A. The Pension System Before 1993⁹⁴

127. Before the first pension reform in 1993 (Law 100), pensions were organized on a PAYG basis. Contribution rates were low compared to the large benefits provided and the very generous pensions granted to some groups. The most important schemes were the more than 1000 pension plans for public sector employees, including those in decentralized institutions and public enterprises, and a mandatory scheme for private sector workers under the social security institute (ISS).

128. Benefits varied widely between the different plans. Plans for public workers provided more generous benefits than those available to private employees. The majority of the public sector plans were noncontributory, whereas the contribution rate for private workers was 6.5 percent of wages and salaries. Retirement ages were five years lower in the public sector than under the ISS. The replacement rate (the pension as a percent of a worker’s wage during some base period) varied from 75 percent for public workers to 45–90 percent⁹⁵ for private workers. For both public and private workers, the calculation of the replacement rate was based on the average salary of the last two years before retirement.

129. By the time of the 1993 reform, pensions for public workers were almost entirely financed by the central and regional governments. Pension payments made by the ISS to private sector workers were slightly below the contributions; consequently, the ISS built financial reserves, which were invested in government securities.⁹⁶ These balances were available to finance future benefit payments only in a bookkeeping sense; from the perspective of the consolidated operations of the public sector, they did not constitute assets that could be drawn down in the future to fund benefits. Instead, they were claims on the public sector itself, and raising taxes, lowering expenditures (other than pensions), or borrowing would be needed to finance a cash deficit of the pension system.

130. The weakness of the pension plans in 1993 were explained by faster demographic change than expected when the different plans were initiated, imbalances of contributions and benefits, inefficient management practices in many plans, a lack of adequate control, and corruption in some cases. Emerging cash imbalances, actuarial deficits, and inequities made clear the need for a change, which would come with Law 100.

B. The Reform of 1993 (Law 100)

131. Law 100 of 1993 was an important step to broaden the coverage of the pension system, reduce inequities, and provide adequate and sustainable retirement benefits; however, as explain below, Law 100 did not fully address the problems. The reform established a dual regime by maintaining the PAYG regime managed by the ISS and introduced, as an alternative, a regime of defined contributions to capitalization funds managed by private institutions. While the insolvent public pension plans would be liquidated, the other plans for public workers would be fully incorporated into the reform in 2014, the end of the transition period.

132. The ISS and the private funds would compete for affiliates who could move back and forth between the regimes every three years. The reform left untouched some special pension regimes; the most important of these were the regimes for teachers, employees of ECOPETROL (the state oil company), and the security forces (army and police).

133. The contribution rate for the public plans that remained open, the ISS pension regime, and the private plans was fixed initially 8 percent of wages and salaries; it was increased gradually to 13.5 percent by 1996 (25 percent paid by employees and 75 percent paid by employers compared to 33 and 67 percent, respectively, before Law 100). At the same time, the retirement age was increased by two years (to 52 years for women and 57 years for men), the minimum number of contributions was raised by 500 weeks to 1,000 weeks, and the replacement rate was fixed at 65 percent. The base salary used to calculate the pension was the average of the last 10 years.

134. Workers with earnings of more than four times the legal minimum wage would have to contribute an additional 1 percent of their income to a newly created solidarity pension fund. Government transfers to the fund would match these contributions. The resources of the fund would be used to supplement the contributions of some groups such as workers with wages below the minimum required to qualify for a pension, and certain other groups.

135. For the transition period to 2014 the system established that men older than 40 years and women older than 35 years in 1994 had to stay in the former system, consisting of the ISS and the funds for public workers that would remain open during the transition. Other contributors could move to capitalization funds or remain in the ISS system; most of the public pension plans were to stop accepting new affiliates. Those who changed affiliation would be provided with recognition bonds whose face value would reflect the present value of their entitlements under the old system. The bonds would be redeemed at the time of retirement.⁹⁷ During the transition period the retirement age would remain at 55 years for women and 60 years for men; after 2014 the ages would be 57 years for women and 62 years for men.

