The Chilean Pension System: A Renewed View

Guillermo Larrain Rios

Superintendent of Pension Funds, President of AIOS

Washington, February 2005

Chilean Pension Funds have grown steadily and

impressively

0

10.000

20.000

30.000

40.000

50.000

60.000

70.000

Años

MM

US

$ d

e D

icie

mb

re d

e 2

004

0%

10%

20%

30%

40%

50%

60%

70%

Pension Funds % of GDP

Coverage with respect to Labor Force

0%

20%

40%

60%

80%

100%

120%

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Nov-2004

Afiliados/ Fza.de Trabajo Cotizantes/ Fza.de Trabajo

Afiliados Cubiertos/ Fza de Trabajo (1)

Chilean Pension Funds have grown steadily and

impressively

Rates of return on assets

-5%

0%

5%

10%

15%

20%

25%

30%

35%

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

Años

Po

rce

nta

jes

Fondo A Fondo B Fondo C Fondo D Fondo E

Chilean Pension Funds have grown steadily and

impressively

Macroeconomic impact of pension funds: analytics

The Corbo/Schmidt-Hebbel model

Pension Reform

Labour Market

Financial Developmt

Saving Investment

TFP

Total employ-

ment

Formalization

Public financing of

transition

Growth

Note these causalities!

Macroeconomic impact of pension funds: estimates

Med.

GDP growth (average 80-01)

4.6

Effects of reform: Savings + Investment

0.13

Labour Markets 0.10 Financial developmt + TFP

0.20

Total contribution 0.49

3,1 3,1

1.0

0,5

0

1

2

3

4

5

"Initial growth", 1960-80 Average growth 1981-2001

Initial Not explained Linked to reform

Three general considerations about the Chilean model

1) Demographics– The old Chilean PAYG system was in crisis: 32

regimes, regressive, underfunded– The AFP model started before the current

demographic transition appeared – From an actuarial point of view, DC systems

are better prepared to adapt to the new demographic paradigm than DB systems for the simple reason than in the latter benefits are defined according to the dynamic of politics not of demographics and, obviously, they need not coincide

Three general considerations about the Chilean model

2) Transitional costs– New workers to new

system; strong incentives to older workers: real wage increased for workers and employers´ contribution ceased.

– Fiscal deficit, persistent and long lasting

– Expenditure cuts in other areas to accommodate it.

– Specific political situation of Chile

Pension system déficit (% GDP)

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

Old system fiscal support Recognition bonds Total

ForecastHistory

S

Dt

Dt+DFP

S’

3) Complementary reforms and markets:Pension reform is not a miracle. WSJ (dec 22, 04)

“True entitlement reform, in other words, would be more than just an

adjustment to the federal fiscal situation. IT WOULD REFORM DEMOCRACY AND EVEN THE

CHARACTER OF THE ELECTORATE ITSELF"

p

F

Three general considerations about the Chilean model

Some institutional requisites for diversification

Fixed income: Mortgage. Corporate.

Variable Income Corporate culture, accountability Corporate governance Minority shareholder´s rights

1. Inflation protection (Macro stability)

2. Investment opportunities

3. Contracts: stable judicial framework

4. Tax distortions minimized.

5. Risk classification… etc…

6. etc…

Exogenous problems: Labour Markets

• Lifetime employment is over, job rotation, frequent unemployment episodes.

• This does not affect people equally: employability differ according to education, economic sector, family linkages etc…

• Poorer workers, more exposed to uncertainties.

• Important characteristic of the labor market : its duality.

