, that under this system the State benefits go only to the most needy.

3.IMPACT ON THE ECONOMY

The new system sought to reduce the tax on employment created by high obligatory pension premium rates. The idea was that if the new system were capable of supporting itself financially based on reduced rates of contribution, the cost of hiring workers would drop and over the long-term increased employment could be achieved (as compared to the old system which served as a disincentive to hiring). Moreover, the implicit tax (the difference between what a worker contributes and the amount he or she would voluntarily contribute given the benefits in question) is also lower, by nature, in a capitalization system. Thus the side-effects created by the new system could be expected to generate employment -- a particularly important result given the inability of the Chilean economy for many years to create sufficient employment. In fact, from 1965 to 1970, the increase in the number of private sector jobs created was lower than the increase in the size of the work force.

As noted earlier, the specific impact on overall savings of the shift from a "pay as you go" system to individual capitalization is not clear. Nonetheless, one would hope that the accumulation of capital generated by the new system would be greater, given that the reserves it produces take the form of savings. This in turn means an increase in the "stock" of capital -- with its subsequent impact on capital markets -- and, eventually, the development of the economy. In any case, it is clear that such a system makes it possible to design modern, sophisticated capital markets which arise from the need to invest pension funds. Thus, private pension fund administrators become the largest institutional investors in the market.

4.SYSTEM EFFICIENCY AND BENEFIT LEVELS

Although the objectives noted earlier, namely: resolving the financial breakdown of the old system; moving forward in deregulating the economy; and, converting the social security system into an catalyst for economic growth rather than posing an obstacle to change were important, they were not decisive. Rather, the primary objective of the reform was to provide Chileans with a means of living out their old age in dignity and of confronting disability and death without ravaging the economic stability of the victim's nuclear family. Thus, the key element in designing the new system was that it provide adequate benefits, which in turn necessitated the creation of an efficient framework for administering workers' savings.

Actuarial calculations indicated at the time of the reform that in order for men to retire at age 65 and women at age 60 with a pension equal to approximately 75% of their final year in the labor force, a system was needed that would generate an average profitability rate of 4% in real terms. An efficient private administrator could be expected to achieve this goal.

The efficiency of the new system needed to be based on competition between private pension fund administrators (AFPs), freedom of affiliation and the justify of workers to change institutions. This meant that the administration firms would endeavor to reduce their administrative costs and obtain an increased number of participants through higher benefits and lower commissions.

Logically enough, the assumption was that each AFP would seek to obtain the best rate of return on the capitalization funds it was administering, thereby retaining existing affiliates and attracting new ones.

IV.STEPS TAKEN TO MODIFY THE OLD SYSTEM

The transition from a fully operational "pay as you go" system to one of individual capitalization requires that a series of steps be taken -- some in advance and others in conjunction with the implementation of the new system -- in order to ensure a smooth transition process.

1.UNIFORMITY OF RETIREMENT REQUIREMENTS DECREE LAW 2,448

In 1979, prior to the study aimed at reforming the pension system and, in fact, before the political decision to do so, a decree law (No. 2,448) was approved which sought to make uniform the requirements for old age retirement. An across-the-board minimum age of 65 was established for men while the minimum for women was set at age 60. Furthermore, retirements based on years of service and so-called "chaser" pensions were eliminated. Even if the type of system had not been modified, these changes were needed in order to avert the financial collapse of the old system and introduce greater equity into the benefits offered. Once the decision to revise the entire system was adopted, it became evident that this initial step was of extraordinary assistance in facilitating the transition process given that the age requirements in existence under the old system could be transferred to the new one. Clearly, the new system would have been wholly incompatible with the variable age requirement structure in place prior to the promulgation of Decree Law 2,448.

2.MODIFICATIONS TO THE RATE OF CONTRIBUTION

Between 1973 and 1980, there was a tendency toward a reduction in the rate of contribution to the social security system (as a percentage of taxable income) among some Cajas and the system on the whole (see Table 6):

Source: P.U.C., Instituto de Economía: ÒEstudio de la Reforma Previsional: Previsión Social Chilena, Antiguo Sistema 1925-1980.

