Appendix I: Main Features of the Chilean Pension Reform 24/
Coverage: With the start of the new scheme as of May 1, 1981 all new entrants to the labor market as dependent workers are covered under the funded retirement system. Self-employed can join the system; insured dependent workers and self-employed under the existing social security system could join the new system or remain in the unfunded scheme.
Eligibility and benefit structure: For old-age benefits it is a defined-contribution plan with individual accounts held with pension. At the age of eligibility the individually accumulated funds can either be converted into an annuity with an insurance company, or withdrawn in a phased sequence (with a maximum size depending on remaining life expectancy). The normal retirement age is 65 (men), and 60 (women). Earlier retirement is possible if the accumulated funds allow for a replacement rate of at least 70 percent of indexed taxable income over the previous 10 years.
Disability and survivors’ benefits follow a defined-benefit plan, with an extra insurance promising to top-up the individual account to a target level set by various formulas. The target benefit level for full (partial) disability is 70 percent (50 percent) of indexed earnings.
The minimum pension covers old-age, disability, and survivorship. The benefit is guaranteed by the government but financing starts only once the individually accumulated funds are exhausted. Eligibility requires at least 20 years of contribution and is income-tested.
Financing and taxation: The mandatory contribution rate paid by every covered worker for retirement is 10 percent; voluntary contributions are possible (and unlimited since 1989). The additional contribution rate of 3 to 4 percent covers disability and survivors’ insurance, and a commission for the AFPs.
Mandatory and voluntary contributions and earnings by the pension funds on behalf of individuals are tax exempt while benefits (as annuities or as phased withdrawals) are subject to income tax.
Organization: Private pension funds (AFP: Administradoras de Fondos de Pensiones; 21 AFPs as of April 1995) which provide fund management services, do the record keeping of individual accounts, purchase the group insurance policy for invalidity and survivorship, and perform collection and payments function; they cover their operating costs and profits through fees. Affiliates are free to select any AFP and to switch any time after a minimum of four months with an AFP.
Funds operate under tight regulation and supervision from the superintendency of pension funds, and have a comprehensive disclosure obligation. The fund operator has to guarantee a minimum rate of return (measured from the average of all funds). Only if the guarantee bond posted with the government are insufficient will government funds become involved.
The investment rules for AFP were very tight and only over the years have been gradually relaxed, allowing for the purchase of domestic shares as of 1985, and investment in foreign assets as of 1990. In April 1995 a new law was passed providing further softening in investment regulations and more flexibility in risk classification of assets.
Transition rules and government guarantees: Prior to the implementation of the reform, the existing retirement system was substantially changed, most importantly the retirement age increased to common levels (65 for men and 60 for women).
Workers that had contributed to the social insurance scheme (at least 12 months during the previous 5 years) and switched to the new system were issued “recognition bonds;” the amount should represent the contributions made under the old system. This bond matures when the worker reaches pensionable age and earns a real rate of interest of 4 percent per annum between the date of switch and maturity.
The workers switching to the new scheme had their salaries grossed-up by the prior (employer’s financed) social security contribution, which amounted to some 20 percent; under the new scheme premium payment totaling between 13 and 14 percent is an employee’s obligation only.
The government covers, through general revenue, the shortfall in the balance of the old system through transfers and finances recognition bonds when they mature.
The main government guarantees under the new system concern the minimum pension, insolvencies of life insurance companies (guaranteeing 100 percent of the value of the annuity up to the minimum pension, and 75 percent above), and insolvencies of pension funds (guaranteeing a minimum rate of return after AFP’s own resources are exhausted).
Appendix II: Data Sources
The data draw from a wide range of different sources mainly official but also private. Long-term time series in official publications are typically not available and sometimes require an index-type linking to overcome structural breaks.
System of National Accounts Data: Banco Central de Chile (various issues (1990 and 1993)); Coeymans (1992) and Coeymans and Mundlak (1993) and Coeymans private data bank for real and nominal capital stock.
