Download - The Latin American Experience
The Latin American Experience
with Pension Reform
by
Salvador Valdés-Prieto*
Annals of Public and Cooperative Economics – Vol.69 No4 – December 1998
* Professor of Economics, Institute of Economics, Universidad Católica de Chile, fax (562) 562 1310, email:
[email protected]. I am grateful to Estelle James for having incited me to write this paper, and for excellent
advice and corrections. Augusto Iglesias and Rodrigo Acuña provided access to the innovative “Statistical Report on
Private Pension Systems in Latin America.” I am grateful for the comments by Estelle James and Julio Bustamante.
All remaining errors are mine.
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Introduction
This paper surveys the Latin American experience with fully funded privately managed
second pillars, introduced in radical pension reforms following the Chilean reform of 1981. As of
late 1997, the Latin American second pillars had 26.7 million members and 15.6 million
contributors. Four countries have now had four or more years of experience with their new
systems -- Chile, Peru, Colombia, and Argentina. Four more recent reformers, Bolivia, Mexico,
El Salvador, and Uruguay are excluded from this survey because their new systems started only
in 1996-1998. Table 1 provides descriptive statistics for the new funded second pillars in the four
selected countries.
This paper attempts to answer the following questions: First, why did many Latin
America countries embrace the radical approach to pension reform pioneered by Chile? Second,
what are the major obstacles to such reforms and how they have been dealt with? Third, what are
the main pitfalls to avoid in such complex pension reforms?
Section 2 of the paper approaches the first question. It presents a brief history of social
security in Latin America, with the purpose of explaining the main elements of the demand for
pension reform. Section 3 identifies three major potential obstacles to pension reform at a
theoretical level, while sections 4 to 7 apply this framework to Chile, Peru, Colombia, and
Argentina. Section 8 summarizes the lessons learned and identifies some of the pitfalls in this
type of pension reform.
2. The Latin American demand for radical pension reform
This section seeks to lay out the reasons that have led policy makers in several Latin
American countries to consider seriously a radical reform of their pension systems, in the
direction of privatization and increased funding.
The Social Security Tradition in Latin America
Social security was adopted in Latin America in two waves: the Southern Cone countries
(Argentina, Chile, and Uruguay) were early adopters, mandating contribution to collective social
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security institutions before the Great Depression of the 1930's (Mesa-Lago, 1989) and before or
simultaneously with several Western European countries. The second wave of adoption happened
in the early post war period, when Mexico (1943), Venezuela (1940), Costa Rica (1941), Peru
(1962) and Colombia (1965) started state-managed social security schemes. The pension systems
in this set of countries enjoyed an abundant cash flow surplus right up to the 1980's, because
population growth was much faster than in the Southern Cone and in addition they were 30 years
less mature.
During the 1960's and 70's a serious problem developed: a significant proportion of
members found that their benefits were much smaller than expected. For example, in Colombia,
the average pension in 1992 was only 1.23 times the minimum salary; in Chile in the late 1970's,
70% of pensioners were receiving the minimum pension. This outcome occurred for many
reasons, such as intended redistribution, unintended reduction of benefits through inflation (see
the case of Venezuela in World Bank, 1994, page 154), legislated caps on benefits, etc. In many
cases individual replacement rates were much below the theoretical levels advertised, feeding
anger and frustration among the middle-class old. These feelings were shared by a growing
proportion of the active workers, who found that they had to support their aged parents even
though they had impeccable contribution records.
The perception of inequity was exacerbated because a number of special interest groups
had obtained special treatment. For example, in Argentina workers who did not pay their
contributions on time were repeatedly allowed to 'regularize' their contribution record by paying
small fractions of the amount due, thus earning access to full benefits. These exemptions were
perceived to be indirectly financed by the benefit reductions that affected the majority. According
to surveys during 1995, 70% of the Uruguayan population perceived the old system as 'unjust' or
'very unjust', and 68% said that they felt 'unprotected' or 'obtained little protection' from the social
security system (Rodríguez, 1996).
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Causing and coinciding with these frustrations, the cash flow of the pension institutions
deteriorated substantially, creating massive fiscal problems. First, evasion of contributions came
to be seen as legitimate self-defense from an expropriatory system, so it became widespread.
Second, relatively short averaging periods allowed many members reaching pension ages to
increase taxable income artificially in order to increase their pensions. Third, just because of age
the pension institutions of the Southern Cone were reaching the phase of system maturation, in
which the initial cash surplus of pay-as-you-go financing turns into a cash deficit at the low initial
contribution rates. Fourth, the countries of the Southern Cone started their demographic
transition, becoming subject to one of the major weaknesses of pay-as-you-go financing. In the
1960s, Uruguayan pension expenditure reached 15% of GDP and 62% of government
expenditure, while the system dependency ratio fell from 4 in the 50's to 1.4 in the 90's. The case
of Uruguay is extreme because it has been compounded by emigration of the young.
Responses
The deterioration of cash flow in the pension institutions was met initially with
substantial increases in contribution rates, but evasion increased further. In some economies it
was easy to escape to the informal sector which set upper bounds to tax revenues.
The real problem was the inability to reform excessively generous benefit formulae once
system maturation squeezed cash flow. Attempts to reduce benefits faced strong political
opposition because the replacement rates were already seen as very low. Interest groups opposed
the needed increases in retirement ages, which in many cases were extremely low, attempts to
tighten the procedures for disability pensions got nowhere, and more generally, rational benefit
reduction proved politically impossible by explicit means. The resulting cash flow deficit is the
source of the widespread statement in Latin America that 'the old pension institutions are broke'.
In order to meet the budget crisis, the Alfonsín government in Argentina resorted to
illegality in 1986 and authorized unilateral reduction of pensions payments. This backfired when
the Supreme Court supported the pensioners that sued and the government had to confront over a
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million lawsuits. Although pensions began to be paid in full again since 1992, the outstanding
debt related to the lawsuits was estimated in 1996 at some 5 billion US$.
The Emergence of an Alternative: the Chilean Reform of 1980
The emergence of an alternative pension model in Chile, and its 12 years of experience as
of 1992, are, in my view, a major explanatory element of the spread of pension reform in Latin
America during the 1990's. For opinion leaders in other Latin American countries, the most
surprising features of the Chilean reform of 1980 seem to be the following:
a) The pension funds were not stolen by their managers, even though Chile went through
a banking crisis and a very deep recession in the 1980's. Many Latin Americans recall banking
scandals where small savers lost substantial amounts to financiers who escaped the country, so
private financial intermediaries have a tarnished image. The fact that privatized pension fund
managers in Chile did not embezzle the pension funds was considered a remarkable feat of
successful institutional engineering.
b) The pension funds were not used by the government to buy equities in insolvent state
enterprises nor forced to buy state bonds that yield less than market interest rates. This was
surprising for observers who suspected that regulation of pension funds would be used by
governments for that purpose, as happened in the collective pension funds that existed in the
initial stages of all pay as you go Latin American pension systems. To the contrary, recent
research shows that privatized pension fund managers in Chile have resisted political pressures
successfully and even sued a state-owned corporation in connection with the bondholder rights
agreed to in bond covenants (Godoy and Valdés-Prieto, 1997).