Moreover, in early 1981 rates were reduced by 20% for all of the Cajas and employers premiums to the pension system were eliminated. Workers salaries were then increased in the same amount as the employer's premium so that the workers' net income did not vary. This change was made in an effort to clarify the impact the new system would have on workers and to bring home the concept that the system of individual capitalization was based exclusively on contributions made by the worker. Premiums under the new scheme, moreover, could be expected to be lower than those required by the old system. Thus, a worker opting for the new system would immediately perceive the reduction in costs proffered by the new pension system (through an increase in his/her net income.)

3.RETIREMENT RECOGNITION BONDS

With the modification of the pension system, workers were given the option of remaining in the old system or shifting over to the new one. Those agreeing to join an AFP were granted a "recognition bond" in acknowledgement of their earlier contributions to their respective Caja. These "bonds" were offered to all workers who, in the five years preceding the enactment of the social security reform, had made at least 12 contributions per month to any given social security institution. That institution, in turn, issued the "bonds" in the worker's name.

The value of the bond is adjusted for inflation and obtains a real profitability of 4% per annum. These funds are added to those accumulated in the worker's AFP account and are made available solely when the worker has fulfilled existing retirement requirements (except in cases of death or disability).

4.INSTITUTIONS: FORMATION OF THE INP AND CAJA MERGERS

In 1981, the state-run social security system was grouped together into three key institutions (with the exception of the cajas belonging to the Armed Forces and National Police):

- EMPART-SSS: the Private Employees Caja, some smaller cajas and the Social Security Service;

- CANAEMPU-FF.CC. (and Hippodromes): the Public Employees Caja, Railroad Caja and several cajas from the racecourse sector.

- CAPREMER-TRIOMAR: the officers and seamen of the Merchant Marines Caja.

These pension programs were brought under the sole jurisdiction of the Ministry of Labor and Social Security which was responsible for appointing caja directors. Supervision and control of these organizations fell to the Superintendency for Social Security.

Furthermore, an Institute for Social Security Normalization (known by its Spanish acronym, INP) was created to propose measures aimed at reforming the system, reconstructing individual accounts to enable the amount of recognition bonds to be calculated and administering a special fund (composed of State contributions, income generated by the sale of the assets of some institutions and investments) to be utilized to cover the deficit generated by the institutions functioning under the old system as well as the payment of recognition bonds transferred to the new system. Thus, by 1988 the three key social security groups mentioned above had been fused into a single institution under the direction of the INP.

5.RELIEF PENSIONS

In 1974 a system of relief pensions aimed at the aged and the handicapped with limited resources and no insurance was implemented. Specifically, such pensions were granted to handicapped persons over age 18, those over 65 and the mentally handicapped of all ages (so long as the latter were not generating family-oriented subsidies). In order to qualify, applicants were required to possess either no sources of income or independently-generated income of no more than 50% of the minimum pension if they lived alone. For those residing with family members, the total family income could not be greater than 50% of the minimum pension.

V.THE NEW PENSION SYSTEM

1. INDIVIDUAL CAPITALIZATION: WHY CHANGE THE SYSTEM?

The adjustments introduced into the pension system by Decree Law 2,448 made uniform the requirements for retirement and helped solidify the system's long-term financial stability. Thus, one must ask why Chile continued to push forward with a reform process aimed at modifying the very nature of its pension system. The response is quite simple. Evaluations conducted at the time showed quite clearly that the problems with the "pay as you go" system arose from its very conception and that specific efforts to correct some of its most negative aspects ran the risk of being repeated over time with new modifications which might once again put the system's financial health in jeopardy. Such modifications could include discriminatory norms and other actions resulting in an unjust, inefficient, bankrupt pension system.

In essence, the destruction of the old system was inherent in its design: by eliminating ties between premiums and the level of benefits received, the system served as an incentive for individual interest groups to press for special legislation aimed at improving their benefits without a corresponding increase in premiums. One way of demonstrating this relationship is to compare the ratio between active workers and retirees in the old system with those of the country as a whole. While in 1960 the relationship was 8.6, in 1975 it reached just 2.5. From this data one might conclude that a large demographic shift, resulting in a substantive increase among the aged, caused the system's financial breakdown. However, in 1960 the population over age 60 represented just 15.58% of the population aged 20-60. In 1980 this relationship stood at 16.74% -- a notably undramatic shift -- indicating that the system was designed to offer benefits beyond its ability to finance them. If Chile had rested on the results of Decree Law 2,448 there was no reason to believe that in another 50 years the system might not once again face a similar crisis (as a result of subsequent legal modifications, the pressure for which, as we have seen, was inherent in the old system).