Distribution of affiliates after densities

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1 2 3 4 5 6 7 8 9 10

Décil de densidad

% d

e af

iliad

os

Decil Salario 10

Decil Salario 9

Decil Salario 8

Decil Salario 7

Decil Salario 6

Decil Salario 5

Decil Salario 4

Decil Salario 3

Decil Salario 2

Decil Salario 1

Exogenous problems: Labour Markets

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

15-19 20-24 25-29 30-34 35-39 40-44 45-49 50-54 55-59 60-64 65 ymás

Age

Dens

ity o

f con

tribu

tions Low

High

– natural reluctance of many workers to contribute for pensions

– proliferation of formal self employed workers: require savings to be liquid in case of need while pension assets are extremely illiquid

Exogenous problems: women, a special case

• Start working later • Earn less (for same

skills), • Retire earlier• Live longer

• Chile has lowest female participation rates, slow change in this

Distribución Vida Potencialmente Activa

19%7%

60%

46%

8%

8%

4%

5%

35%

10%

0%10%20%30%40%50%

60%70%80%90%

100%

Hombre Mujer

Inactivo

Desempleado

Sin contrato

Con contrato

Independiente

Exogenous problems: Life expectancy

• For given savings, now must finance more years

• Consequence: pensions are smaller

• Two contradictions: people live longer… – and retires earlier – and feel better:

old age jobs!

Endogenous problems: accumulation and

disbursement

Accumulation phase:

a) AFP (P2)

b) Voluntary (P3)

Disbursement phase:

a) LIC

b) AFP

P1: Solidarity through State

Endogenous problems:competition and

concentration• Two design problems impact competition:

– Inelasticity of demand: mostly explained by the mandatory character of the product sold. The pension market is artificial, there is no spontaneous demand for it and that´s why people do not pay much attention to relevant variables in this market specially while they are young.

– Economies of scale: typical in financial sectors but more present here due to the necessary exclusive nature of the commercial firm that distribute pensions.

Reforming the reform 1: Multifondos

• At the beginning there was only one portfolio

• Strict regulation on limits

• Minimum relative return

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Oct-0

3

Sector Extranjero

Sector Empresas

Sector Financiero

Sector Estatal

Reforming the reform 1: Multifondos

• Herd behaviour appeared (more than elsewhere)• Two opposing views on that:

– minimize likelihood of individual errors of judgement: safety element.

– as portfolios do not vary, nor do returns. AFPs offered only one portfolio, very similar to each other.

• From the perspective of the affiliate:– the benefit of being informed was smaller compared to

the cost of doing it. The management of pension savings started to look more as a commodity inducing further indifference.

– People received statements but it was useless: desinformation

• 93% declared they did not know the price • 56% declared ignorance of the balance of their personal

accounts• 54% of men and 64% of women declared that they have

never changed from one AFP to another

Reforming the reform 1: Multifondos

80

20

60

40

40

60

20

80100

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Perc

enta

ge

Fund A Fund B Fund C Fund D Fund E

Variable Income Fixed Income

0

5.000

10.000

15.000

20.000

25.000

30.000

Up to

20 20-2

5

25-3

0

30-3

5

35-4

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40-4

5

45-5

0

50-5

5

55-6

0

60-6

5

65-7

0

70 an

d Up

Fondo A

Fondo E

Reforming the reform 1: Multifondos

Rentabilidad real y Riesgo de cada AFP y Tipo de Fondo(Septiembre 2002 - Agosto 2004)

4B5B

1B6B

5C3C6C6D

2D4D5D3D

2E

1E6E

4E3E5E

1A6A

5A

3A

2A

4A

3B2B1D1C

4C2C

0%

5%

10%

15%

20%

1% 2% 3% 4% 5% 6% 7%Riesgo anualizado (desviación estándar)

Rean

tabil

idad

real

anua

lizad

a

•Herd amplified 5 times.

0

5

10

15

20

25

30

35

Returns Price Help salesperson AFP image Gift Friend´srecommendation

Doesn´t know

apr 2001

sep 2004

Reforming the reform 2: The Scomp

3,4%3,6% 3,5%

4,7% 4,7%

5,6%5,3% 5,5%

5,8% 5,9%

2,7%2,4%

2,7%

3,9%

0%

1%

2%

3%

4%

5%

6%

7%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sep-04

Summary

• Chile has a succesful pension system. In spite of that, I requires reform in three areas:– Coverage: independent workers, first pillar– Industrial organization: diminish barriers to

entry– Investment regime

The Chilean Pension System: A Renewed View

Guillermo Larrain Rios

Superintendent of Pension Funds, President of AIOS

Washington, February 2005