c) The high realized rate of return, which reached 12% per annum above inflation during
1981-1993, allowed the expected size of Chilean pensions to increase to generous levels, even
though contribution rates were reduced substantially. The rates of return obtained in 1995-97
were -2.5%, 3.5% and 4.7%, as the local stock market fell. However, during the 1990's the
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domestic bond market has offered CPI-indexed fixed income instruments at prices that imply real
returns of 6-7% for the next 20 years. This is the best estimate of future returns.
d) Even though pension fund investments were highly regulated at the start, they appear
to have contributed significantly to capital market development. In particular, they have improved
liquidity in security markets and have demanded services such as risk rating, which are useful to
other agents as well. They have provided domestic financing for large scale projects, a segment of
the capital market that did not exist previously. They stimulated new legislation designed to
manage and limit conflicts of interest and improve governance at the largest Chilean corporations.
e) It was shown by example that the poor old could be taken care of without using the
redistributive benefit formula offered by conventional pension systems. The provision of tax-
financed targeted benefits to the poor old, via a minimum pension program or via targeted
assistance pensions distributed by the municipalities and financed with general tax revenue,
proved that redistributive aims could be pursued effectively in a privatized pension system.
The lobbies in favor of pension reform
In the early 1990's a powerful convergence of ideas and interests in several Latin
American countries began to shape a serious demand for pension reform following the Chilean
model. A worldwide tide of ideas began to favor privatization, openness to international trade
and to foreign investment, and these ideas were taking hold among influential political leaders in
Latin America. More specifically, those politicians realized that funded pensions opened the way
to a blurring of the traditional division of citizens between workers (exploited) and capitalists
(oppressors), as workers could be turned into a new type of capitalist through the language of
individual accounts.
Among interest groups, business leaders realized that gaining access to a large pool of
domestic savings could allow them to play senior-league entrepreneurial games with huge profit
opportunities, while at the same time paying good returns to pensioners. More narrowly, financial
intermediaries found that private fund management companies could be a profitable new line of
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business. Private sector interest groups provided the funding for a number of the evaluation
studies of pension systems in Latin America in the 1990s, which in some cases laid the
groundwork for pension reform.
Established economists and multilateral lending institutions encouraged a pension reform
along the lines of the Chilean model. In many cases the multilateral institutions financed studies
needed for actual reforms. Frequently mentioned - but hard to measure - were the positive
externalities of pension funds in the promotion of financial market development and more
efficient labor markets.
However, demand for a radical pension reform has been weak in Brazil. Among the
factors that might explain this difference, we can suggest the following: First, economic policy in
Brazil exhibits a tradition in favor of government intervention, so the worldwide tide of ideas in
favor of privatization has had a delayed impact as compared to Spanish America. Second, the
corporate sector in Brazil already has set up a substantial occupational pension system based on
tax advantages, with assets above 60 U.S.$. billion (more than twice the Chilean pension funds)
and growing rapidly. This industry meets the demand for decent pensions from higher-income
workers and provides corporations with some discretionary investment funds. As the corporate
sector in Brazil has been dominated by state-owned enterprises, the Brazilian private sector has
not financed major reform studies or proposals. Thirdly, the chronic fiscal deficits in Brazil
during the 90's have been a major obstacle to increases in the degree of funding of the existing
state-run pension system. Brazil is now considering a different type of reform, based on a
notional defined contribution scheme (see paper on Sweden in this volume).
3. A framework for considering country case studies
The previous section has shown how a demand for radical pension reform took shape in
many Latin American countries. However, implementation problems of a technical or political
nature can prevent the satisfaction of this demand. This section identifies three major objections
to pension reform, which will be used below to guide the country case studies.
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Objection 1: Fiscal constraints
Any pension reform that diverts contributions from the old system towards a new system
deprives the old system of the resources usually directed to pay pension benefits. If the old
system has no significant financial assets to sell, as is the case in most of Latin America, the old
system has to resort to its guarantor, which is the state. The state can raise the funds by issuing
debt or by adjusting its current account, namely increasing taxes or reducing expenditures.
Many analyses of the fiscal constraint stop here. That is a mistake, because a natural
purchaser of eventual debt issued by the government is the new system, which gets the
contribution revenue but has no benefits to pay (yet) because it is just starting. However, the new
pension system may wish to diversify away from government debt. It turns out that this can be
accommodated easily. For example, if the new pension system buys just 60% of the new
government debt, it must devote 40% of its assets to other assets. Then the sellers of those other
assets will have the resources to buy the remaining 40% of the new government debt. Because of
the explicit interest cost incurred when the implicit debt turned into an explicit debt, a complete
wash requires a further policy measure. Workers who gain from the higher (market) rate of return
must cover the higher (market) interest cost borne by the government by accepting an incremental
wage tax (see Valdés-Prieto, 1997). This full debt financing option has been used in Bolivia and
Uruguay, which decided to finance the reform by issuing additional debt, at least initially.
The other countries decided to make some adjustment to the primary fiscal accounts. The
reasons for this are varied, ranging from perceived gains of having the new system invest a
substantial portion in private sector assets, to perceived gains of using the "pension reform
excuse" to increase fiscal and thus national saving, and to constraints imposed by private sector
lenders (or the IMF) when they have failed to monitor the total debt of the government including
unfunded pension liabilities and might interpret increases in the explicit public debt as a signal of
reductions in overall fiscal solvency.
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In general, the maximum potential size of the fiscal obstacle to pension reform that
countries must overcome is the size of the debt implicit in the old public pay as you go system,
i.e. the present value of accrued pension liabilities to both pensioners (still alive) and current
active workers minusing assets that the system has. In this spirit, the OECD has published
statistics that show that the implicit pension debt is above 150% of GDP in most Western
European countries and Japan.
This concept measures a true debt only to the extent that the state is committed to
honoring guaranteed benefits. A debt concept assumes that future governments will not introduce
laws that increase retirement age, raise contribution rates or reduce starting benefits, and will not
take administrative actions that reduce the real value of benefits, such as introducing lags in
benefit adjustment to inflation and failing to provide full indexation of past wages when benefits
are first determined. If such laws and administrative actions are expected, then the pension debt
should be adjusted downwards to include the probability of default and its likely size. Partial
default can be the result of abuse by previously active generations that legislated excessive
pension increases for themselves, the result of abuse by young generations who want to reduce
their tax liability even if this hurts pensioners, or the result of unexpected new developments that
warrant a benevolent reallocation of burdens across generations. This list shows that pension debt
can be quite different from contractual public debt.
Table 2 reports the available estimates of the size of the implicit pension debt in the old
systems in Latin America just before the pension reforms. Table 2 suggests that the "fiscal
constraint" was larger in the Southern Cone countries than in the rest of the reformers. The fact
that all these countries reformed anyway, and that some countries with relatively small debts have
not reformed, suggests that other forces are also at work, hence further delving into the country
cases is productive.
Objection 2: Underdeveloped Capital Market
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For a funded pension system to operate efficiently, some financial markets must be
available. If not, the pension funds are forced to invest in land, urban real estate and private
equity in business firms. A lack of assets with liquid markets and transparent prices exposes
pension funds to substantial transaction costs and uncertainty. Workers become exposed to fraud
by pension fund managers, because supervision of their activities becomes impossible and the
supervisory agency becomes vulnerable to corruption. Some of the failures of the old pension
systems in Latin America originated in underdeveloped financial markets.