2.PRIVATE ADMINISTRATION: THE NEW AFPs, EXCLUSIVITY AND DOMAIN

Once the decision had been made to replace the "pay as you go" system with an individual capitalization program in which benefits were to bear a direct relationship to premiums, there were in essence two potential ways of organizing the new system: insurance or capital accumulation.

a.Insurance or accumulation?

An insurance-based system means that a worker contracts with an insurance company to receive a pension in exchange for payment of a periodic premium (retirement contributions). The relationship between the premium and the pension is essentially determined by long-term market interest rate in effect at the time the agreement is signed. The primary advantage of this system for the worker is that he/she will know exactly how much pension money will be available upon retirement. However, this system represents a tremendous risk for the insurer who has to set a long-term variable. Moreover, in the Chilean case, the situation was further complicated by the underdeveloped and exclusively domestic financial market in which long-term investment instruments of this type were rare.

Since the Chilean capital markets did not offer good investment options, insurance companies might have been able to off-set their risks through large capital holdings and reserves. However, such a procedure would have created a barrier to market participation, thereby limiting competition. In addition, given that there was a risk of an imbalance of funds -- resulting from the rigid economic environment which the insurance companies would not be able to overlook -- in all truth the economic risk would have remained even if it could have been off-set financially by increased capital and reserves. These conditions led policy designers to believe that such a system could increase operational expenses to the point of making it inviable.

The better option, then, was the accumulation of funds, setting a minimum premium and allowing the amount of the pension to be the floating result of the profitability of the investments made with the funds accumulated in an individual account. Thus, while the risk to the worker would be greater under this system, the overall risk for the system was modest. Moreover, the accumulation system ensured greater competition since did not require large amounts of investment capital. In an effort to compensate for the risk undertaken by individuals, mechanisms were implemented that allow additional voluntary contributions to increase the amount of the pension and the option of moving forward the retirement date.

b.Administrative Institutions

In order to administer the system, private institutions were needed. These institutions, in turn, would have to be efficient in order to remain competitive. The idea of granting administration to banks, through a trust, was discarded for practical reasons. At the time of the 1980 reform, there were doubts as to the financial stability of the banks and the efficiency of existing banking supervision mechanisms. Two years later, a crisis in Chilean capital markets proved that the decision had been a good one. Furthermore, the question of a possible conflict of interest arose given that bank deposits were one of the logical investment options for social security funds.

Thus, Chile's policy planners opted for a system administered by new private institutions, so-called AFPs, which were created specifically for this purpose, with exclusive domain over retirement funds. An oversight agency was also created, the Superintendency of AFPs, whose staff was small and highly qualified. The time lag between passage of the new legislation and the starting date of the new system gave private investors time to design the new institutions. The AFPs were to be financial intermediaries or "mandatees" of the funds they were administering (rather than the owners of said funds). Thus, a separate "Pension Fund" was created as an independent patrimony in which worker premiums and investment profits were to be kept.

Naturally, the question of whether AFP-style institutions with exclusive domain are the best alternative for administering this type of system is open to debate. Insurance companies or financial institutions engaged in similar areas of business might also be valid options, depending on conditions in any given country.

3.INVESTMENT: PROFITABILITY, RISK, DIVERSIFICATION AND GUARANTIES

The level of benefits, and therefore the merit of the system, depended on the profitability of the investments made. As we have said, actuarial calculations indicated that in order for men to retire at age 65 and women at age 60 with a pension equal to approximately 75% of their final year of income, a system that provided real profitability of an average of 4% per annum was needed. This figure appeared to be well within the realm of possibilities for the Chilean economy. The next matter was to formulate a portfolio of investment instruments available to the AFPs that would enable them to achieve this rate of return.

The objectives of profitability and competition to attract affiliates had to be compensated with the protection that contributors' payments warranted. Workers were being required to save for their pensions and therefore a supervisory agency was created to oversee the system. Furthermore, investment diversification regulations were established in order reduce risks. Investment options and limits were established by law. Initially, the options were oriented toward debt instruments, especially public debt. There were three reasons for this: first, there was a need to generate trust in the system (investments in paper backed by the State would achieve this); second, it was a way of relieving the cash-flow problem generated by the social security reform itself; and third, capital markets at the time did not offer other options (this modus operandi would give the market time to develop other alternatives).