Fiscal Data: Flores-Jaña (1991), Dirección de Presupuestos, and Instituto Libertad y Desarrollo, mimeographed.
Pension Systems and Labor Market Data: Iglesias et al. (1991), Superintendencia de AFP (various issues); Superintendencia de la Seguridad Social (various issues); Instituto Nacional de Estadísticas (various issues).
Financial Data: Banco Central de Chile (Boletín Mensual, various issues), and Desormeaux’s private data bank (Instituto de Economía, Pontificia Universidad Católica de Chile).
Arrau, P., “La Reforma Previsional Chilena y su Financiamento Durante la Transición,” Colección Estudios CIEPLAN 32 (June 1991), pp. 5–44.
Arrau, P., and K. Schmidt-Hebbel, “Macroeconomic and Intergenerational Welfare Effects of a Transition from Pay-As-You-Go to Fully-Funded Pensions,” Background paper for the World Bank Study on Old-Age Security (mimeographed, Washington, 1993).
Arcaya, O.G., and S. Valdés-Prieto, Democracy and Pensions in Chile: Experience with Two Systems” (mimeographed, Catholic University of Chile, 1994).
Auerbach, A.J., and D.N. Weil, “ The Increasing Annuitization of Elderly: Estimates and Implications for Intergenerational Transfers, Inequality, and National Saving,” NBER Working Paper No. 4182 (October 1992).
Bencivenga, V., and B. Smith, “Financial Intermediation and Endogenous Growth,” Review of Economic Studies, Vol. 58 (1991), pp. 195–209.
Bencivenga, V., and R. Starr, “Equity Markets, Transaction Costs, and Capital Accumulation,” an illustration paper presented at the World Bank Conference on Stock Markets, Corporate Finance, and Economic Growth, February 16 and 17, 1995 (Washington).
Bosworth, B.P., R. Dornbush, and L. Laban, eds., “The Chilean Economy: Policy Lessons and Challenges” (Washington: The Brookings Institution, 1994).
Breyer, F., “On the Intergenerational Pareto Efficiency of Pay-As-You-Go Financed Pension Systems,” Journal of Institutional and Theoretical Economics, Vol. 145 (1989), pp. 643–58.
Breyer, F., and M. Straub, “Welfare Effects of Unfunded Pension Systems when Labor Supply is Endogenous,” Journal of Public Economics, Vol. 50 (1993), pp. 77–91.
Coeymans, J.E., “Productividad, Salarios y Empleo en la Economía Chilena: Un Enfoque de Oferta Agregada,” Cuadernos de Economía, Vol. 29, No. 87 (1992), pp. 229–63.
Coeymans, J.E., and Y. Mundlak, “Structural Growth in Chile: 1962-82, International Food Policy Research Institute,” Research Report No. 95 (Washington, 1993).
Corbo, V., and K. Schmidt-Hebbel, “Public Policies and Private Saving in Developing Countries,” Journal of Development Economics, Vol. 36 (1991), pp. 89–115.
Corsetti, G., “An Endogenous Growth Model of Social Security and the Size of the Informal Sector,” Revista de Análisis Económico, Vol. 9, No. 1 (1994), pp. 57–76.
De Castro, Sergio, ed., “El Ladrillo: Bases de la Política Económica del Gobierno Militar Chileno” (Santiago de Chile: Centro de Estudios Públicos, 1992).
De la Cuadra, S., and S. Valdés-Prieto, “Myths and Facts about Financial Liberalization in Chile: 1974-1983,” in If Texas were Chile: A Primer on Banking Reform, ed. by P.L. Brock (San Francisco: ICS Press, 1992a), pp. 11–129.
De la Cuadra, S., “Bank Structure in Chile,” in Banking Structures in Major Countries, ed. by Boston et al (Kluwer Academic Publishers, 1992b), pp. 59–112.
Diamond, D.W., “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies, Vol. 51, No. 3 (1984), pp. 393–414.