This obstacle to reform can be overcome if the country embarks on liberalization of the
domestic financial market, or if up to 100% investment in foreign financial markets is allowed.
However, the liberalization program does not have to be completed before the pension reform
starts. For the first five or seven years the pension funds are small, so modest domestic markets in
bank deposits, government debt and some foreign assets may be enough to start.
Thus, the true nature of this obstacle lies in the ability of the political elite of a country to
manage and complete the transitional phase between the initial conditions and a fully developed
set of financial markets. Although the particulars differ, several reforming countries in Latin
America have substantial reservations about the quality of their capital market institutions. That
may explain why most countries - except Mexico and Bolivia - copied the Chilean approach of
tight investment restrictions coupled with case-by-case evaluation in a state-controlled Risk
Classification Commission (RCC). This approach has the advantage of providing more time for
the capital market to mature, but raises questions about the reliability of such heavy-handed
government intervention, even for a transitional period.
I argue that financial market underdevelopment is likely to force the failure of a reform
that attempts to increase the degree of funding of pension liabilities, unless a large CPI-indexed
long term bond market emerges within a decade. In Latin America it is highly likely that one or
more episodes of inflation and devaluation will reduce dramatically the real value of nominal
bonds over the time horizons for which individuals participate in a pension system. In the absence
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of a substantial supply of CPI-indexed long term bonds, the benefits promised by the pension
system are exposed to catastrophic inflation risk.
Many pay as you go financed pensions have introduced CPI indexation of benefits, taking
advantage of the fact that contribution revenue is highly responsive to wage inflation. Funded
systems can potentially do the same because bank debtors, home owners and corporations that
sell to the domestic consumer market can also issue CPI-indexed debt without suffering serious
mismatch problems. Of course, CPI-indexed debt is subject to credit risk, which is correlated with
monetary and exchange rate turmoil. However, as CPI-indexed debt protects borrowers from the
random wealth losses imposed by monetary turmoil, lenders avoid paying an inflation risk
premium when they place such debt. Few observers have realized the critical importance of this
aspect of capital market development, and up to 1997 no Latin American reformer has a CPI-
indexed debt market except for Chile and, incipiently, Mexico.
Objection 3: Redistribution and Equity
An argument against any reform in which the funded second pillar sets benefits in strict
proportion to individual contributions, is that this approach wastes an opportunity for income
redistribution. A standard response is that the first pillar, which gives subsidies to the poor old,
takes care of distributional objectives. However, if a progressive first pillar cannot be
implemented due to technical constraints, the conventional integrated approach seems to be more
equitable and reform may be rejected.
To assess this obstacle it is necessary to describe the technical constraints to the
development of a progressive first pillar. The tax system in many Latin American countries does
not include individual tax filing - so redistribution through direct taxes is not feasible -. In the
countries where individual tax filing was introduced in the 1930's, its coverage has remained
limited to just a few high earners. For example, in Chile 93.7% of individual tax subjects in 1997
were either exempt from taxes or paid income taxes at a rate of 5%. In addition, many Latin
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American countries do not have institutions capable of independent poverty evaluation or means
testing - so assistance pensions targeted to the poor old are not feasible.
Conventional integrated systems overcome these constraints by using the contribution
histories of members as a proxy for income levels. However, the individual accounts in a second
pillar provide the same information on individual contribution histories, so they have the potential
to be used to perform redistribution at the same coarse level as conventional integrated pension
systems. Thus, it is possible to base subsidies on indicators such as the ratio between the size of
an individual's accumulation and average accumulations at the same age. This is precisely what
the minimum pension guarantee does: it bases a government subsidy on the difference between
the self-financed pension of an individual and a minimum standard set by the government.
Another aspect of the distributional obstacle to pension reform is the source of financing
for subsidies to the poor old. In a conventional integrated pension system the subsidies are
financed with a payroll tax on members, unless the government provides substantial general
funds. Members are a convenient tax base from an administrative point of view, although the
distortions imposed on the labor market may be significant. Similarly, in a second pillar with
individual accounts taxation can also be limited to members, by establishing a solidarity tax on
contributions (as in Peru in 1994-95) or can be targeted to regular contributors (usually higher
earners) by taxing the interest earned by pension funds.
A third aspect of the distributional obstacle to pension reform is the transparency of
financing subsidies to the poor old. In a conventional integrated pension system, taxation is
hidden in the progressive benefit formula. In contrast, frequent reporting of individual account
balances in a second pillar make such subsidies from the first pillar explicit. This can make a
difference for the political equilibrium, but the difference does not relate only to redistribution. It
also relates to transparency and the opportunities for abuse. If a democracy needs redistribution to
be implicit and hidden to survive, then that democracy may be vulnerable to many other
distortions as well, including perverse redistributions (captured by the rich).
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4. Implementation Experience: Chile 1981-97
The fact that Chile solved many implementation problems was a source of ideas and
experience for all the Latin American reforms of the 1990's. Chile did not supply experience in
overcoming democratic political obstacles to a pension reform, because its reform happened
under military rule.
Fiscal Obstacles
The Chilean reform was first proposed in early 1973, before the military takeover, by a
group of Chilean economists trained at the University of Chicago (El Ladrillo, 1992). When the
'Chicago Boys' were called to take charge of some Ministries related to economic policy in 1975,
they started technical work for implementation of their pension reform proposal. They
discovered shortly that the impact of the reform on government cash flow would be substantial,
given their aim to avoid debt financing from the beginning. Given the fiscal problems linked to
the 50% drop in the world price of copper in 1975, then earning a large share of fiscal revenue,
the pension reform was postponed.
Still, the Chilean government continued technical studies of the proposed reform. In
January 1979 this work matured in a comprehensive reform of the old system, which unified and
tightened many aspects of the previously fragmented system such as pension ages and inflation
indexation methods. Apparently, this left the civilian pension portion of the social security
network with a small cash surplus. But the Chicago boys wanted to go further and worked on a
radical reform.
During the 1979-80 period, the Chilean government attacked the cash flow implications
of their choice of zero debt financing in a remarkable way: First, it began building a primary
surplus in the fiscal accounts three years before the reform started1, as opposed to incurring a cash
deficit first and then introducing changes in taxes and primary expenditures to cover it. Two facts
may help explain the selection of this strategy: (a) the military government was able to resist
demands for higher expenditure, in part because of tight control of the media and in part because
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of the popularity of President Pinochet; and (b) economic growth in Chile was very fast in those
years (real GDP grew at an average of 8% in 1978-1980), raising tax revenue. In this setting real
government expenditure could still be raised by 6% per year to appease growing demands while a
primary surplus was being built.
Second, as the new funded pension system would earn a higher rate of return, the
contribution rate was reduced. The Labor Ministry realized that this reduction created space for
the introduction of a new wage tax, which would not be detected because the combination would
not reduce take-home pay. This wage tax was set at 3% of wages initially, decreased slowly over
the next few years, and it was used in the interim to help finance the transition (Piñera, 1991).
Despite this cautious approach to the fiscal impact of the move to funding, the
International Monetary Fund still opposed the Chilean reform on the grounds that it posed a
danger to sound public finances. As technical work for reforming the pension institutions that
served the Armed Forces had been delayed and was more demanding than the one performed for
the civilian institutions, the IMF was appeased by leaving the military outside the reform. This
meant that the military remained in the old system, under the terms of the reform of 1979.