Eventually, new investment options were opened up to AFPs, among these corporate stocks were particularly important. This helped to broaden fund options, allow for higher profitability rates than those granted by set-income instruments as well as to reduce Chile's debt-capital relationship by capitalizing companies which had been affected by the crisis of 1982. Lastly, the option of investing in private stocks was of particular use to the government in moving forward with its policy of privatizing state-owned companies. The availability of institutional buyers for the shares issued by these companies was a distinct boon to the privatization program which required large-scale purchases and vast purchasing power.

From the start, the system included regulations on diversification, establishing limits on investments issued by a single party and limits on types of instruments. Later it became clear that investment instruments needed to be classified and, given their fluid nature, a risk classification commission was created.

These mechanisms ensured reasonable safety in the investment of pension funds. In addition, two mechanisms were created aimed at ensuring a minimum profitability for pension funds. The first consisted of establishing a maximum deviation a given AFP's profitability on investments could have as compared to the system's average. For this purpose, a profitability fluctuation reserve was created as a part of the fund with monies obtained through excess profits generated at an earlier date. If profitability for a given period drops below the maximum permissible deviation, reserve funds are utilized. Should the drop be greater than the available reserve funds, monies from the system's required reserves (equal to 1% of Pension Funds) are utilized. As of the time of this publication, this had occurred only once in the 11 years the system has been in operation.

The second "safety" mechanism is the State's guaranteed minimum pension. If, with all of the other mechanisms mentioned above in effect, an affiliate reaches the end of his/her active life with a total pension lower than the minimum established by law, the State will make up the difference so long as certain basic criteria, in terms of the number of years of contribution, are met. Thus, the State's contribution reaches only the most needy, making the system solidary; a true network of support between the wealthy and the impoverished.

4.BENEFITS: TYPES OF PENSIONS, LIFE-TIME INCOME, SCHEDULED WITHDRAWALS

The new social security system was designed to provide three types of benefits: old age, disability and survival. The variety of needs affecting each of these categories determined the new framework in which these benefits were to be provided.

Old age, at least in chronological terms, is a fact of life. Thus, old age pensions can be covered through an accumulation of funds as described above. In order to achieve this accumulation, a minimum obligatory contribution rate of 10% of worker income was established to finance an old age pension (additional contributions are voluntary).

Affiliate disability or death, on the other hand, are not predictable occurrences and may occur at any time. Thus, it is possible that an affiliate may not have sufficient funds accumulated at the type of the mishap to ensure a pension that bears some resemblance to his/her level of income. Therefore, insurance is required. AFPs periodically acquire insurance to provide affiliates with disability and survival pensions should tragedy strike (an additional variable fee which fluctuates between 2% and 3.75% is charged). The relationship between this insurance and income level is established by law. The additional fee for these benefits is part of the AFP's pay and therefore has become one of the areas in which the Administradoras compete for affiliates. Furthermore, the AFPs may charge affiliates commissions to cover administrative costs.

a.Disability Pensions

Non-retired affiliates who do not meet the minimum age requirements for retirement who lose at least 50% of their work ability, either through illness or the weakening of their physical or intellectual strength, are entitled to disability pensions. A committee of three physicians appointed by the Superintendency of AFPs, through its offices around the country, determines whether a person qualifies for a disability pension. In order to be declared completely disabled, the loss of capabilities must be over 66%. Other affiliates losing over 50% but less than 66% of their capabilities are considered partially disabled. The legislation also contemplates "transitory disability," which entitles the affiliate to a three-year pension. Upon completion of the three year period, a second review is conducted to determine whether such benefits will be retracted or whether a permanent disability pension will be granted.

b.Survival Pensions

Benefits are provided to affiliates' survivors. No differentiation is made as to whether the affiliate is active or retired at the time of passing. Pensions are granted to widows/widowers, orphans, mothers of children born out of wedlock and the mother or father of the affiliate if there are no other beneficiaries.

c. Withdrawal Options

Old age retirement occurs when certain requirements have been met such as age (65 for men, 60 for women) or when the amount of accumulated funds allows for early retirement. In the latter case, the amount of funds required is tied to before-retirement income so as to ensure that early retirement affiliates will not become a burden to society in the future nor suffer a dramatic drop in living standards.

