The Fall of Pension Funds in Chile: A Lesson from the Downturn

Imagine if you were about to withdraw your life savings to begin your retirement, and then discovered you had lost almost 17% of that money.

That is the situation facing many older workers in Chile. In July 2007, the savings of Chilean workers totaled US$104 billion, according to CENDA, the Chilean economic research center. That is a large number given the small size of the country’s economy. But from the time the U.S. subprime crisis began to set off alarm bells in the middle of 2007, to the moment last September when the crisis blew up, the total has dropped considerably.

Chile’s savings system for seniors is individualized, mandatory and administered by private firms known as Administrators of Pension Funds, or AFPs. Employees cannot withdraw their funds until they retire, but they can choose the type of instrument they want to invest in. These range from variable income funds labeled A, B, C, and D – in which AFP can invest up to 45% of the funds outside Chile – to the variable-income fund E. The funds carry a range of estimated risk and return profiles.

Workers who kept their savings in fund A, for example, have lost almost 17% of their money during this period, according to estimates by CENDA. So a Chilean worker who saved 30 million pesos (US$48,000) in that fund has lost more than 6 million pesos (US$9,720).

Augusto Octavio Castillo, a professor at the business school of Adolfo Ibañez University, says that when you approach retirement age, “you have to avoid exposure to risk, and it is logical to transfer funds into less risky funds such as the E, which invests all of its money in fixed income. So workers who were on the brink of retirement and transferred their money to fund E before the crisis exploded suffered less significant losses.” The big problem is that few people did that.

Chilean pension funds have suffered very dramatic losses, and have openly recommended on television that the public not make their next investment decisions under pressure brought on by market conditions. They have asked the younger population to remain in variable income funds – A, B, and C. For those close to retirement, they suggest changing to fund E.

Are these recommendations strong enough? For some, the damage has already been done. For others, the way the AFPs have allocated those funds seems like a lottery that involves financial speculation. Does that mean there aren’t enough mechanisms for guaranteeing the profitability of savers?

More Risk Exposure at an Earlier Age

David Díaz, professor of economics and business at the University of Chile, agrees with the AFP’s recommendations. He notes, “While it is true that investing in variable income funds – especially A and B – is much riskier, this risk is compensated for by a larger return when you think in periods of 20 years. Over that length of time, there are many possibilities for stock market prices to rise and to compensate for the declines. The appropriate investment decisions for younger contributors is to keep their savings in variable income funds – A, B, and C – and give time for the market to recover.

Fernando Bravo, professor of economics and business at the University of Chile, has a similar view. He notes that “variable income funds are riskier, but they also have better expectations for gains over the longer term than D and E funds. Fund A represents a real return of 4.21% compared with 2.74% for fund E. Young people must invest in variable income funds while those who are older should change info funds D and E. Even though they provide lower profitability, they are less exposed to possible losses.

Pablo Castañeda, professor at the Adolfo Ibáñez University’s center for financial innovation, also believes that the AFPs’ suggestions are reasonable. He draws a parallel between the investment decision of a contributor and his own human capital. “When he is young, the contributor brings significant human capital, and it is natural for him to assume the risk of investing part of his financial wealth in shares and variable income in order to increase their value. To the degree that human capital erodes with the passage of time, the individual must guarantee the amount of his financial wealth in portfolios that are more conservative or offer fixed income,” says Castañeda.

Nevertheless, Salvador Valdés, professor at the Catholic University of Chile’s Institute of Economics, warns that you shouldn’t confuse the recommendations made by AFPs with the allocations that Chilean law provides by default for workers who have not chosen a fund. “I agree that younger contributors who have not chosen a fund should be assigned to funds that have a higher percentage of shares and variable income, but they should not be assigned directly to fund A, as they do things today. Likewise, I believe that those who are about to retire and who have not chosen a fund, should be assigned, first of all, to fund D. However, once they have completed their sixties [reached the age of 70], they should be transferred to fund E. Currently, they are moved to fund D, but not to E,” Valdes says.

Risk-Free Investment — An Impossible Dream

“No sort of investment is risk-free in this economy,” says Díaz, referring to critics who say the AFPs don’t offer mechanisms for protecting savers.