Capital Market Obstacles
The technical work performed over 1976-1980 had shown that some financial
liberalization was a precondition for successful investment and insurance by future pension funds.
This link, plus the merits of financial liberalization per se, led the Chilean authorities to assign a
high priority to capital market development. Thus banks were allowed to issue CPI-indexed
deposits and to lend in CPI-indexed terms in 1974, a primary market for Treasury securities was
organized in 1976, the mutual fund law was reformed in 1976, banks were privatized in 1976, a
new securities law copied from the U.S. was adopted in 1978, a CPI-indexed mortgage bond
market was authorized and promoted since 1978, insurance premia and reinsurance were
liberalized in 1980, corporation law and again the securities law were reformed in 1981. The
design and implementation of this set of reforms required a major effort from the government.
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This massive effort failed in the short run because the newly introduced bank supervisory
authority was unable to prevent both massive fraud and sophisticated risk taking that abused the
government guarantee on bank deposits, while the security market's supervisory authorities were
unable to prevent significant manipulation of equity prices, leading to the insolvency of the
banking system in 1982 (De la Cuadra and Valdés-Prieto, 1992).
Although financial liberalization succeeded in the longer term, by mid 1980, the rising
perception of potential bank insolvency fueled significant opposition against pension reform
among a number of Army generals. Privately, those generals argued that no safe investments
were available apart from government paper, short-term bank deposits and mortgage bonds.
Moreover, they argued against privatization of pension management, on the grounds that the
pension managers would be precisely the same dubious financiers that were misbehaving in the
banking and security businesses.
Looking back, it seems possible that the pressure exerted by those generals saved the
Chilean pension reform. To appease them, the reformers led by José Piñera (then Labor Minister)
designed draconian investment guidelines that prohibited pension funds from buying equities and
commercial paper issued by holding companies, and imposed detailed diversification
requirements across groups of companies controlled by any one business group. In addition,
commercial banks were banned from entering the pension fund industry. The establishment of a
relative rate of return guarantee also provided some assurance that dubious fund managers would
be expelled from the AFP industry without losses to the workers.
The investment restrictions prevented the new pension funds from participating in the
massive drop in the Santiago stock exchange from June 1981 to June 1983, and in the huge losses
in commercial paper issued by holding companies in 1982-3. These drops also set the stage for
the subsequent huge returns obtained in equity investments over 1985-1993. The pension funds
participated in the upswing after equity holding was authorized by a reform to the pension law.
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It is possible that the long horizon gained by the military government in the 1980
referendum was essential for the success of this reform. The reformers had a strong faith that
improvement of the detailed regulations would be possible because the military government
would remain in place at least until 1989. Even in 1985, investment in equities was authorized by
the Military Junta only after the creation of a state-controlled 'Risk Classification Commission'
(RCC), which was granted the power to enlarge and restrict the set of listed securities from which
'privately-managed' pension funds could choose. This list never comprised more than 15 equities
until 1990, so the power of the state in guiding pension investments was enormous. However, just
before the military devolved power to an elected president in March 1990, they passed a law
changing the membership of the RCC so that members chosen by the private pension fund
managers would hold the majority: the military were dismantling their control structure before
power was transferred to a democratic government.
The worst fears of the military, that their reforms would be undone by future democratic
governments, proved to be false. In March 1995, the elected Parliament reformed the set of
investment limits by streamlining them, liberalizing them further, improving disclosure
requirements and introducing new rules to limit conflicts of interest. By the end of 1996, the
Chilean pension funds held equity in 100 different local firms, and held 1% of assets abroad.
Distributional Objections
In the case of Chile, the objection that a defined contribution system is not redistributive
to the poor was faced by extending the minimum pension (in a more generous version) to the new
system. A detailed public scrutiny of social spending and social assistance programs had taken
place in Chile during 1974-80. This had shown that at least 20% of the population had remained
in extreme poverty with virtually no support from society for decades, while unions and the
political parties had limited their attention to income redistribution within the formal sector. In
this setting, providing a minimum pension guarantee as a first pillar was deemed a sufficient
progressive effort within the formal sector, and calls for going further were disregarded.
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The distributional argument reemerged in an unexpected area, which is the structure of
the commissions charged by the private pension fund management companies (AFPs) to workers.
The original 1981 law authorized Chilean AFPs to charge three fees, the first being a flat amount
per account per year (called fixed fee), the second a flat percentage of the taxable income and the
third a flat percentage of assets. In the first years the flat fee was not small - 36 U.S. dollars per
year - and this was given as evidence of the regressive nature of the new pension system. This
objection did not block the reform, as it was first raised the year after the new system was in
operation. However, it was taken seriously by the military government, which decided to exert
informal regulatory pressures on AFPs to eliminate the flat fee. This objective was almost
achieved in the 1990's, as several AFPs found that the other fees cover the marginal cost of
service, provided that the reported wage exceeds the minimum wage. Other countries, such as
Bolivia and Peru, have relied instead on explicit prohibition of flat fees.
5. Implementation Experience: Peru 1993-7
Peru decreed a radical pension reform in December 1992, operations began in June 1993,
and the reform was further reformed in July 1995.
Fiscal cash flow
The fiscal obstacle loomed large in Peru in 1992, as the country was just recovering from
hyperinflation caused by a fiscal deficit that had reached 10% of GDP. In part because of its
limited credibility, the government did not dare to finance the cash flow impact of the reform
with additional public debt. In order to limit the impact of the reform on government cash flow,
the following departures from the Chilean path were adopted:
a) No previous build up of a primary surplus.
b) The armed forces and also some government employees were prevented by law from
switching to the new system.
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c) Young generations entering the covered labor force were allowed to choose between
the old pay as you go system and the new funded second pillar (thus, the old system was not to be
replaced fully, as in Chile).
d) Active workers who chose to switch to the new system were required to pay a higher
contribution rate in the new system than in the old one. This forced the worker and employer to
share an extra burden, reduced the number of people changing to the new system and thus
alleviated the government's cash flow. On the other hand, it threatened the new system's ability to
exploit economies of scale.
e) The pensionable age in the new system is 65 for both men and women, but in the old
system pensionable ages remained at 60 for men and 55 for women. This made the new system
less attractive, so fewer older people switched, further alleviating the government's cash flow
during the early years of the reform.
f) The recognition bond (RB) that compensates switchers for accrued contributions in the
old system has an inflation-adjusted value, but earns a zero real interest rate and its issue value
was capped at 12,000 US$. Moreover, the government did not issue or pay any RB during the
first 18 months of operation of the new system. In addition, the RB just recognized contributions
made until 1992, so if somebody switched later he lost more recent contributions. (A law
approved in November 1996 created an extra RB to acknowledge contributions made between
January 1993 and December 1996, providing the worker switched within 1997).
g) A 'solidarity contribution' of 1% of the wage was levied on those workers who
switched to the new system. The revenue of this tax was paid to the old system for 'social
purposes'.
h) Fees paid by workers to AFPs are subject to the personal income tax, but the implicit
administrative fee charged by the old system is exempt.
i) A separate mandatory health insurance contribution, which must be paid to the state, is
higher for those who switch to the new system.