Affiliates who fulfill old age or disability requirements and survivors of deceased affiliates may make use of the funds available in an individual account in order to form a pension in the following fashions:

- Immediate Life-Time Income

The funds accumulated in the individual's account are transferred to a life insurance company chosen by the affiliate in exchange for a life-long monthly payment expressed in readjustable monetary units. A survival pension for beneficiaries is also contemplated in this agreement. In order for the affiliate to select this option, the pension offered must be equal to or higher than the minimum monthly pension established by the State.

- Scheduled Withdrawal

Accumulated funds remain in an account with the AFP and monthly withdrawals in readjustable monetary units are made in accordance with a pre-established schedule that is recalculated annually. Under this system, there is no life-time insurance, rather the value of the pension is recalculated annually in accordance with the retiree's life expectancy. In this sense, it is less "certain" since the amount of the pension may drop over time if the retiree lives longer than the initial life expectancy calculations would have indicated. However, this option does have two important advantages: 1) larger pensions may be obtained during the early years of retirement; and 2) any funds remaining in the account after the affiliates death may be transferred to his/her legal heirs.

- Temporary Income with Differed Life-Time Income

A combination of the other two options. The affiliate takes out insurance for a monthly life-time income as of some future date established in the contract and leaves sufficient funds in an AFP account so as to insure a Temporary Income until the date the life-time income payments begin.

VI.PERFORMANCE OF THE NEW SYSTEM

1. IMPLEMENTATION

Implementing the new system naturally posed a series of challenges. First, there was a need to have qualified institutions with state-of-the-art technology capable of managing the vast quantities of information inherent in an individual capitalization program in an efficient and accurate fashion.

The system, moreover, needed to be prepared to confront a start-up period characterized by high levels of unawareness and misinterpretation among workers, employees as well as considerable disarray resulting from the competition among AFP sales forces in their effort to gain affiliates.

Thus, it was crucially important to confront these challenges with an oversight agency which would be strong enough to manage the system but was committed to the advantages of private administration. Such an agency would set operations regulations for the AFPs aimed at fostering trust the system's credibility and security among affiliates and employers alike.

Furthermore, such an agency needed to have both a profound understanding of the nature of the system and creativity in order to implement on-the-spot adjustments to correct weaknesses in the system as they emerged. Superintendency of AFPs, created for this purpose, was able to provide these services through its small but highly qualified and knowledgeable staff.

2. INDUSTRY CHARACTERISTICS

In 1981, the first year the new system was operational, 12 Administradoras de Fondos de Previsiones (AFPs) were formed. As of December 31, 1990, that is, almost ten years later, 14 AFPs were in operation, dividing among them a market of 3,739,544 affiliates. The annual average rate of affiliation, 10.3%, takes into consideration the initial rush when the AFPs commenced operations, a pace that has stabilized over time. The evolution of affiliates can be seen in Chart 2.

a. Market Participation

Of the 3,739,544 affiliates, the three AFPs with the largest market share are Provida (29%), Santa Mar’a (20.1%) and Habitat (17.1%) which comprise 69% of the pension fund market (see Chart 4).

Chart 2Evolution of affiliation inthe New System

Chart 3Affiliates by Sex(as of Dec 31, 1990)

Chart 4Market share of Affiliates(as of Dec 31, 1990)

In 1981 the three largest AFPs accounted for 73% of affiliations to the new system, thus, it is apparent that over time a certain dispersion has occurred.

b. Resources Administered

In December 1990 the resources accumulated in pension funds totaled over 2.4 billion pesos, reflecting a growth rate of 33% in real terms as compared to the previous year and an average annual growth rate of 42% as compared to December 1981 (Chart 5).

c. Premiums and Commissions

The commissions charged by the AFPs have tended to decline over time while the 10% basic premium rate has remained intact. Furthermore, a percentage commission based on annual account balance was eliminated in 1988 (Chart 6).

Chart 5Funds Accumated as of December of each year($ as of December 1990)

Source : Bolet’n Estadistico Mensual S.A.F.P.

Chart 6Evolution of Fixed Commission(in December 1990 $)

Evolution of Percentual Commission(Annual % of account balance)

Evolution of Additional Contributions(% of taxable income as of Dec. of each year)

Evolution of Basic Contibution(monthy % of taxable income)

Source : Bolet’n Estadistico Mensual S.A.F.P.

d. Results of the AFPs

The operating profits of the system for 1990 totaled over 15.6 billion pesos. Provida showed the highest operational profit at 6.037 billion, while Futuro registered the smallest profits with 5.3 billion (Chart 7).

