Pension Reform in Chile

Pension Reform in Chile DAVID BRAVO, P.Universidad Católica de Chile (david.bravo@uc.cl) International Workshop on Pension Reform: Global Trends and China s Experiences The Institute of Population and Labor Economics-Chinese Academy of Social Sciences Beijing, October 15-16, 2017

This presentation: I. The Chilean Pension System since 1981 II. The 2008 reforms III. The 2014-2015 Presidential Advisory Commission IV. Diagnosis V. The Commission s Global Proposals VI. The Commission s Specific Recommendations VII. Proposals, impacts and costs VIII. Political Context and Current Debate

I. The Chilean Pension System since 1981

I. The 1981 reform Chile introduced mandatory funded individual accounts in 1981, provided by private specialist firms (Administradoras de Fondos de Pensiones, AFPs). The new system was mandatory for new entrants and optional for those affiliated to the old Pay-as-you-go System. Contribution rates decreased between 13-20 p.p.of wages up to 10% of wages.

I. The 1981 reform Huge fiscal cost of the transition: due to the deficit of the old system; the cost of a bond payable at the pension age recognizing contributions made under the old system; and the financing of a guarantee of minimum pensions and social assistance pensions. Present value of these payments estimated for 1981 at 136% of GDP (not including the cost of the pension of the Armed Forces). Annual costs have reached almost 5% of GDP in 1984; and projected 2,7% in 2025 and will stay until 2050 (taking 70 years to pay off).

Objectives of pension systems (Barr and Diamond) The primary objective of pensions is economic security in old age Achieving that objective requires: Poverty relief Consumption smoothing across a person s lifetime Insurance against low income and wealth in old age

On the 1981 reform Individual funded accounts are complex and costly to implement. If well implemented they provide consumption smoothing but little risk sharing or poverty relief. The 1981 arrangements were not a pension system but only part of a pension system. But there were also design problems in the 1981 reform.

II. The 2008 reforms

II. The 2008 reforms Reforms introduced as a result of the 2006 Commission Key role played by new longitudinal data bringing evidence for the first time on contribution gaps along individual history among others. Two main reforms: Creation of a non-contributory solidarity pension Tackling the problem of high administrative fees with an auction mechanism

Non-contributory solidarity pension Based on test of age and residence. Targeted on bottom 60% of the pensioner income distribution. Covers urban, rural, formal and informal, employed and self-employed. Covers old age, disability and survival. Financed through taxes. Turned the system into a genuine strategy by including poverty relief.

Non-contributory solidarity pension

Auction mechanism To tackle problem of continuing high administrative charges Accumulation: AFPs bid for all new entrants over a twoyear period, who have to stay with the winning bidder for at least 18 months. AFP had to offer the same low commission to its existing members and to any new members. Benefits: endorsed the Online Pension Consultation and Bidding System (SCOMP) introduced in 2004; mandatory to consult SCOMP, which includes insurance companies bidding for individual retirees.

Auction mechanism To tackle problem of continuing high administrative charges Accumulation: AFPs bid for all new entrants over a twoyear period, who have to stay with the winning bidder for at least 18 months. AFP had to offer the same low commission to its existing members and to any new members. Benefits: endorsed the Online Pension Consultation and Bidding System (SCOMP) introduced in 2004; mandatory to consult SCOMP, which includes insurance companies bidding for individual retirees.

Assessment The 2008 reform was sound because it addressed the three core objectives of poverty relief, old-age income insurance, and consumption smoothing. Positive impact on coverage, gender gap, poverty in old age with an acceptable cost in terms of incentives. But it left unfinished business.

III. The 2014-15 Presidential Advisory Commission

III. The 2014-15 Commission Created on April 29th 2014 by President Bachelet Goals: To study the Chilean Pension System regarding its observed and projected results, developing a diagnosis concerning its attributes, limitations, weaknesses and challenges. To develop proposals aimed at resolving the problems. Composed of 24 national and international members (pro-bono work). Final report delivered to the President Sept.14th, 2015

The Work of the Commission Downloads from the Commission s web page Type of Documents Downloads Public Hearings Presentations 58.674 Previous Meetings Reports 6.776 Sessions 2.933 Official Documents 4.445 http://www.comision-pensiones.cl Documents received through the web 13.422 International Conference Presentations 1.980

IV. Evaluation of the Chilean Pension System

Around 70% of currently employed contribute to the pension system Coverage of the employed has increased moderately since 1990. Chilean Occupational Coverage Rate is the highest in LatinAmerica Non-coverage: 55% self-employed; 45% wage workers (including domestic service)