18
j) The government stopped contributing on behalf of its own workers who switched to the
new system. Arrears built up from December 1993 until mid 1995.
Many of these fiscal decisions had the impact of disadvantaging the new system, therefore
keeping workers in the old system and reducing the financing gap. They had the dual purpose of
dealing with political obstacles. The old system was not reformed, so the old benefit formulae
remained in all their variety and continued serving the established unions and political parties.
The reform of 1995 and subsequent regulation
Fortunately, Peru experienced very fast economic growth in 1994-1997, increasing fiscal
revenue. The government took the opportunity to eliminate many of the initial handicaps imposed
on the new system that had put the reform in trouble2. In July 1995 it adopted the following
measures:
a) The government paid in full its contribution arrears (on behalf of state employees),
although RBs are still pending.
b) The contribution rate to the old system was raised from 8.5% to 13%; the contribution
rate to the new system was reduced temporarily from 10% to 9%; and the 'solidarity contribution'
of 1% of the wage of those who chose the new system was eliminated. Given that administration
and insurance charges in the new system add another 4% of wages to costs, this combination of
moves eliminated the incentive for employers and workers to prefer the old system, as the total
cost was equalized at 13% of wages in both systems.
c) The retirement age was raised in the old system to the same level as in the new system
(65 for both men and women), helping to equalize the incentive for workers to choose between
the systems.
d) Upon formal employment new workers are assigned to the new system unless, within
10 days they choose the old system, which they must do in writing. It is clear that the old system
is being eliminated over time.
19
An interesting question is why anybody was willing to invest in the Peruvian AFP
business under the original restrictive conditions listed above, which raised the risk of large losses
for fund managers. In practice, the only willing investors were local business groups and Chilean
AFPs. The latter felt confident to operate under such conditions and realized that this could be a
profitable business. In addition, they could gain by promoting pension reform in other Latin
American countries, and they realized that the best publicity would be a successful start under
democratic conditions.
Solidarity and redistribution
Redistribution has always been a concern in Peru because of widespread poverty. But
fiscal constraints, limited administrative ability, and political obstacles have meant that there is no
social assistance pension in Peru, nor did the old system guarantee a minimum pension before the
reform. A large portion of the labor force works in the uncovered sector (37% in Lima). Under
these conditions, a minimum pension that requires a significant contribution record (such as 20
years) would just benefit the middle classes, while a low requisite contribution record (such as 5
years) would be too expensive.
The introduction of the new system in 1993, which did not include a minimum pension
either, increased political pressure for explicit redistribution. In legislation passed in July 1995 a
minimum pension was introduced in Peru for the first time (although as of 1997 it was still not
operating). This suggests that a pension reform may actually help in introducing an explicit and
targeted first pillar.
Capital market development
During the initial years, the obstacle related to capital market development has been less
significant than in the Chilean reform. Peruvian banking did not experience a crisis during these
years and the country did not suffer a debt crisis. However, during the first two years, the
instruments available in the Peruvian capital market were limited largely to government bills and
debt securities issued by banks and other financial firms (Aporte, 1995). Portfolio options
20
improved markedly in the next two years. As of March 1997, 0.5% of the aggregate portfolio was
invested in government bills, 28.8% in time deposits, 35.5% in corporate bonds, 34.7% in
corporate equities and 0.5% in mortgage bonds (Primamérica, 1997). During this period a risk
classification scheme was adopted.
The obstacle raised by limited capital market development has not been overcome yet,
because investment options remain limited and do not include long-term fixed income
instruments in CPI-indexed terms. The absence of CPI-indexed bonds means that pensioners are
exposed to inflation surprises. Although the U.S. dollar can operate as a substitute safe haven,
there is no local supply of long term bonds denominated in dollars. While up to 5% of the pension
funds can be invested internationally, this limit has not been approached.
6. Implementation Experience: Colombia 1994-7
As in the other countries, pension reform was seen in Colombia as part of a wider
package of policy reforms, pushing for free operation of markets and privatization. However, the
Colombian reforms were also presented as part of a package of political reforms, which promoted
civic rights, citizen participation, decentralization and social protection, including improved
social security (Ayala, 1995).
Fiscal cash flow
When discussion of the pension reform began in Colombia, it was agreed that a single
institution financed with the pay-as-you-go method would perform both redistribution to the poor
old (by paying a flat universal pension) and an earnings-related pension, as in the past. A
mandatory funded second pillar would provide a second layer of earnings-related pensions, so
that savings and insurance would be supplied by both institutions together, as in Switzerland.
However, fiscal considerations overturned that initial agreement. Simulations found that
the universal pension in the mixed institution would be too expensive in the long run. Given
political restrictions on retirement ages and the level of the universal pension, a high contribution
rate was required for the pay-as-you-go system. However, political constraints on total
21
contribution rates implied that the contribution rate to the funded pillar would be too small to
justify it. Thus, politicians in Colombia were faced with the choice between no funded privately
managed second pillar (continuation of the old system, albeit improved) versus a radical reform
in which the existing system was replaced completely by a privately managed second funded
pillar complemented with a minimum pension (Ayala, 1995).
The political agreement reached in Colombia was that two systems—a straight pay-as-
you-go system and a multi-pillar system that included a privately-managed funded second pillar
plus a minimum pension first pillar would coexist permanently, but each individual would have to
choose between them. This deal preserved a low contribution rate and assured the existence of an
option with more perceived solidarity (the old system).
Another essential element of the political agreement in Colombia was that the old system
was allowed to continue in a relatively unreformed state, purposefully avoiding adjustments of
the benefit rules, retirement ages and contribution rates to levels that would assure financial
equilibrium in the long run. The reason offered was that the growth in coverage and the growth of
GDP allowed ample time to introduce further reforms later on, if needed. The concept of a
hidden pension debt which would continue to grow faster than GDP was ignored here (Ayala,
1995).
In Colombia, transition costs were financed by:
a) Issuing more public debt, part of which would be bought by the new pension funds.
b) As there are many fiscally decentralized regional units in Colombia which have at least
some responsibility for existing pension obligations, the cash-flow effect for the national
government was cut by transferring part of the debt to these regional units.
c) The contribution rate for old age, disability and death has been raised from 6.5% in
1992 to 13.5% in 1997, both for the old and the new systems. Given current demographics, this
allows the old system to accumulate a large surplus during a transitory period (it will incur a
22
deficit later on). This surplus, plus initial reserves close to 900 million US$, will help finance the
cash flow deficit expected for the next decades.
d) Although government workers were allowed to switch to the new system, their
benefits continued to be so attractive that a low rate of transfer was assured. As these groups are
responsible for 54% of the implicit pension debt, their virtual exclusion from the new system
reduced fiscal pressure substantially but it also reduces the long run gain from the reform (Ayala,
1995).
The actual cash deficit generated by the reform has been above expectations as many
workers have switched (Ayala 1995). Although the old system institution spends heavily on
advertising, the pension fund management companies that operate the new system have done the
same and had obtained 45% of the potential market as of June 1996.
Capital market development
The objection to reform raised by capital market underdevelopment was not considered
critical in Colombia. Starting in 1990, Colombia adopted a thorough reform of its capital market,
privatizing some commercial banks, improving bank supervision and opening up the securities
markets. Colombia has significant equity and bond markets, modest exchange controls and most
financial prices are freely determined by market participants. Therefore, limited portfolio
regulations were imposed on the new funded second pillar: up to 45% can be invested in federal
debt, while investment in equities and foreign securities was authorized from the beginning.