Chart 7Operating Profits of AFPs for 1990

e. AFP Employees

As of January 31, 1991, there were 11,565 people working for AFPs, including sales staff. This figure nearly triples that of December 1982 (Chart 8).

Chart 8Number of workers per AFP(As of Jan 31, 1991: includes sales force)

Source : FECU as of Jan. 31, 1990

3. PENSION LEVELS

As can be seen in Chart 9, the average pension paid by the new system for all types of pensions are higher than those paid out by the cajas under the old system. Average pensions in December of 1990 were: old age, $34,182; disability, $63,916; survival, $27,752; and orphanhood $9,474. The differences between the AFP system and the old one amount to 1.4 times for old age, 2.2 times for disability, 1.5 times for survival and 1.4 for orphanhood pensions.

Chart 9Average Amount Paid by the New Systemand the "Cajas" in Dec 1990

Source : Bolet’n Estadistico Mensual S.A.F.P.

Furthermore, the number of pensions paid out rose from 4,465 in 1982 to 79,946 in December of 1990 as a result of the maturation process the new system is undergoing (Chart 10).

Chart 10Evolution of the # of pensionspaid in Dec. of each yr.

Source : Bolet’n Estadistico Mensual S.A.F.P.

4. PROFITABILITY OF INVESTMENTS AND IMPACT ON THE CAPITALS MARKET

The profitability of investments made by the AFPs can be measured by the profitability of monthly premium as reflected in the fluctuation that those contributions undergo. Thus profitability evolution has been as follows (see Chart 11):

Chart 11Real Annual Profitability of payments(adjusted for CPI and "UF")

Source : Bolet’n Estadistico Mensual S.A.F.P.

This data shows a real, annual, system-wide profitability rate of 13% between July 1981 and December 1990. The AFP obtaining the highest profitability reached 14% while the lowest came in at 12.5% (see Chart 12).

Chart 12Annual Average Accumalated Profitability July 1981 - Dec. 1990(adjusted for UF)

Source : Bolet’n Estadistico Mensual S.A.F.P.

For the period January-December 1990, the system's real average profitability rate was 15.6%, with a range among different AFPs from 13.3% to 19.4%. (See Chart 13).

Chart 13AFP Profitability in 1990(adjusted for UF)

Source : Bolet’n Estadistico Mensual S.A.F.P.

Although profitability is hard to predict over the long term, the very fact that these levels have been achieved provides an initial endorsement of the system since future pension levels will be even higher than early projections, representing a significant improvement over the old system. These factors can be expected to consolidate the Chilean social security reform as a highly successful experience.

a. Impact on Capitals Markets

The impact of the social security reform on capital markets has been extraordinarily important. Investments made by the AFPs have changed the structure of Chile's financial and stock markets. For example, as of September 1990, 56.1% of mortgages and 53.9% of corporate bonds were held by Pension Funds. From this, we can deduce that pension funds are helping to finance homes and investment in private companies in addition to their participation in other areas of the economy. In October of 1990, pension funds accounted for US$564 million (8.9% of total Fund investments) worth of shares. By June of 1991, that rate of investment had increased to almost 1.7 billion, representing 19.9% of the Funds' total. The AFPs have served as important institutional investors, providing an additional source of financing for the entire economy and serving as a key element in the development of an efficient, transparent capital market in Chile.

In December of 1990, the accumulated monies in Pension Funds totaled 2,244,481,000, equivalent to 26.6% of GNP. In 1982, that ratio had been only 3.6%. Compared with financial liabilities, these funds represented 19.5% of the 1990 total whereas in December of 1982 they represented 5.3%. Lastly, in December of 1990 pension funds represented 44.6% of new investments made in the financial system; in December of 1982 that figure had stood at just 4.4%.

Another aspect worth noting is the impact, both in quantity and quality, of the presence of large quantities of pension funds on the life insurance market. In 1990, sales-generated income for life insurance companies totaled US$492 million. Of this, US$92 million was in sales to AFPs for affiliate disability and death coverage, while US$300 million was in sales of life-time income plans, one of the pension options established by the legislation that created the AFP system.

The 2,244,481,000 pesos accumulated as of December 31, 1990 were invested as shown in below (see Chart 14).