Diamond, P., and S. Valdés-Prieto, “Social Security Reforms in Chile,” Documento de Trabajo No. 161 (Instituto de Economía de la Pontificia Universidad Católica de Chile, Octubre 1993).
Flores-Jaña, T., “Sector Público no Financiero,” Programa Interamericano de Macroeconomía Aplicada (Santiago: Instituto de Economía de la Pontificia Universidad Católica de Chile, 1991).
Greenwood, J., and B. Jovanovic, “Financial Development, Growth and the Distribution of Income,” Journal of Political Economy, Vol. 98, No. 5 (1990), pp. 1076–107.
Holzmann, R., ed., “Ökonomische Analyse der Sozialversicherung, Schriftenreihe des Ludwig, Boltzmann Instituts für ökotvondsche Analysen,” Bd. 3, Wien (Manz 1988).
Holzmann, R., “Funded and Private Pensions for Eastern European Countries in Transition,” Revista de Análisis Económico, Vol. 9, No. 1 (1994), pp. 169–210.
Homburg, S., “The Efficiency of Unfunded Pension Schemes,” Journal of Institutional and Theoretical Economics, Vol. 146 (1990), pp. 640–47.
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Larrain, F., “Public Sector Behavior in a Highly Indebted Country: The Contrasting Chilean Experience,” in The Public Sector and the Latin American Crisis ed. by F. Larrain, and M. Selowsky (San Francisco: ICS Press, 1991), pp. 89–136.
Levine, R., and S. Zervos, “Policy, Stock Market Development, and Long-Run Growth Part I,” paper presented at the World Bank Conference on Stock Markets, Corporate Finance, and Economic Growth, February 16 and 17, 1995.
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The first version of this paper was prepared while I was a guest professor at the Instituto de Economía, Pontificia Universidad Católica de Chile in March-April 1995, and a revised version while I was academic scholar at the Fiscal Affairs Department in June-August 1995. I want to thank both institutions for their encouragement and support, and the possibility to present the results at their research seminars where I received many valuable comments. Special thanks for helpful comments and support go to Salvador Valdés-Prieto, Peter Diamond, Ross Levine, Philip Gerson, Sandy Mackenzie, and Vito Tanzi. All errors and omissions are, of course, my own doing.
For a detailed survey and analysis of the Chilean pension reform in English see Diamond and Valdés-Prieto (1993); a very short summary is provided in the Annex.
For Austrian evidence of a negative correlation between the internal rate of return of the public scheme and the market rate of interest, see Holzmann (1988).
It has to be stressed that the mere change of the financing mechanism of an unsustainable unfunded retirement scheme is not sufficient to put it on a sustainable funded basis. Any real pension reform has to undertake two changes essentially simultaneously: reducing the commitment of the given pension scheme (with given target income replacement rates, essentially through an increase in the retirement age) and shifting the financing mechanism. This was done in the Chilean pension reform by harmonizing the different pension schemes and increasing the standard retirement age to 65 for men and 60 for women.
The other equations of this growth model are traditional and specify the output, Y, via a production function with constant returns to scale on capital, K, and labor, N, (man-hours in efficiency units):
Y = F(K,N) = Nf(k),
an exogenous growth rate, n, of population/employed (in man-hours L)
∂L/∂t = nL,
a definition equation between N and L via the technical-change multiplier, T:
N = TL, and
the capital coefficient:
k = K/N.
∂(·)/∂t is the time derivative and, δ, the rate of depreciation of capital.
This result is valid for both environments but the steady-state capital intensity in the competitive equilibrium, k**, tends to exceed the planner’s solution, k*.
In the decentralized solution the net rate of return with externalities is f′(k*) - δ = λ + n + α(κ, …)k*, still leaving a growth differential of α(κ,…)k* for compensation of the transition generation.
