Insurance and Pension in Chile

A formal definition of insurance is given as follows: "A promise of compensation for specific potential future losses in exchange for a periodic payment."  There are in fact many types of insurance, but this article will focus on only two specific types: life insurance and pensions  Our discussion will be in the context of the country of Chile.

Life insurance is a contract between the purchaser of the policy (known as the policyholder) and the insurance company (known as the insurer). Under the terms of a life insurance contract, the insurer promises to make payments of a certain sum to a person or party (a beneficiary) named by the owner of the policy (policyholder) when the named person in the policy (the insured) dies during the coverage period.  Death may strike anyone prematurely. When death takes the life of a family provider, surviving family members often suffer if they are left without an adequate income or the means to provide even basic necessities.  Life insurance therefore secures the economic future of the survivors.  In Chile, life insurance is provided by more than 30 private insurance companies, including traditional U.S. and European companies as well as several strong Chilean competitors.

Pensions are post-retirement benefits that employees receive from employers after they retire.  The importance of the Chilean pension system extends far beyond the country of Chile, for it was an experiment with implications for other countries around the world.  For this reason, it is worthwhile to read the detailed words of the leading proponent José Piñera:

In Chile, the Pension Reform law of 1980 introduced a revolutionary innovation. The law gave every worker the choice to opt out fully from the government-run pension system and instead put the former payroll tax in a privately managed Personal Retirement Account (PRA). Since 95 percent of the workers chose the PRA system, the end result was a "privatization from below" of Chile's Social Security system.

Under Chile's new social security system, what determines a worker's retirement benefit is the amount of money he accumulates in his PRA during his working years. Neither the worker nor the employer pays a payroll tax. Nor does the worker collect a government-funded benefit. Instead, 10 percent of his wage coming from the previous payroll tax is deposited, tax free, by his employer each month in his own PRA.  The 10 percent rate was calculated on the assumption of a 4 percent average real return in the PRA during the whole working life, so that the typical worker would have sufficient money in his account to fund a retirement benefit equal to approximately 70 percent of his final salary. A worker may contribute up to an additional 10 percent of his wage each month also deductible from taxable income, as a form of voluntary savings. The return on the PRA is tax free. Upon retirement, when funds are withdrawn, taxes are paid according to the income tax bracket at that moment.

A worker may choose any one of the private Pension Fund companies (called "Administradora de Fondos de Pensiones,'' AFP) to manage his PRA. A key provision is totally free entry to the AFP industry, both for domestic and foreign companies (that can own up to 100 percent of them), in order to provide competition and thus benefit workers. These companies can engage in no other activities and are subject to strict supervision by a government entity, the "Superintendency of AFP," that was created to provide highly technical oversight to prevent theft or fraud.

Each AFP operates five mutual funds, with different bond/share proportions (the original scheme was with only one fund for each AFP). Older workers have to belong to mutual funds highly invested in fixed income securities, while young workers can have up to 80 percent of their funds in shares. Investment decisions are made by the AFP, but the worker can choose both the AFP and, within limits, the preferred fund. The law sets only maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio; and the spirit of the reform is that those regulations should be reduced progressively as the AFP companies gain experience and capital markets work better. There is no obligation whatsoever to invest in government bonds or any other security. Legally, the AFP company and the mutual funds are separate entities. Thus, should an AFP go under, the assets of the mutual funds-that is, the workers' investments-are not affected at all and only the AFP's shareholders lose their capital.

Workers are free to change from one AFP company to another, and from one fund to another. There is then competition among the companies to provide a higher return on investment, better customer service, or a lower commission. Each worker is given a PRA passbook (if they want to update their balances visiting their AFP) and they receive a regular statement by mail every three months informing him how much money has been accumulated in his retirement account and how well his investment fund has performed. The account bears the worker's name, is his property, and will be used to pay his old age retirement benefit (with a provision for survivors' benefits).

As should be expected, individual preferences about old age differ as much as any other preferences. Some people want to work forever; others cannot wait to cease working and to indulge in their true vocations or hobbies. The pay-as-you-go system does not permit the satisfaction of such preferences, except through collective pressure to have, for example, an early retirement age for powerful political constituencies. It is a one-size-fits-all scheme that may exact a high price in human happiness.

The PRA system, on the other hand, allows for individual preferences to be translated into individual decisions that will produce the desired outcome. In the branch offices of many AFPs, there are user-friendly computer terminals that permit the worker to calculate the expected value of his future retirement benefit, based on the money in his account, the life expectancy of his age group, and the year in which he wishes to retire. Alternatively, the worker can specify the retirement benefit he wishes to receive and determine how much extra money he must deposit each month if he wants to retire at a given age. Once he gets the answer, he simply asks his employer to withdraw that new percentage from his salary. Of course, he can adjust that figure as time goes on, depending on the actual yield of his pension fund or other relevant variables (for example, longer life expectancies).

The option to opt out for a PRA system was given to all private and public sector employees.  Self-employed workers are not compelled to participate in the PRA system, as they were not in the government pay-as-you-go system, because of the practical difficulties in a country like Chile of enforcing any mandatory system for self-employed people. But the Pension Reform allowed them to enter the PRA system if they wish, thus creating an incentive for informal workers to join the formal economy.

The Social Security Reform system maintained a "safety net." A worker who has contributed for at least 20 years but whose benefit, upon reaching retirement age, is below what the law defines as a "minimum pension" is entitled to receive that benefit level from general government revenue sources once his PRA has been depleted. (Those without 20 years of contributions can apply for a welfare-type retirement benefit at a lower level.)