Chart 14AFP Inestment Portfolios

VII. REMAINING CHALLENGES

The success attributed to the new system by a broad range of observers and analysts does not mean that challenges do not remain. The system's natural evolution and the evolution of the context in which it develops (the Chilean economy), give rise each day to new challenges which must be overcome. Some of the key issues currently under discussion in Chile are as follows:

1. PENSION FUND INVESTMENTS

The challenges facing pension funds for the future are tremendous. The magnitude of the funds and their rapid growth have meant an important and expanding demand by the AFPs for additional investment options. However, the number of potential financial instruments is limited, expands slowly and is further complicated by the restrictions on how and where AFPs can invest the nation's pension funds. Clearly, ways need to be found to increase the types of investment options available and adjust to the AFPs growing needs. In order to do this, the private sector needs to make every effort to increase investment possibilities while the public sector must seek to create the necessary conditions and loosen regulations on investing in new or existing instruments in an effort to ensure an adequate supply of investment options for the AFPs until pension fund growth stabilizes. Naturally, the level of pensions AFPs are able to provide their affiliates will depend to a large extent on the availability of attractive investment options.

Chile's Pension Funds are growing at over US$200 million per month and accumulated monies now total close to US$10 billion. In five years, this figure could double. The most immediate effect is that existing authorized investment options for AFPs (consisting of Central Bank and Treasury documents, mortgages, corporate bonds and debentures, CDs with financial institutions and stocks), with their classifications and limitations, are already fairly saturated. The lack of options could lead to an over-investment in these types of instruments. This would clearly not be healthy for the capital market nor for the economy as a whole. For example, analysts have attributed the consistent rise in stock market price indexes to the unwavering and growing demand for instruments in which to place pension fund monies. As noted earlier, in October of 1990 Pension Funds accounted for US$564 million (8.9% of total Fund investment) in stocks. By June of 1991, that rate of investment had increased to almost 1.7 billion, representing 19.9% of the Funds' total. In other words, an increase of over 1 billion dollars in just eight months.

The new options under study are: participation in the financing of public works through private concessions; financing of new investment projects; investment funds; and risk capital. All of these options, assuming appropriate operating mechanisms are found, appear to be interesting. In fact, the primary element under discussion is what instruments will be used to permit pension fund monies to be utilized in this type of investment. It seems that bonds which can be converted into shares may be the best way of entering into these new fields.

Another option put forth by some analysts is the possibility of investing pension fund monies in the commodities market, such as futures and options.

A third clear option is investment abroad. According to existing legislation, the AFPs may invest between 1 and 10% of pension funds in instruments emitted abroad. Nonetheless, the Central Bank, the Risk Classification Commission and the Superintendency of AFPs have not yet reached the agreements necessary nor issued regulations which would make this system operational. Nonetheless, at the time of publication, such changes were under active study. The existing regulations allow for AFPs to invest abroad no more than 1% per year of their funds over a five year period. The percentage of investment may then be increased to 10%. The Central Bank is responsible for setting the maximum limits for overseas investments in any given year so long as that limit is within the bounds of the law.

A study conducted by Chilean economist JosŽ Ram—n Valente and published by the Center for Public Studies (CEP) suggests that allowing pension monies to be invested abroad would increase the rate of return and significantly reduce risk.

If funds were invested in accordance with current legislation (which excludes stocks), Valente concludes that pension levels could be increased by 18%. If the legislation were modified to permit investment in stocks, the study projects that the increase in pensions could reach over 40%.

Clearly, the most important issue the Chilean social security system faces today is how to expand options for investing the vast quantities of funds being generated, including the option of investing abroad. The breakdown of the old system, as we have seen, was caused by a variety of factors. However, the most important effect of its collapse was to sentence a generation of Chileans to living out their old age in precarious conditions. Any measure which, based on rational criteria, offers the possibility of increasing pensions under the new system serves as a guarantee that history will not repeat itself.

2. NEW PRODUCTS, EXCLUSIVE DOMAIN AND MARKET EXCLUSIVITY

Just as the possibility of opening up new areas of investment for AFPs has been under study, so has the option of allowing them to offer new products to affiliates. The argument in favor of permitting them to do so sustains that, given that such a long time goes by between the date contributions commence and the date of retirement, affiliates feel out of touch with their AFP. Increased levels of affiliate identification, based on new products, are said to enhance the perception workers have of the system. Such an attitudinal shift, the argument affirms, would help to strengthen the system overall. Detractors note the temptation of utilizing the accumulated monies to provide benefits which in the long run will only reduce the value of pensions. After all, they say, the system was created to provide pension benefits. In any case, we cannot overlook the fact that this is precisely what happened under the old system.

