Pinochet’s private pensions

For twenty-five years or so, the privatised pension scheme introduced in Chile under the Pinochet regime by his labour minister, Jose Pinera, has been touted as a model for the world to follow. It’s been particularly influential in the US debate over social security privatisation but has also had some influence in Australia, which has a somewhat similar setup, though we arrived at it by a different route – Chile scrapped its defined-benefit state pension scheme, keeping a basic safety net, Australia started with a means-tested flat-rate pension, but has tried to expand private superannuation since the 1980s

Now the New York Times reports that the Chilean scheme is not delivering the promised benefits . Lots of people are getting less than they would have under the old scheme and large numbers are falling back on the government safety net. Fees have chewed up as much as a third of contributions.

Why has this bad news taken so long to emerge. Complaints about fees have been around almost since the start, but right through the 1980s, they were ignored becuase investment returns were exceptionally high. This in turn reflects the fact that Pinera had the good luck or good judgement to start the scheme when the stock market was at an all-time low, thanks to a financial crisis (in retrospect the first of many cases where financial market darlings got into trouble). The economy recovered and the stock market boomed. Once gross returns fell back to normal levels, the bite taken out by fees became unbearable.

All of this raises the issue of risk. Under a privatised defined-contribution, your returns, and therefore your retirement, depend heavily on timing. 1981 was a great time to start investing in the Chilean stock market, and also in the US market. At least for the US, 2000 was a good time to get out. Anyone who started investing in the US market in the late 1990s (and didn’t manage to outperform it) is well behind where they would have been if they had put their money into government bonds.

On average, returns from the stockmarket are higher. But this is just another way of saying that, on average, investors want a higher return to justify the additional risk. So a switch from a defined-benefit scheme to a private accounts scheme with the same average return and higher risk is a real loss, just as if someone sought to repay a debt contracted in 1981 with the same amount in 2005 dollars.

I’ll have more to say about this soon, I hope.

15 thoughts on “Pinochet’s private pensions

  1. It seems to me the Chilean pensioners who have got low benefits now because they retired just after the stock market tanked were badly advised. The closer they were to retirement, the more they shoud have switched their investments into less risky asset classes. Any financial adviser worth his fees will tell his clients to do that.

  2. Milton, the problem is that the commissions are so high that they would wipe out the earnings from a bond strategy. We haven’t seen so much of this here because most of the money has gone to relatively low cost industry funds. The introduction of choice may change this.

  3. The industry funds have only a small fraction of total superannuation funds, because their members have been confined to employees on certain awards.

    You are right that choice may change this, but not in the way to you think. Superannuation choice, as a policy, was designed by the Government to nobble the industry funds, which it sees as “union” funds (despite the fact that they are 50% owned by employer groups). But the investment performance of the industry funds has been at least as good at (and in many cases better than) the funds run by the financial institutions, and the fees are much lower. Ironically, choice will probably be a boon to the industry funds, especially since they will also cross-sell products like cheap home loans and cheap credit cards.

  4. “So a switch from a defined-benefit scheme to a private accounts scheme with the same average return and higher risk is a real loss…”

    Prima facie for the individual, yes, but I doubt you’re including in your calculation the marginal benefit of lower taxes as a result of pensions privatisation. For the community it means a lower tax burden is required to fund the incomes of retirees, and a lower deadweight loss from redistributing income through the government.

    As you’re no doubt aware, we face the same issue here in Australia: most people who believe the 9% SGC will fund their existing lifestyle intro retirement are kidding themselves. People need to save more.

    Could you produce some more data on management fees in Chile? My understanding was that fees average around 1% of funds under management, which seems reasonable relative to most developed markets.

  5. Fyoder, according the NY article, “spending on pensions makes up more than a quarter of the (Chilean) national budget”. Equal to education and health combined.

    How do you square this with your claim that private accounts mean “a lower deadweight loss from redistributing income through the government.”?

  6. Sean,

    I couldn’t find that quote in the article. If it’s true it is not suprising that the Chilean state still bears a large burden given that:

    (1) the article does say that 50% of the workforce isn’t covered by the scheme anyway, and so a sizeable chuk of the population would still rely upon a state pension;

    (2) many of those who have contributed haven’t saved enough in total to fund their entire retirement needs, and so would rely upon some form of state pension;

    (3) even though it began in 1981, few workers contemplating retirement now would have been contributing their entire working life, assuming a retirement age of 65ish, and so would reply upon some form of state pension; and

    (4) the full impact of the reform won’t be seen in government finances until the first generation of lifelong contributors retire and start to draw down their savings rather than receive a pension. That’s unlikely until about 1981 + 45 years (i.e. 65 years retirement age less assumed 20 years-old entry into workforce), or around 2026.

    It’s also likely that the state’s burden would be even higher without the scheme.

  7. Well, here is what I had to say on the general area six years ago. It’s not the Cassandra story, but isn’t there some other ancient fable about the effects of having foresight yet not being able to do anything with it? Something about knowledge without power?

  8. John

    I think you are confusing in the way that you talk about ‘defined benefit pensions’ and ‘your returns’ in the same breath. A pension is either a defined benfit or market linked. If it is defined benefit then the pensioner should have no risk and the pension provider carries the risk. In that case the provider should be concerned about investment returns. If the pensioner is entitled to a defined benefit pension and does not receive it, then there is obviously a fault in the regulatory regime. That is, the provider must pay a defined benefit pension using alll means necessary. If that isn’t the case then the pension is a market linked one and the pensioner is carrying the risk.

  9. John, what is your point?

    In Australia ComSuper pays uncommercially high pension rates. Fees are an issue and individuals bear the responsibility of ensuring they have enough to retire on in the manner they are accustommed to. So some people in Chile are unhappy? and the point is?

  10. John – you said “most of the money has gone to relatively low cost industry funds”.

    I say prove it!! Because I don’t believe you. Most of the money has probably gone into private managed funds.

  11. According to this
    “Industry funds and corporate funds represent 11.6 per cent ($75.2 billion) and 9.1 per cent ($59.3 billion) of total superannuation assets, respectively, as at September 2004”.

  12. Public sector funds have pretty much the same characteristics as industry funds. Still, I was wrong on the general point. Retail and DIY funds account more than half the total according to the stats linked by DD.

    I must say I’m surprised by these numbers. Retail funds are listed as having nearly 14 million members, pretty much equal to the entire adult population. Can anyone explain this?

  13. Razor, on your first comment, reread the post. The phrase “your returns” occurs in reference to defined-contribution, not defined-benefit schemes.

    On your second comment, our incomprehension is mutual.

  14. “Can anyone explain this?”

    You can be a member of more than one retailer fund. I am a member of two.

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