There is no Chilean-style 'Risk Classification Commission', due to the existence of respected
private risk-rating companies, but a minimum relative rate of return regulation was introduced.
However, Colombian pension funds are unable to reduce their exposure to inflation risk
because few long-term CPI-indexed bonds are available.
Redistribution and poverty
The Colombian second pillar is accompanied by a minimum pension guarantee (equal to
one minimum wage, which is now close to 55% of the median wage) financed by the general
23
treasury, as its first pillar. In addition, during the negotiations for this reform, Colombia agreed to
create its first non-contributory pension for the poor old. To help finance redistributions a special
'solidarity tax' of 1% was imposed on the excess of taxable salaries above 4 minimum wages,
regardless of the system chosen. The revenue is used to finance subsidies to the accounts of poor
workers in the new second pillar and minimum pension top-ups for those in the old system. This
shows that pension reform can be an opportunity to improve social protection, provided the
administrative capacity and political will are available.
The new funded pillar allows early pensions to every worker who accumulates enough
funds to finance a pension equal to 110% of the minimum salary (which is also the minimum
pension). This rule implies that the new Colombian system does not attempt to produce pensions
that are proportional to past wages or contributions. It merely aims to force savings up to the level
needed to finance poverty level pensions, which is close to 140 U.S.$/month. Because early and
normal age pensions do not have to meet a target replacement rate above this level, Colombia's
second pillar is only a weak instrument of forced saving and insurance.
Sustainability of the Colombian reform
The financial sustainability of the Colombian reform has been jeopardized by a bizarre
switching option. Colombian workers are allowed to switch back and forth between the old and
the new systems, provided at least 3 years have passed since the previous switch. This option
implies that workers might wait until pension age to choose the system that pays them the highest
pension. These strategies may be very expensive for taxpayers in the long run.
In the case of members who switch from the old to the new system, the transfer value is a
pension (recognition) bond. For example, if a man finds that he suffered a reduction in his real
wage from ages 52 to 62, he may prefer to claim his 'pension bond' (recognition bond) from the
old system and switch to the second pillar, because the latter gives more weight to investment
returns. However, if he switches at age 62 the pension bond will be called immediately, draining
the cash flow of the old system. This may impose a heavy strain on the fiscal balance.
24
For switches back to the old system, the transfer value is the accumulated account
balance in the second pillar. For example, if asset prices drop (maybe because of tighter monetary
policy), people about to get a pension in the second pillar may switch back to the old system. The
heavy cash infusion enjoyed by the old system may encourage the political system to increase the
generosity of the pension formulae, attracting even more switches. In addition, the switches
would force the AFPs to liquidate part of their investment holdings, a factor that might reinforce
the initial drop in asset prices and also reinforce the initial switching process. Thus, the new
funded second pillar may be subject to unexpected contractions and may disappear in a prolonged
recession, compromising the solvency of the old system in the long run.
As both systems require the same contribution rate (13.5%), the difference is shown
directly in the benefit levels. In the old system, the replacement rate is 85% of the average real
taxable salary during the previous 10 years or the entire lifetime, whichever is larger. In the new
funded system the replacement rate is governed by the expected net investment return (after
commissions). Unless the real rate of return is extremely high it is unlikely that an 85%
replacement rate will be achieved.
From the ex-ante point of view of a young worker who is choosing between systems, as
in Peru or Argentina, the financial incentive is governed by the difference between the expected
rates of return, risk and liquidity in the two systems. However, Colombian workers have been
granted the right to choose ex-post, at pension age. Thus, the government has granted them a put
option on lifetime investment returns, whose exercise price is the benefit in the old system. As the
old system has not been reformed, the exercise price of this put option is high, so the guarantee
appears to be extremely expensive. A rational worker would join the new system when young,
knowing that he could always switch back at the end if the old system turns out to be superior.
This helps explain why many workers have joined.
Most analysts in Colombia agree about the need to withdraw this guarantee. However,
the current arrangement is the product of the political deal that individuals would be granted the
25
right to choose between the two pension systems. This cannot be renegotiated easily because any
deal would imply large losses for some groups.
In my view, there exists a compensating factor that may reduce the fiscal cost of this
guarantee substantially, which is the higher liquidity offered by the new funded system. The new
funded second pillar offers an early pension as soon as the worker has enough funds to pay for a
pension equal to 110% of the minimum pension, while the old system requires waiting until age
62 (men). It is likely that many middle-income workers will prefer the early pension in the new
system. But once they do this, they lose the option to switch back to the old system and pick up
the guarantee. Only lower income workers would stay in the old system, but this does not
influence the fiscal cost because they are likely to get the minimum pension in any case.
More generally, the Colombian reform appears less likely to succeed than the other
reform cases reviewed here because the government has not supported the new funded system.
After the Gaviria government yielded power in June 1994, the Samper government publicly
supported the old system over the new, although it did not initiate further legislation3. The lack
of government support also shows up in the absence of an independent and well-staffed
Superintendency for the new funded second pillar. Supervision is in charge of a division of the
Superintendency of Banks. No detailed statistical information on the new system was provided by
this body during the first 4 years of operation.
7. Implementation Experience: Argentina 1994-7
The Argentinean Congress approved a pension reform in September 1993, and operations
began in July 1994. Contrary to Colombia, Argentina requires each worker to participate
simultaneously in two pillars: (a) the redistributive pillar that pays a flat universal pension; and
(b) a second pillar that pays pensions related to individual contributions. In the second pillar
workers can choose (initially up to twice in their lifetime, now only once) between a funded
second pillar similar to the Chilean one and a pay-as-you-go financed public pillar with a
conventional benefit formula. The contribution to the first pillar is by the employer and initially
26
was set at 16%; the second pillar consumes a contribution of 11% from the worker, regardless of
the option4.
Fiscal cash flow
The major obstacle to the Argentinean pension reform was the decision to limit the use of
public debt to cover the fiscal cash flow impact of the reform during the transition. In 1990
Argentina was coming out of a decade of hyperinflation, so fiscal stability was and continues to
be a critical issue.
In an influential study presented while discussion was taking place in Congress, Schultess
and Demarco (1994) argued that the fiscal obstacle could be dealt with in the following way:
a) The reform would reduce evasion, and this would increase contribution revenue
without increasing expenditures for a few decades. This effect was expected because the reform
tightens considerably the link between individual contributions and benefits. However, the link
after the reform would be still be far from tight, due to the 16% contribution to the first pillar.
b) Economic growth would be increased by the pension reform, providing new tax
revenue that would help cover the cash flow impact of the reform. This would be compounded by
higher efficiency in the tax system.
c) The remaining portion of the cash flow deficit would be financed by issuing public
debt at market interest rates, which in turn would be bought voluntarily by the new pension funds
in the funded second pillar.
Three more measures were taken to cover the impact on cash flow:
d) Military personnel and the police were excluded from the reform. The employees of
provincial and municipal governments were also excluded initially, but they would be
incorporated once the federal fiscal authorities agreed to special financing and transition plans
with those governments. Those plans were negotiated during 1995-6 and those groups were
brought into the new system.