136. The resources of the private capitalization funds are invested in equities, bonds, and money market instruments. Law 100 established maximum investment limits per instrument and issuer, expressed as a percent of the total investment of the fund. At the time of their retirement, participants in these funds would use the accumulated funds in their individual accounts to purchase an annuity from an insurance company or combine the annuity with withdrawals.

C. Issues to be Addressed in a New Reform

137. As designed, the reform enacted in 1993 did not resolve the problems of the PAYG regime, and some of the principles set down in the reform have not been fully applied. Hence, the actuarial deficit has increased and cash imbalances have emerged in the ISS despite the increase in the contribution rate. The main reason of this is the reduction in the number of contributors, which has been more pronounced than expected at the time of the approval of Law 100, mainly as younger people have chosen the private plans. In addition, the government budget has covered the gap between payments of pensions and contributions for the public plans.

138. The system has also confronted other problems. The option for participants to move back and forth between the ISS and private institutions impose additional costs on the PAYG regime. The changes involve administrative costs, and workers will switch to the ISS if the pension they receive there is higher than what they would receive from private funds.

139. Under Law 100, the regimes that were insolvent in 1993 were to be closed. However, many insolvent schemes were kept open and there are a number of irregularities in granting benefits under some of these schemes. There is no institution in Colombia that audits compliance with the provisions of the original plans and certify the benefits.

140. The reform enacted in 1993 left a number of public plans outside the general system. The pension systems for teachers, oil workers, and security forces are explicitly excluded. As regards pensions for workers of the public oil company (ECOPETROL), a portion of the oil-price windfall of 1999 and 2000 was allocated in public sector entities to fund the pension liabilities of the company. In addition, collective bargaining agreements in public sector entities may provide for more generous benefits than established by Law100%.

141. Colombian private pension funds are required to guarantee a minimum rate of return to their affiliates, defined as a combination of the performance of a reference portfolio of investments and the average returns obtained by the industry. At present, this benchmark leaves no room for investing in long-term instruments and taking reasonable risks to maximize profitability. This restriction prevents these funds from playing an active role in the development of a domestic medium-term securities market.

142. Against the background presented above and the constraint imposed by the need to secure fiscal sustainability of Colombia’s public finances over the medium and longer term, the following paragraphs present a summary of the main issues facing the authorities in designing the next pension reform, which will be presented to congress this year.

• To avoid large tax increases in the future, the next reform will need to generate a significant reduction in the actuarial deficit of the PAYG system. Therefore, changes in the main pension parameters are needed, including in the retirement ages, the minimum contribution periods, contribution rates, and/or the replacement rates. Also, the possibility open to workers of moving between the PAYG regime and private funds may need to be restricted. At the same time, the option of raising the contribution rates has to be assessed in light of the present payroll taxes and other charges on salaries, which are very high.⁹⁸ If the system is not overhauled, the cash deficit of the PAYG system (the ISS and the public plans) could grow to 5 percent of GDP in 2010.

• Regardless of the changes in the main pension parameters, during the transition period of the forthcoming reforms, the prospective cash deficits of the ISS and the public plans that have remained open are a matter of concern. Therefore, one important objective of the next reform would be to define a short transition period, and if changes in the main pension parameters should prove insufficient, additional receipts would need to be allocated to the system; for example, a reallocation of some of the payroll taxes might serve to enhance the finances of the ISS and the public plans to help reduce the financial gap.

• For financial and equity reasons, the public sector regimes excluded from Law 100, should be included in the general system. At the same time, balanced by the right of collective bargaining, some limits on labor contracts for public sector workers granting benefits over those defined by the general regime would need to be established.

• Because of the irregularities in granting benefits and problems regarding personal records of affiliates, a public agency might be created to enforce compliance with the rules of the system and certify benefits.

• For efficiency and financial reasons, new regulations to let private funds diversify their portfolio are needed.