Chile, which established the Western Hemisphere's first pay-as-you-go Social Security system in 1924, led the way into uncharted territory in 1981 when it became the first nation in the world to privatize Social Security.
Nineteen years later, the Chilean system is still being fine-tuned, but it has successfully converted what was an inefficient, nearly bankrupt retirement system into a sound system of individual retirement accounts. Versions of the Chilean model have spread to most other Latin American countries.
Now Texas Gov. George W. Bush, the presumptive Republican presidential nominee, has proposed letting U.S. workers divert a portion of their Social Security payroll tax to personal retirement accounts that would be used to pay part of their future benefits. Democratic Sens. Bob Kerrey of Nebraska and Daniel Patrick Moynihan of New York have endorsed a similar idea, and several members of Congress of both parties have introduced legislation, although Vice President Al Gore, the presumptive Democratic nominee, strongly opposes it.
What Chile did is worth examining, although its reform was far more drastic than anything proposed for the United States. It went to full-fledged privatization for individuals just entering the workforce. They were required to contribute 10% of earnings plus a 3% administrative fee each month to one of several pension fund management companies that were restricted to making very conservative investments.
People already working had a choice of staying with the old system or switching to the new one. Those who switched got credit for their contributions to the old system in the form of "recognition bonds." The bonds accrue interest at 4%; the government cashes them when the worker retires and adds the money to the worker's individual account. Only about 7 percent of workers are in the old system, which is financed through employees' contributions and government subsidies, and which is gradually being phased out.
The Chilean system has been under attack from detractors since its inception for, among other things, having been established under a military dictatorship (true, but the country kept the system after the dictator was gone), for high administrative fees (also true, but they have been reduced and are to be reduced further in the future), and because participation is voluntary for the 26% or so who are self-employed (again true, just as it was under the previous system).
However, claims that workers have fared less well and that the reformed system is itself unsustainable ring hollow. Through 1998, retirement benefits averaged being 19.6% higher than under the old system. Workers are allowed to retire at any time funds in their accounts are actuarially sufficient for early retirement. Until 1996, according to Jose Garcia Cantera, one of the authors of SalomonSmithBarney's "Private Pension Funds in Latin America: 1999 Update," "returns were so high that many workers retired several years before reaching the legal age of 65."
When the new system was established, officials estimated it would require an average real return of 4% per year to guarantee a pension level above 80% of a retiree's last salary. Since 1996, Garcia Cantera reports, returns have decreased, but are still "extremely high in real terms, well in excess of the minimum level to guarantee the pension." Despite real returns of a negative 2.5% in 1995 and a negative 1.1% in 1998, from inception through last November the real annual return has averaged 10.9%. It has never been lower than 10.7%. To fall below 4%, Garcia Cantera writes, "returns would have to be negative 2% for the next 20 years, which seems highly unlikely."
One of the reasons for below-average performance from 1995 through 1998 was that the highly restrictive investment limits prevented the fund management companies from adjusting their allocation decisions. The Superintendency of Private Pension Funds has since increased the limit on foreign equities from 8% to 10% of total investment. Another change allows fund management companies to manage a second fund composed of fixed-income instruments and to adjust the existing fund to be more aggressive, with a longer-term horizon.
A major challenge that Chile faced was financing the transition from a pay-as-you-go system to a fully funded system. The country was able to accumulate a budget surplus of about 5.5% percent of gross domestic product (GDP), much of it by selling state-owned enterprises to the private sector. Chile has paid off more than half of the remaining unfunded liability from the old system from budget surpluses, and expects it to take about 30 more years to pay off the remainder.
Chile took radical action when its Social Security system was on the brink of collapse. The relatively mild action proposed by Bush, Kerrey, Moynihan and others can be a big step toward saving our system from ever reaching that point.
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The National Center for Policy Analysis is a public policy research institute founded in 1983 and internationally known for its studies on public policy issues. The NCPA is headquartered in Dallas, Texas, with an office in Washington, D.C.