27
e) Compensation to those who switch to the new system in mid career was reduced as
compared to the 'recognition bond' model used in Chile. Argentina created instead a
'compensatory pension', paid by the old system over time once the individuals gets pensioned.
The amount spent on the compensatory provision was reduced by (i) excluding those who get
disabled, even if they switch, (ii) imposing a ceiling on the total replacement rate, (52.5% of the
average revalued salary during the last ten years of work); (iii) a ceiling on the amount of the
compensatory pension (for workers with 35 years of contribution, this is 38.5% of the average
taxable wage).
f) A substantial implicit wage tax was levied by imposing a 16% contribution rate to the
first pillar, which is significantly larger than required for the first pillar alone in its early years.
In practice, the rosy predictions of an increase in coverage and a reduction in evasion has
not materialized. In February 1996, the government reduced the 16% contribution rate to some
12% on average, and even less in 1997-8 (the reduction differed between regions) with the
avowed purpose of reducing labor costs to stimulate employment. The fiscal impact of this
measure was to be met by increasing other taxes, such as a VAT. This suggests that in the final
analysis, the cash flow impact of the transition will be absorbed through an increase in the
primary surplus.
Capital Market Development
The obstacle to reform stemming from capital market underdevelopment has not been
significant in Argentina up to now. As of September 1997, 46% was invested in government debt,
23% in domestic equity, 2.8% in long term private debt, 0.02 % in foreign paper (directly), 2% in
open ended mutual funds and the rest in short term bank liabilities. The only substantial change
from 1994 to 1997 was the growth in the equity share at the expense of the bank deposit share.
Argentinean pension funds held 33 different domestic equities as of September 1997.
Argentina does not allow CPI-indexed bonds. Proposals to introduce them are rejected
because the required deregulation might be interpreted by the financial markets as a weakness of
28
the monetary authorities in their resolve to keep the fixed exchange rate regime introduced in
1991 forever, regardless of the costs in terms of unemployment. Thus markets for peso-
denominated long-term debt and CPI-indexed debt do not exist in Argentina; however some
dollar-denominated mortgage loans have been introduced recently.
The wisdom of a policy against CPI-indexed debt should be questioned. First, even if
the Argentinean peso remains fixed to the US dollar forever, if the United States experiences just
5% inflation in a single decade in the future, the value of Argentinean pensions will erode
significantly. Second, the credibility game should not be overrated. The universal basic pension is
indexed to the average of covered taxable wages5, and nobody interprets this as a weakness in the
exchange rate regime. Third, If Argentina devalues the peso and experiences inflation, the real
value of any long-term debt might be severely eroded, and the fully funded second pillar may be
seen as a failure.
Redistribution and solidarity
The first pillar is rather complicated in Argentina. The universal basic pension (paid to all
workers with at least 30 years of contributing service) pays a fluctuating benefit, of 2.5 times the
average contribution registered in the previous semester to the second pillar, which implies 27.5%
of the average taxable wage or 187 US$/month in 1996. This benefit is revalued annually
according to the increase in nominal average contribution. Any worker with the right to a full first
pillar pension must get more than this as total pension, because this worker has contributed also
to one of the second pillars, so must have earned the right to a second layer of pensions. The
effective first pillar is given by another section of the law6, which guarantees a minimum to the
sum of pensions obtained from the first and second pillars. This minimum is 40.3% of the average
taxable salary or 275 US$/month.
An objection to having the basic universal pension is that the government loses a major
opportunity to improve its cash flow: if the basic universal benefit is reduced, but the 40.3%
minimum remains as it is, then poor pensioners would not be affected but higher income workers
29
would face reduced total benefits. The government could use this surplus to reduce the 16%
contribution rate paid by employers (increasing the competitiveness of Argentinean production),
gaining political support from those whose taxes were reduced by more than the reduction in
benefits. However, there might be a political loss involved if a substantial middle class faces a
reduction in benefits larger than the reduction in taxes.
Although the first pillar appears to be very progressive, in practice its redistributive
impact is uncertain because (a) poorer workers tend to move more frequently into self-
employment, so the requirement of 30 years of contribution is less likely to be met by the poor,
and if it is not met this pillar pays zero; (b) there is a minimum taxable wage equal to 33% of the
average taxable salary. The poor whose actual wage is lower contribute on the basis of the
minimum taxable wage, so they face a higher proportional reduction in take-home wages; (c)
higher income workers tend to get a larger share of their compensation in forms different from a
wage, so the 16% contribution tends to be less than 16% of their compensation; and (d) the
maximum taxable income (6.6 times the average taxable salary) caps the 16% contribution paid
by the higher paid workers.
Given these problems, it is fortunate that in addition to the first pillar, Argentina has
maintained its historical tradition of paying non-contributory pensions to the poor old, financed
with general revenue.
Other Political Constraints
As in other countries, an important political constraint was the constitutional right
acquired by members of the original pension system to remain in the old system. To adapt to this,
Argentina gave workers of all ages the right to choose the second pillar (funded versus pay as you
go). The law favors the funded second pillar, as it presumes the worker has chosen the funded
second pillar unless he or she declares the opposite in writing. However, as in Peru, the political
compromise was to grant this choice to new generations of workers as well, when they enter the
labor force.
30
In Argentina the state showed its technical and administrative capacity by proposing a
simultaneous major reform of the state-run pay-as-you-go financed second pillar. Benefit rules
were tightened and retirement ages were raised gradually so that by year 2001 they will be 65 for
men and 60 for women. The Menem government has managed to unify the benefit formula for
old age and disability, eliminating a host of special programs that had evolved in response to
interest group pressures. Administration was unified under one institution (ANSES).
This aspect of the reform required a direct confrontation with powerful interest groups.
According to interviews, the opposition from unions and some political parties to the Argentinean
reform dissolved noticeably as soon as it was agreed that they could own and operate pension
fund management companies (AFJPs), as either profit or non-profit organizations.
Groups built around government unions objected to a complete privatization of the
management of the new funded second pillar. This was dealt with by requiring the state-owned
commercial bank, Banco de la Nación Argentina, to set up a pension fund management company
(AFJP). This state-owned AFJP was granted a special competitive advantage - its pension fund
would guarantee a rate of return set by law. Initially this guaranteed interest rate was equal to the
US Dollar LIBO, even though this opened a major fiscal risk. A few months later, the Menem
government passed a regulation linking the guaranteed rate to the interest rate paid on saving
deposits in pesos, which is much lower and eliminates foreign exchange risk.
The privately owned AFJPs feared subsidized competition of AFJP Nación. This fear was
allayed while simultaneously accommodating another source of political pressure, by requiring
AFJP Nación to invest at least 30% of its portfolio in debt issued by provincial governments,
which paid a low interest rate. As of September 30, 1997, AFJP Nación managed just 6.6% of the
aggregate funds and had 8.2% of all members of the new system. In the year to June 1996, AFJP
Nación obtained a rate of return 3.61 percentage points below the average of all funds (second
lowest out of 23), but its performance improved in the following year7.
