Bachelet’s Star Plan: Reform of the Pension System

Chile has one of the worst income distributions in Latin America. This inequality was at the centre of the electoral battle which Michelle Bachelet won on March 11. The new head of state made a commitment to carry out a 36-measure plan during the first 100 days of her government, where the majority of the measures are aimed at improving the situation of the most disadvantaged social groups. In her first press conference after taking office, Bachelet said: “We are going to create a system of effective social protection which will meet the needs of Chileans from earliest infancy through to adulthood.” She took advantage of the occasion to announce the first two of the 36 measures: immediate free treatment in public hospitals for people over 60 who are covered by the state health system (Fonasa), and a readjustment of the lowest pensions which will benefit one million pensioners. The cost of this rescaling will be around $350 million, an amount which has been included in a discretionary section of the annual budget fixed by the previous administration. At present, minimum pensions vary between $155 and $180.

 

In its entirety, Bachelet’s pro-equality programme will cost $6 billion, an amount which will make up 2% of Gross Domestic Product (GDP) in the year 2009. The new finance minister — the economist and ex-Harvard professor Andrés Velasco – told the press that this expenditure will be financed by economic growth, high copper prices, and better tax collection from combatting avoidance and evasion. Concurrently, and with the aim of making the jump towards development, the minister has signalled that the government will put an emphasis on “greater innnovation and adoption of technologies by companies, greater commitment to small and medium enterprises, greater effort in education, and better access to financing.”

 

Accumulated Political Capital

These measures have won a lot of support for the President, who is also highly regarded for being an expert in military affairs and speaking five languages fluently. She already has an index of popular support of 65%, according to a survey carried out by the conservative daily El Mercurio and the consultancy Opina. This opinion poll also revealed that 85% of those consulted believe that Bachelet will do “as well or better” than her predecessor, Ricardo Lagos, who retired from government with approval ratings of over 70%.

 

These figures reflect, morevoer, citizen support for the new style imposed by Bachelet. In her first decisions she showed independence from the four parties – Socialist, Christian Democrat, Party for Democracy, and Social Democrat Radical Party – which form the Coalition that has governed the South American nation since 1990. Moreover, when choosing collaborators, she has given preference to academic and technical merits over party membership while not shying away from the issue of gender inequality. During the campaign, Bachelet promised that men and women would have equal representation in her 20-member cabinet and she has kept her word. Ten Secretaries of State positions are occupied by women, including Defense, Economics, Mining, Health, Planning and Secretary of the Presidency (legislative coordination). This is a radical change when one considers that there were only five women in Lagos’ first cabinet.

 

The experts have declared that the political capital which Bachelet currently enjoys will be crucial in order to achieve legislative support for one of most eagerly-awaited promises: the reform of the obligatory system of private administration of pensions set up in 1981 during the dictatorship of Augusto Pinochet. Undoubtedly, this will be followed with great interest by the international community given that this system, based on individual saving and capitalization (each worker with a contract has to place 10% of his or her salary into an account administered by a fund manager called AFP) has established a paradigm at the world level.

 

Overcoming Coverage Failures

In what way has a model that has been adopted, albeit with variations, by the majority of Latin American countries and even by far-flung countries such as Kazakhstan failed? How should it be reformed? The responses are categorical. According to the analysis from Bachelet’s government, around the year 2030 one out of every two Chileans will simply not have any right to a minimum pension because they will not have saved for the 20 years required by law to have the right to receive the benefit. Also, the authorities point out that the AFPs form a highly-concentrated noncompetitive market which works against price incentives.

 

To resolve this crisis, Bachelet created a a technical commission headed by former budget director Mario Marcel, whose objective is to diagnose the problem in collaboration with social agents in order to shape the reform project to be presented to Congress during the second half of this year. The commitment of the President is that the main beneficiaries of the reform should be self-employed workers and those with informal jobs, young people who arrive late to the labor market and, especially, women, whose salaries are on average lower than those of men.

 

The question therefore arises as to whether the AFP system is the sole culprit behind the incomplete coverage which Chilean workers face. Olivia Mitchell, Wharton professor and director of the Pension Research Council, answers that her research on the Chilean case, based on the Social Forecast Survey (Encuesta de Previsión Social) – fruit of a recent cooperation agreement between the University of Chile and the University of Pennsylvania – shows that the periods when there are no contributions to the pension system correspond above all to times when individuals are unemployed. So, to the extent that people work in wage jobs, they do tend to contribute remarkably consistently. The issue seems to be, therefore, that “many people hold wage jobs intermittently, but spend periods outside the wage sector. The labor market therefore should be further examined to see how well it is functioning and whether its functioning can be improved to enhance retirement security.”

 

In fact, official figures show that only 63.7% of occupied workers in Chile contribute to a pension management fund, and not all of them contribute regularly. To resolve these coverage failures, the Bachelet reform aims at strengthening the system through two channels: increasing the frequency and level of the contributions made by workers (contribution channel), and strengthening the protective role of the State through programs aimed at ensuring a decent level of income in old age once the funds in the individual capitalization account run out or in cases where the funds do not even meet the requirements for the minimum pension.