No strictly comparable FIRs could be established for the pre- and post 1975 period. However, the available data for Chile suggest a long-term decrease in the FIR-2 from 63 percent (1940), 32 percent (1950), 29 percent (1960), with a slight increase to 39 percent (1971) prior to a major shake-up of the economy (Cerda and Zeballos (1975)). The increase in the FIRs between 1975-1980/81 corresponds to a period of accelerated growth and very fast and little regulated financial market liberalization, being held responsible for the banking crisis of 1981/83.
In the late 1970s, the credits to the private sector were financed largely by borrowing from abroad. The banking crisis emerged with the collapse of copper prices and the strong devaluation of the peso.
These data are used in Levine and Zervos (1995), and the access granted by Ross Levine is gratefully acknowledged.
For an analysis of the experience and mistakes of financial market liberalization during this early period of economic reform, see De la Cuadra and Valdés-Prieto (1992a and 1992b) and Valdés-Prieto (1992).
A further approach in preparation intends to investigate the impact of pension fund activities on asset-price mismatching on a monthly basis, using monthly stock, turnover, and return data of pension funds.
The parameter estimates for the ΔFIR and ΔSMI variables slightly differ from previously presented estimates due to data revisions and the normalization of the respective sample average to one. The normalization allows for a direct parameter comparison between different financial market indicators and a straightforward interpretation of the parameter value.
The approach uses the data structure of the Almon lag to calculate a composite variable ΔFMI(1,s)t = 1sΔFMIt + 2sΔFMIt-1 + …1sΔFMIt-1. Thus ΔFMI(2,2)t = ΔFMIt + 4ΔFMIt-1 + 9ΔFMIt-2. This approach results from economic, econometric, and data considerations. Economically one would assume that improvements in the financial market, measured by changes in the level of FMI, will have little immediate impact, but that the impact follows with a lag, and the strength of the impact growing over time for some periods. However, a direct application of the traditional Almon procedure is prevented by the short period of observation, with increasing s under the full Almon approach reducing the degree of freedom on a pro-rata basis. In addition, ΔFMI(1,s) for 1 and s=1,…, 3 proved to be highly correlated. Finally, unless very strict conditions are met, the Almon procedure will yield biased and inconsistent estimates.
The multiplicity of social security funds prior to 1981 with frequent double counting and the lack of comparability does not allow a comparison with post-1981 developments. But the past-1981 data are also surrounded by uncertainties, inter alia:
The total number of actual contributors to the new scheme, as regularly published by the Superintendencia de AFP comprises payments for the current month, for cleared arrears of past months, and for payments in transit (not yet allocated to individual AFP). Only if the distribution of these payments between current/arrears/transit over the months is constant is the number of actual contributors a good indicator for effective contributors.
Military and police staff have conserved their unfunded schemes (i.e., they are not required to contribute to the new scheme) but the number of contributors is not published. In order to calculate the ratio of old and new contributors to mandatory contributors requires an estimation of their number (for which a ratio to the published number of beneficiaries is taken).
Our reported point estimates of FMI on capital accumulation of 0.004 to 0.008 are close to the estimate in the cross-country study of 0.011 (with a t-value of 2.38); Levine and Zervos (1995).
The premium payments until 1989 are available from Iglesias et al. (1991). For outer years they were calculated from the wage bill and the number of contributors, corrected for indicated underpayment of premiums for the period until 1989.
The flow returns on AFP assets were calculated by the average yearly stock and a representative interest rate of the financial market.
In principle, the flows ought to be corrected for savings generated in the up-stream insurance companies and dissavings by benefit payout. Both data were not at hand.
The impact of pension reform on labor market performance was not econometrically investigated. Yet, since 1980 the growth rate of labor force was 1.7 percentage points per annum above the growth rate of the working population, the value which is taken for deriving the high-growth estimate.
This description draws on various sources, in particular, Iglesias et al. (1991), Diamond and Valdés-Prieto (1993), and Superintendencia de AFP (various issues). For interesting insights into the political economy of this pension reform see Piñera (1991), then the Minister of Labor and Social Affairs, and a main driving force for the implementation of the reform. The intellectual antecedents of the reform approach, however, go back to at least 1973 (De Castro (1992)).