Jorge Gregoire, also a professor of economics and business at the University of Chile, agrees. He notes, “Financial markets, whether they are shares, bonds or general financial instruments, operate with high levels of volatility, and none are immune from risk. By their very nature, these markets provide significant levels of speculation, and they go along, incubating like bubbles. It is the Central Bank that is in charge with balancing this situation.”

Díaz says that even those instruments that are supposedly risk-free or fixed-income can generate greater losses than variable-income funds. “The fixed part of those investments is associated with the timely payment of the interest that is promised. The investor always runs the risk that the interest payments are not paid within the time frame allotted for them, which is what happened with those investors who bought Argentine government bonds.”

He was referring to an incident from December 23, 2001, when the value of Argentine government bonds plummeted after the government stopped making its debt payments, and it went into default. The worst economic and political crisis in the country’s ensued as the government declared that it was incapable of paying its foreign debt, which totaled US$132 billion. To manage the crisis, the Argentine government offered to exchange the old bonds for new bonds that would mature in 2033. Seventy-six percent of investors accepted that plan. The remaining 23% rejected it, setting off a lawsuit against Argentina, aimed at canceling the entire debt, including the interest. I investors who accepted the new arrangement lost an estimated 43.14% of the value of their new bonds, as well as interest.

A System that Provides Benefits

Castañeda believes that the Chilean pension system remains efficient. He argues that it “has provided meaningful profits for its contributors. Naturally, the recent crisis deprived them of a good part of the money they earned but you need to remember that the difference between their costs and their profits is still positive from the viewpoint of long-term returns as well as the health of the country’s fiscal accounts. I don’t share the view that there aren’t enough mechanisms for protecting the profitability of savers. Especially after the latest reform, when they introduced a solid basic pension that sets a floor for dealing with recent turbulence.”

Those reforms came in March 2008, when the government of [Chilean president] Michelle Bachelet introduced a provisional reforms that included  the creation of a Common Pension System, intended to benefit a greater number of workers and involve a larger amount of money because it would add disabled and independent workers to groups already covered..

What’s more, Díaz argues that although the AFPs in Chile are not perfect, “as a system for administering pensions, it is one of the best in the [Latin American] region. By transferring responsibility to the individual, it provides multiple benefits such as building savings and, especially, does not give the government too much responsibility to use funds that come from active workers to underwrite retirees.”

If the government were to assume responsibility for administering pensions, Díaz says, the active labor force would have to pay for the pensions of the entire mass of pensioners. “In contrast, with the current system, the government acts like an institution that protects those who were, in effect, incapable of generating a minimal retirement [fund].”

As for the losses inflicted on those about to retire, and who kept their savings in variable income funds – A,B,C, or D – Bravo explains that, given the magnitude of those losses, the government and the AFPs themselves cannot now begin to compensate each participant. “The accumulated amounts in the pension funds are long-term investments. The only thing left to do now is to wait until the recessionary economic cycle is over because share prices will [eventually] rise, along with the value of variable income instruments A, B, and C.”

Castillo adds, “The only ones really hurt in this crisis are those who were going to retire during this period and who had none of their savings in fund E. Nevertheless, I insist that the recent losses are more than compensated for by the cumulative gains since the system in Chile went into effect.”

The Next Challenges for AFPS

“We should establish better mechanisms for controlling risks, and the government should review its regulations,” recommends Gregoire. He argues that one strategy would be to set up systems that would allow shared monitoring by the AFPs, their contributors, and the government. “For example, you need to improve the transparency of information that the administrators deliver to their contributors regarding commissions, portfolio investments and risks.”

Meanwhile, Díaz believes that it would be worthwhile to begin a discussion AFP’s commissions and how they can affect portfolio performance. “There are still AFPs that charge a fixed commission or which generate income even when their portfolios register losses. The system of charges and commissions should be related to the real performance of administrators. They should study the parameters of performance, adjusting for both the risk and the return, rather than considering performance adjusted only to the return ”

Castañeda believes that the government, through the role played by its pension supervisory agency, should look at setting maximum allowable losses for abnormal investment periods. “This could translate into an obligation for the AFPs to introduce various instruments that limit potential losses, in the most harmless way possible for the long-term profitability of savers,” he says.

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