 

In a recent seminar organized by Expansiva, a think tank linked to liberal sectors of the coalition and whose members include various ministers of Bachelet’s cabinet, a series of papers containing proposals by academics and specialists to resolve the failures of the pension system were discussed.

 

In one of these pieces of work, the expert from the Economic Commission for Latin America and the Caribbean (ECLAC), Eduardo Fajnzylber, evaluates three alternative models – minimum pensions, targeted pensions and universal pensions – for providing a minimum income for people during old age through the solidarity role of the State. Fajnzylber suggests that universal pensions possess a series of attractive attributes with regard to incentives, effectiveness and economic policy. According to his projections, however, the high proportion of people with at least 13 years of contributions implies a high relative cost of financing non-contributory pensions for the whole population. At the other extreme, the expert points out in his document that the combination of a minimum graduated pension with a pension targeted at individuals with unsatisfied basic needs represents the most economic way to guarantee a minimum base for the whole population, though it brings with it the problems faced by any system of targeting: disincentives to save, political clientism, administration costs, coverage for the most informed and not necessarily for the most needy, etc. Fajnzylber maintains that coverage can be extended to adequate levels with a limited fiscal effort, though he concludes in his paper that “the different options have radically different costs associated with them”.

 

More Competition, Lower Prices

The Bachelet reform also seeks to eliminate entry barriers to the previsional business in order to instill greater competition and thereby reduce the commissions that the AFPs charge for managing individual accounts. Twenty-five years into the Chilean model, the industry has witnessed a progressive concentration of investment decisions in the capital market, where the six companies in operation manage resources which are the equivalent of 70% of Chilean GDP (some $100 billion). The result has been a lack of incentives to reduce commissions in what is a captive market.

 

On this issue, Mitchell points out that international research shows that money management is very much scale driven; larger funds can be less expensive to run. Thus, she holds that it is not surprising that the number of funds has declined in most Latin nations which have AFORES-type systems.

 

One of the proposals concerning competition which the technical commission set up by Bachelet could evaluate is the idea by a management professor at the Pontificia Universidad Católica de Chile (PUC), Jorge Tarziján, of separating the management of individual accounts from the management of funds (the latter should also include distribution, sales and maintenance/administration activities). This would give rise to two types of entities: the Pension Fund Managers (AFP) and Individual Account Managers (ACI). Tarziján says that the main benefits of his proposal would spring from the greater entry of institutions into both types of activity. This greater entry of firms “stems from the fact that when the businesses are separated, the minimum size needed to make entry profitable is reduced. For example, there are less economies of scale in the management of pension funds. Investments are lower when entering one business than when entering two.” Similarly, he adds, other non-AFP entities which have spare capacity (such as banks and clearing houses) “could use this capacity for the business of managing accounts without getting involved in the AFP business. At the end of the day, this greater competition should end up favoring the affiliates.”

 

Which institutions or firms in the financial system would be most qualified to take on both branches of the previsional business? The PUC professor responds that fund management could be taken on by many different entities and persons with experience in that task “provided that care is taken to avoid potential conflicts of interest.” Account management, meanwhile, “can be taken on by any entities which have operating systems and some branch network,” such as banks.

 

However, Tarziján provides a warning. The decrease of barriers to entry will raise competition, “but this increased competition will not necessarily mean lower prices, though it could lead to a higher quality service.” For this reason it is crucial, he adds, that along with the reduction of barriers there should be a “very strong” information campaign about the importance of price for the consumer, and that “they be clear, for example, that this is deducted from their salary. I believe that information, on a large scale, is an important issue which needs improving, and that the system will have weaknesses if people do not understand it or if they are cannot be convinced that it is a good system, one to which you have to contribute money every month or for a long time in order to have better pensions.”

 

Mitchell agrees about the value of information but also refers to a consumer culture. “There is still much room for consumer education in Chile, so that participants begin to devote more attention to the fees and charges that they are clearly not paying much attention to at present.” According to the studies of both universities, around half of the participants report knowing what the contribution rate to the pension system is, and only about one-quarter are accurate. “Fewer than 3% know either the fixed or variable AFP commission rates. There is clearly much to be done, to raise financial awareness and literacy.”

 

An alternative way to increase competition in the system, according to another study circulated by Expansiva and headed by the ex-superintendent (regulator) of the AFP system, Guillermo Larraín, is through tendering by groups of affiliates. In the opinion of this specialist and analysts Pablo Castañeda and Rubén Castro, this mechanism directly attacks the main entry barrier into the industry: the threat by the incumbents (the AFP’s) of a “commercial war.” The authors of the proposal argue that “this threat constitutes a socially undesirable situation in that it generates a price level above that which would exist in a competitive situation, while in the case of a commercial war it generates a considerable increase in the system’s operating costs without any noticeable social benefits.” They explain that the tendering should be organized in such a way as to achieve its objective, “either by generating the entry of new competitors into the system or by increasing competition between existing firms, which in turn makes it necessary that the project be attractive to both types of actors.” In their paper, Larraín, Castañeda and Castro highlight that it is “crucial” that the tendering be compatible with the long-term development of the industry “without generating excessive business risks which would be associated with greater commissions and lower willingness to participate in the industry.”

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