90% of 65 and older are covered by pension benefits of some kind Coverage of women has significantly increased since 2008 Reform. Chilean Coverage Rate is the highest in LatinAmerica

However there are significant contribution gaps along the individual history Contribution Density1980-2009. Affiliates and Non-Affiliates between 18 and 60 years sold (Administrative Data) Percentile Affiliates Affiliates +Non affiliates (AD 2009) (AD 2009) p10 0,0% 0,0% p25 11,5% 0,0% p50 39,8% 28,1% p75 69,2% 64,5% p90 86,6% 84,2% Average 41,7% 35,4% Using longitudinal data the table shows the distribution of individuals for the proportion of time since 1981 with contributions. Affiliates are those either in the old system or those who have contributed at least 1 month in the AFP system.

Median Replacement Rates for AFP pensioners 2007-2014 Proportion of months with contributions Self-financed Pensions Self-financed Pensions + Solidarity Pillar (APS) Women Men Total Women Men Total Low (<=25%) 4% 5% 4% 21% 128% 64% Number of cases 20.877 11.588 32.465 20.877 11.588 32.465 Medium-Low (26% - 50%) 10% 23% 13% 15% 69% 33% Number of cases 43.449 29.493 72.942 43.449 29.493 72.942 Medium-High (51% - 75%) 23% 45% 33% 27% 57% 42% Number of cases 51.797 54.435 106.232 51.797 54.435 106.232 High (>75%) 36% 55% 46% 37% 59% 48% Number of cases 53.819 71.963 125.782 53.819 71.963 125.782 Total Replacement Rate 24% 48% 34% 31% 60% 45% Number of cases 170.311 167.508 337.819 170.311 167.508 337.819 Actual benefits as proportion of wages in the last 10 years (replacement rates) are low compared to expectations even for high density of contribution groups. However pensioners 2007-2014 contributed also in the old PAYG system and the recognition bond amounts on average 30% of the benefit. Pure AFP pensioners will be found after 2025. Solidarity Pillar established since 2008.

Projected Median Replacement Rates 2025-2035 Proportion of months with contributions Self-financed Pensions Self-financed Pensions + Solidarity Pillar (APS) Women Men Total Women Men Total Low (<=25%) 3,3% 4,7% 3,8% 34,8% 34,5% 34,7% Number of cases 356.743 154.915 511.658 356.743 154.915 511.658 Medium-Low (26% - 50%) 8,3% 11,8% 9,6% 31,0% 34,4% 32,0% Number of cases 309.922 202.596 512.518 309.922 202.596 512.518 Medium-High (51% - 75%) 19,3% 24,7% 21,9% 35,9% 42,1% 39,8% Number of cases 229.918 280.222 510.140 229.918 280.222 510.140 High (>75%) 31,0% 42,3% 38,9% 36,8% 49,2% 46,6% Number of cases 106.547 398.471 505.018 106.547 398.471 505.018 Total Replacement Rate 8,3% 24,7% 15,3% 34,1% 41,0% 37,2% Number of cases 1.003.130 1.036.204 2.039.334 1.003.130 1.036.204 2.039.334 Replacement rates 2025-2035 with pure AFP pensioners will show much lower figures. Solidarity Pillar Supplement will amount more than 50% of the self-financed median benefit. Simulations use longitudinal survey with real history of contributions until 2014 and projections using individual patterns until 2035.

Comparison with OECD Average Replacement Rates Proportion of months with pension contributions Average time contributed Men Replacement Rate OECD Women Average time contributed Replacement Rate Gap Chile-OECD in Replacement Rates (percentage points) Gap for men Gap for women Low 13,6% 30,9% 13,3% 30,9% -10,8-11,3 Medium-Low 35,2% 38,5% 35% 38,9% -12,9-15,0 Medium-High 67,6 52,1% 67,5% 51,7% -16,4-22,8 High 89,2% 61,5% 89,2% 61% -17,8-26,3 100% contributions 100% 66,1% 100% 65,6% -17,9-27,7 Figures provided by the OECD to the Pension Commission. Replacement rates for Chile are also provided by the same source.

Low pension benefits Pension benefits (replacement rates) are low compared to expectations (70% or higher based on cases promoted at the selling of the AFP system). Pension benefits currently observed will be lower in 2025-2035. Replacement rates are low compared with OECD averages. But Chilean contribution rate (10%) is much lower than the OECD average (19%).