The authors of Chile's social security legislation believed strongly in the latter argument and thus AFPs were not authorized to provide any other type of benefit. In 1988, however, a special voluntary savings account was introduced. These accounts are managed separately from the obligatory contributions and withdrawals can be freely made up to four times in a calendar year. This form of savings also has certain tax benefits. Subsequent modifications made it possible for funds accumulated in these accounts to be considered part of advance savings required for Chileans to apply for State housing subsidies. Clearly, these new products do not endanger the end goal of providing quality pensions to affiliates. However, the challenge of creating a greater sense of identification between affiliates and their AFPs persists.

The issue of the exclusive domain of the AFPs has given rise to a second debate. If AFPs are permitted to move into other areas, why not allow other institutions, such as banks and insurance companies, to participate in the administration of pension funds? Although a profound analysis of this matter is beyond the purpose of this publication, it is worth mentioning two elements which must be taken into consideration in analyzing this situation:

a. The decision to adopt an exclusive domain for AFPs, as we have said, was made on the basis of a series of practical considerations dealing with the overall objectives of the system. Those objectives were, essentially, to provide good pensions within a reasonably secure framework for affiliates and to work within the bounds of the financial markets existing in Chile at the time of the reform. These objectives continue to be valid. In order to analyze the situation properly, one would have to review whether the current situation in Chile's financial markets meets the demands these objectives impose.

b. There would be a conflict of interest for some institutions interested in entering the social security field given that many of the AFPs investments are channelled through banks and life insurance firms. In order to permit participation by these institutions, a review of existing regulations would have to be conducted to see if affiliates interests would be sufficiently protected.

3. COMPETITION: PRICES, COMMISSIONS AND TRANSPARENCY

Competition in the AFP market is crucial to the extent that it ensures that private firms participating in the industry will seek to be as efficient as possible. Consumers, in this case the affiliates, look for the AFP which offers the most attractive conditions. Thus, competition in this industry emerges in the effort to provide the best services and, naturally, the lowest prices.

The commission structure AFPs utilize to charge their affiliates is fairly complex, and thus the pricing structure is equally complicated. In other words, affiliates do not have access to fully transparent information. With the initiation of the system, AFPs were authorized to charge commissions for the deposit of periodic premiums, individual account maintenance, transfer of the balance to another AFP and for withdrawals made under scheduled withdrawal plans. These commissions could be either pre-set or percentage-based.

The complexity of the problem has diminished over time with the simplification of commissions structures. At present no fee is charged for account maintenance or for withdrawals while fees for account transfer are rare.

Set commissions affect the balance accumulated in individual accounts, while percentage-based fees are calculated on the basis of contributors net income. The composition of commissions has varied over time, thereby increasing the importance of those which affect net income. In any case, following an increase between 1981 and 1983, cost of commissions has tended to drop.

The book Ten Years of History for the AFP System, published by AFP Habitat, contains a broad range of information on the development of AFPs which was compiled by a team led by economist Augusto Iglesias. Their data on commissions indicates that in 1983 the average cost to a contributor was 5% of pay and that by December of 1990 that figure had dropped to just 3.2%.

The challenge in this sense is to devise the simplest possible price structure, thereby providing accurate information to affiliates on the conditions offered by each AFP. The idea is not, however, to limit excessively the items for which AFPs may charge commissions, as these items must be representative of the costs that an AFP effectively encounters in administering affiliate accounts.

4. OLDER GENERATIONS

Lastly, a word about the older generations may be of use to others designing a social security reform. The new Chilean pension system was not aimed at solving the problems of those who had retired under the old system. Thanks to its design and capitalization-based concept, the new system was conceived as a way of avoiding the retirement trauma of the eldery among future generations of Chilean retirees. Thus far, the system has been successful in achieving this goal.

This perspective, which is conceptually clear to any country which has accumulated oversized liabilities, is not always understood, particularly among older retirees. Thus, in practice, government authorities cannot ignore the often dramatic situation of those who retired under the old system, even after a social security reform has been successfully implemented. In other words, a reform, no matter how well conceived, cannot be the panacea for all of the social security problems a country may face.