The government-run disability and survivor program, a source of systematic abuse given the inexistence of incentives to control its fair use, was also fully privatized. Each AFP has to provide this service to its affiliated workers by taking out, through open and transparent bidding, group life and disability coverage from private life insurance companies. This coverage is paid for by an additional worker contribution of around two percent of salary, which includes the commission to the AFP for administrative and fund investing expenses.

A key feature of the Reform was the change in the meaning of "retirement." The legal retirement age is 65 for men and 60 for women (those were the ages in the former pay-as-you-go system, and were not discussed or changed during the reform process because they are not a structural characteristic of the PRA system). But in the PRA system, workers with sufficient savings in their accounts to buy a "reasonable annuity" (defined as 50 percent of the average salary of the previous 10 years, as long as it is higher than the "minimum pension''), can cease working, begin withdrawing their money and stop contributing to their accounts. Of course, workers can continue working after beginning to retire their money. A worker must reach the legal retirement age to be eligible for the government subsidy that guarantees the minimum pension. But in no way is there an obligation to cease working, at any age, nor is there an obligation to continue working or saving for retirement benefit purposes once you have assured yourself a "reasonable" benefit as described above.

Upon retiring, a worker may choose from three general payout options. In the first case, a retiree may use the capital in his PRA to purchase an annuity from any private life insurance company. The annuity must guarantee a constant monthly income for life, indexed to inflation (there are indexed bonds available in the Chilean capital market so that companies can invest accordingly), plus survivors' benefits for the worker's dependents (wife, and orphans under the age of 21). Second, a retiree may leave his funds in the PRA and make programmed withdrawals, subject to limits based on the life expectancy of the retiree and his dependents; with this option, if he dies, the remaining funds in his account form a part of his estate and can be given to his dependent heirs basically tax-free. In both cases, he can withdraw as a lump-sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages. And third, he can choose any mix he wants from the previous two.

We will now refer to some survey data from the TGI Chile study.  This is a survey of 2,004 persons between the ages of 12 to 64 in Gran Santiago interviewed during the first half of 2002.  Within the survey, the respondents were asked if they have life insurance and pension plan.  11.1% of the respondents said they hold life insurance policies and 43.7% of them said they have pension plans.

In the next two charts, we show the incidences by age/sex groups.  Life insurance holders are much more likely to be middle-aged or older males.  This reflects the fact that they are most likely the principal income-earners within their households, and life insurance is therefore precisely directed towards them.  As for the pension plans, they are more likely to be male than female, with the distribution being fairly constant after 25 years of age.

(Source: 2002 TGI Chile)

(Source: 2002 TGI Chile)

The gender gap in the previous charts must surely be related to participation in the labor force.  In the next chart, we show the incidences by employment status and occupations.  Both financial instruments have higher incidences among the employed than the unemployed.  Life insurance has higher incidences among the occupations that are likely to yield higher income (professional/managerial class), but pension does not show that trend.

(Source: 2002 TGI Chile)

In the next chart, we show the incidences by socio-economic level.  Both financial instruments show increasing incidences going up the socio-economic scale.  The increase is much higher for life insurance policies than for pension plans.  Apart from the obvious explanation that these financial instruments reflect the monetary value of life (and therefore whether or not it is worth paying the policy premia), this is also the consequence of the specific Chilean systems. 

(Source: 2002 TGI Chile)

The Chilean pension system is not without its detractors (see example).  According to government statistics, and confirmed by the survey results that we presented here, about half of the workforce will not be covered by any pension plan.  Many of these excluded people are engaged in the informal economy.  It is one thing to say that they are entitled to participate through voluntary contributions to pensions, but the reality is that most of them do not because they have little or no disposable income to spare.  These people can expect nothing from this pension system.  And even among those who have a theoretical pension plan, their net payment is so low that they will be entitled only to the minimum pension guaranteed by the government, namely at 75 percent of the minimum salary.  In the end, perhaps only a quarter of the workforce will be able to obtain some meaningful payout from this system.  

Another key legend of the Chilean pension reform is the high "double digit" returns on investment.  The critics say that this is illusory and, even if true so far, unsustainable.  The United Nations Program for Development’s 2000 report on Human Development in Chile points out that the AFPs charge considerable management fees; more precisely, the fees amount to "more than a fifth of the net contributions to the system."  Therefore, according to the study by the Chilean brokerage firm CB Capitales, the real rate of return in the individual accounts has averaged only 5.1% since 1982.  When the economy was expanding, the stock prices grew at 30 percent a year.  But if and when the economy slumps, those growth rates disappear and individual accounts experience net decreases.  The only thing that is for certain is that the AFPs will maintain their profit levels regardless.

The AFPs were set up as an open, competitive market.  But while there is tremendous pressure on the AFPs to get as much commitment as they can, the consumers have little or no real reason to switch since the AFPs look very similar with respect to fee structures and past performances.  Instead, there is a lot of hard-sell tactics by the AFPs to recruit new accounts, with special gifts and incentives.  It is said that about half of the account holders will switch AFPs every six months just to take advantage of the special offers (such as consumer electronics, liquor, mountain bikes, etc) and these switches are not economically productive activities.

The book on the Chilean pension system is not closed yet.  The full story will be a developing one that will be unfold over the many years ahead.

(posted by Roland Soong, 12/26/2002)