Competition and Fees Fees have declined after the implementation of the bidding process for new affiliates. Currently 80% of affiliates belong to more expensive AFPs. Very low pension literacy and knowledge. Room for more competition.

Unsatisfactory knowledge of key features of the pension system

Gender Women labor histories more incomplete than men translate into lower pension savings Gender roles and sex division of work: women devote on average 4 hours/week to household and family care activities compared to 1,3 horas/week for men (INE, 2007). Gender gaps in labor market participation and wages translate into lower pension saving accumulation.

Gender But gender gaps are increased by pension rules: Lifetables differentiated by sex Different pension ages: Men: 65 years old Women: 60 years old As women live more than men these rules amplify labor market and earlier gaps.

Chile: Rapid population ageing: 1950-2010 evolution of ratio (population 15-59)/ (population 60 and older)

Evaluation Since the 2008 Reform, the chilean pension system can be characterized as a system that combines a SOLIDARITY PILLAR financed through taxes with an INDIVIDUAL SAVINGS PILLAR financed by contributions that each individual makes into their individual account.

Evaluation: discontent The Survey on Opinions on the Pension System carried out by the Commission revealed a marked absence of social legitimacy. A majority of the population (70%) believes that the pensions of the system do not allow to finance an adequate level of life. 72% of the population believe that only a complete change in the AFP system would help improve pensiones and 66% believe that most of the responsibility for low pensions lies with the AFPs. 79% of survey respondents agree with the creation of a State AFP and 69% would transfer their funds to it if it existed.

Several of the current problems come from the design of the 1981 Reform Contribution rate is decreased (13-20 points) to 10% from the PAYG to the new AFP System. What was the empirical basis for this decision? The decrease in the rate boosted the net wage if workers switched to the new system. Pension age differences between men and women were not changed in 1981 (65 men; 60 women) Military personnel were the only ones allowed to keep permanently in the old PAYGO system (Cajas Capredena and Dipreca).

Summary Known problems of funded individual accounts. Low coverage, largely because of informality. Inadequate pensions, largely because of incomplete contributions records. Continued high charges. Higher exposure to risk. Gender inequality. Hostility towards the AFP system (real, though unclear whether the root hostility was the pension design or the level of benefits).

V. The Commission s Global Proposals

V. Global Proposals What is the nature of the reforms needed? How structural do the changes need to be? The Commission categorized the views expressed by various members into 3 positions, called Global Proposals

V. Global Proposals Global Proposal A: retain current strategy and work within it to improve it. Global Proposal B: partial move to PAYG. Global Proposal C: full move to PAYG.

Global Proposal A (12 votes) Builds on the 2008 reform by: Expanding the non-contributory system by: Increasing the solidarity pension Financing the increase through increased taxes and a new 2% employer contribution. Reforming the savings element by introducing: A new 2% employer contribution to AFP accounts A new government AFP Further action to reduce charges Improving gender equity by: Over time, equalizing pension ages between men and women Mandating the use of unisex life tables Motivation: to increase benefits immediately in a way that preserves sustainability

Global Proposal B (11 votes) Diverts contributions on earnings up to 350,000 pesos (US$520/month) into a new partially-funded element, organized through citizen social security accounts (which may take the form of notional accounts). Redesigns the solidarity pillar Higher non-contributory pension for bottom 80%. Tax-financed match to the new social security accounts for people with low pensions. Financing the match is a 3-4% increase in the contributions from employers, and with complimentary support from state contributions. Motivations To address the widespread hostility towards AFP system. To increase (and help finance) pensions immediately.

Global Proposal C (1 vote) Absorbs both the stock of assets of the AFP system and the flow of contributions into a new DB system Global Proposal C seeks to respond to the views expressed during the public participation process by transforming the system into one that is purely pay-asyou-go The full amount of contributions will be used as income to pay contributory pensions, with no State subsidies On average, retirement benefits would be increased by 75-100%. Contribution rates will not be raised until 2035. Motivations Higher benefits. An ideological objection to the AFP system.

V. Global Proposals As a result the Commission does not support Global Proposal C. Main reasons included: Transfer all deposits/savings of the property of workers into the PAYG system, taking their individual accounts without compensation Proposal requires an abrupt and large increase in contributions and taxes while the reserves are depleted Moving to a fully PAYG system reduces saving and investment Very optimistic assumptions Problems of financial sustainability.

Global Proposals There was consensus in going to a mixed system far from the extremes: Not coming back to a pure individual savings approach (like the 1981 model) Not coming back to a PAYG system (proposal C) Proposal A is the soundest strategy. Fiscal Costs: Proposal A: about 0.5 % PIB Proposal B: about 2.5 % PIB (Ministry of Finance)

Why Proposal A? The 2008 strategy is sound The various parts of the system fit together to achieve the multiple objectives of poverty relief, insurance and consumption smoothing. The solidarity pension provides poverty relief and some insurance. Individual accounts mainly provide consumption smoothing. Long, stable history.

Why Proposal A? Good base for expanding the solidarity pillar Range of flexible options for increasing pensions Gains for formal and informal workers, including women Option of greater gains for those with smallest AFP pension Thus higher pensions within chosen fiscal envelope Can achieve similar distributional effects to Proposal B. Individual accounts also a sound base for reform Adequate replacement rate for workers with fairly complete contributions records. Government AFP with default option. Option of central clearing house for record keeping, transferring contributions to funds and policing against evasion (as in Sweden). Option of move towards a lower cost plan, e.g. default in the Swedish Premium Pension or US Thrift Savings Plan. Maintain saving.

Problems with Proposal B Focus mainly on the formal sector NDC + positive match benefits formal-sector workers Highest benefits for workers with high contribution densities Low AFP pensions mainly for people with incomplete contribution records, a particular problem for women; NDC does not address problem. Lack of specificity Hard to judge distributional effects, though with strong suspicion of concealed redistribution from future workers and pensioners Hard to judge finance. Vulnerability to political pressure to raise $350K ceiling Government might not resist such pressures since a further move towards PAYG can create short-term fiscal windfall. Hence risk that Proposal B will approach Proposal C. Insufficient attention to significant additional administrative costs.

Problems with Proposal B: Effect on saving Transferring benefits from future retirees to current ones risks negative impacts on aggregate saving Declining fertility will lead to a smaller workforce. Rational response is to make each worker more productive through increased investment in human and physical capital. Reforms that reduce saving affect output growth, hence fundamentally the wrong way to go in Chile.

VI. The Commission s Specific Recommendations

III.2. Specific Recommendations The Commission approved a total of 58 specific recommendations.

VII. Proposals: Impact and Costs

Specific Recommendations -Annual fiscal cost associated to the 58 specific proposals around 0.4% GDP (Source: Dirección de Presupuestos) -First round impacts on pensions and replacement rates: Increase in Replacement Rates of 13.5 percentage points for men and 29 percentage points for women (Based on estimations from Superintendency of Pensions)

Main proposals based on impact on pensions: Increase in contribution rates from 10 to 14 points Increase in benefits of the solidarity pillar: 20% increase and increase in coverage to the 80% of the population Mandatory contribution for self-employed workers Equalization of pension retirement age for men and women to 65 years old New compensation benefits for caregivers

VIII. Political Context and Current Debate

Recent developments Commision Report delivered to the President September 14th, 2015 President Bachelet appointed a Ministers Committee to analyze and discuss the Report. Discontent with the Pension System took place between june and july 2015. Motivated by extremely high pensions from the military PAYG system and massive manifestations against AFPs. Manifestations claiming to come back to a PAYG system.

Recent developments August 9, 2016, the President committed a reform and a national agreement. Some keypoints: Increase in contribution rate from 10 to 15% but discussion on its distribution Rejection on coming back to a PAYG system August, 2017, in the final months of her administration, the President sends a reform to Congress.

Recent developments 5 p.points would be managed not by the AFPs but by a new public institution (Collective Savings Council). 3% will go to individual accounts in this new institution and 2% to a collective fund. The collective fund will fund intergenerational subsidies (20% of self-financed pensions) and a compensatory transfer to women compensating the differential life expectancy with men. intragenerational subsidies and a transfer to women.

Recent developments Residual will be distributed among the contributors of the generation according to the prop. of months contributed, entering to their individual collective accounts.

Recent developments However, several doubts on the success of this project. A new administration entering in March 2018. Hard to reach an agreement in the middle of the political campaign.

References Barr, Nicholas and Diamond, Peter (2008), Reforming pensions. Principles and Policy Choices. Oxford University Press. Barr, Nicholas and Diamond, Peter (2016), Reforming pensions in Chile, Polityka Społeczna, No. 1, 2016, pp. 4-9, http://econ.lse.ac.uk/staff/nb/barr_and_diamond_2016_chile.pdf Executive Summary: Presidential Advisory Commission on the Pension System 2015 (2015), www.comision-pensiones.cl Final Report: Presidential Advisory Commission on the Pension System 2015 (2015), www.comision-pensiones.cl