8. Conclusions
31
Any descriptive survey of the Latin American reforms is likely to argue that they diverge
considerably from the Chilean one. This paper seeks answers to three questions: First, why did
many Latin America countries embrace the radical approach to pension reform pioneered by
Chile? Section 2 of the paper finds that existing state-managed pension systems failed to meet the
expectations that justified them in the first place, of providing significant security to their
members. This frustration pervades public opinion in Latin America and might be shared in
Eastern Europe and the former Soviet Union, but seems to be absent in Western Europe and
Japan. The other factor in explaining a demand for reform is that an alternative was developed in
Chile over 1973-1992. This alternative pension approach offers the prospect of higher and more
reliable pensions for a lower contribution, while also providing a number of positive side effects
on national saving and capital market development. Other Latin American countries therefore had
a reform model that could be adapted to their needs.
The second question examined was: what are the mayor obstacles to such reforms and
how have they been dealt with? Section 3 identified three major objections to pension reform
towards fully funded, privately managed second pillars, which were used later to guide the
country case studies. The three objections are fiscal constraints during the transition phase, the
underdevelopment of the domestic capital market and the inability of such pension systems to
provide income redistribution.
The objection regarding fiscal constraints has been frequently misunderstood. The paper
argues that the size of the fiscal obstacle is given by the size of the planned adjustment to the
fiscal balance sheet, not by the size of the cash deficit imposed by the reform of the old system.
Contrary to expectations, the paper finds that even countries coming out of hyperinflation, such as
Peru and Argentina, have managed the fiscal constraint reasonably well by issuing implicit public
debt for an extended number of years, during which the primary fiscal balance has been gradually
improved. Of course, as this process takes many years, it has yet to be seen whether faster
economic growth will allow these countries to pay their way out of the debt implicit in their old
32
pension systems. Among the countries included in this study, Argentina is the most vulnerable,
because of the high initial level of public debt, explicit and pension-related. This implies that
pension reform is easier when adopted before system maturity and before population aging sets
in.
As expected, the objection relating to the underdevelopment of the domestic capital
market has been minor during the first few years after reform, due to the small size of the pension
assets in the first few years. Thus, it remains to be seen if each country will be able to upgrade its
financial markets to meet this objection. The main challenges ahead in this area are developing
sound and efficient banking systems, reaching enough liquidity in the secondary markets for the
main local equities and bonds, the creation of a substantial market in long-term CPI-indexed debt
and international diversification.
Up to date, the only country that has overcome most of these challenges is Chile,
although aided by some luck. Chile experienced a massive banking crisis in 1982-85, when the
pension funds were small, but subsequent reforms left banking in a solid situation while
providing low cost intermediation services to institutional investors. The Chilean pension funds
escaped the 1982-85 crisis unscathed due to tight investment regulations, but such foresight by
the authorities cannot be counted upon for the future. A market for long term CPI-indexed debt
has been growing since 1978 and by now is substantial, allowing some 60% of pension fund
assets to be CPI-indexed. However, Chile has not yet undertaken international diversification in
the expected scale. Chilean pension benefits continue exposed to the vagaries of local booms and
recessions, which have been acute in the past.
The other countries have thus far failed to develop a market for long term CPI-indexed
debt or liquid secondary equity markets. The solvency of the domestic banking system has
improved in most of the reform countries during the 1990's, after substantial efforts by the
authorities. However, the very modest scale of international diversification undertaken up to now
by Latin American second pillars implies that their pensions continue to be exposed to highly
33
volatile local business conditions. The political nature of the constraints that prevent stronger
international diversification suggest that capital market underdevelopment continues to be a
major obstacle for reform and may even undo them in some future recession.
Finally, the objection that funded second pillars prevent desirable income redistribution
has been proved false. The paper finds that the new systems have not hindered - and on the
contrary, in Peru and Colombia have stimulated- the introduction of tax-transfer schemes in favor
of the poor old, increasing solidarity and the scale of income redistribution.
On the basis of these findings of the previous sections, Table 3 offers a summary of our
evaluation of the extent to which each reform has overcome the three objections to reform
analyzed in this paper. The table suggests that most of the reforms are not yet solid outside of
Chile, although Argentina comes close. This is not surprising, given the small number of years of
experience. In our view, a similar evaluation of the Chilean reform circa 1985 would have led to
a similar conclusion, so this result may be due simply to the youth of the new systems. An
important lesson of the Latin American experience is that reform is an ongoing process that
continues long after it is first implemented.
The final question posed by this paper is what are the main pitfalls to avoid in radical
pension reforms? In our view, the danger of failing to foresee the intricate connections between
different aspects of complex reforms is a major potential danger. One way to reduce this risk is
to simplify the design of the new pension system as much as possible.
The Colombian option to switch between the pay as you go and the fully funded systems
every three years is difficult to comprehend for most economists, let alone the members. This
feature of the Colombian reform appears to introduce substantial dangers of fiscal solvency, as it
grants a put option on investment risk. In the longer term it is likely that most members will learn
how to exploit the arbitrage opportunities opened up by this free option. In this case, complexity
got out of hand and closing the gap is difficult because the full political compromise may have to
be renegotiated.
34
35
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Cerda, L. and G. Grandolini (1997) "México: la reforma al sistema de pensiones", Gaceta deEconomía, Año 2, Núm. 4, p. 63 -105., México.
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Diamond, P. and S. Valdés-Prieto (1994) "Social Security Reforms", Chapter 6 in The ChileanEconomy, edited by Bosworth, B., R. Dornbusch and R. Laban, The Brookings Institution,Washington, D.C.
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Mesa-Lago, C. (1989) Ascent to Bankruptcy: Financing Social Security in Latin America,University of Pittsburgh Press.
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1 This point has been reported by Juan Carlos Méndez, Budget Director at the time.2 Law 26,504, approved in July 1995 to take effect from August 1, 1995.3 According to Bustos (1995).4 This covers old age, disability and survivorship benefits, and also fees and administrative costs.5The pensions paid by the PAYG second pillar may be adjusted over time according to what the annual budget lawindicates.6 Article 125 of Law 24.241.7 Sources: Memoria Trimestral Nº 8 (April-June 1996), and Nº 13 (July-September 1997), Superintendencia de AFJP,Buenos Aires.
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TABLE 1: Funded and Privately-managed Second Pillars in Latin America(as of September 1997)
Country Peru Colombia Argentina Chile
Date operations started Jun 93 Apr 94 Jul 94 May 81
Contributors as of Sept. 97(switchers plus new entrants to the labor force)
(millions) 0.6 1.6 3.2 3.2
Members as of Sept. 97(number of accounts)
(millions) 1.7 2.4 5.5a 5.7
Contribution Revenue, annual(Millions of US$) 412 485b 3,593 2,963
Aggregate Pension Fundas of September 97
(Millions of US $) 1,423 1,216 8,393 31,050
Return above Inflation 12 mo. up to Sept. 97(% per year) 8.0% 12.6%c 24.8% 2.9%
Nº of Fund Management. Co.(as of Sep. 1997) 5 8 20 13
Notes: (a) The official figure is 6.1 million, but recently the Superintendency of AFJPannounced that 0.6 million would be erased from the registries shortly. Other lawsprevented those workers from joining the new second pillar, so their employers nevermade a contribution on their behalf; (b) estimate; (c) for the 24 -month period ending inAugust, 1997.Sources: Statistical Report on Private Pension Systems in Latin America, December1997, issued by Primamérica (1997); other sources.
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Table 2: Accrued Pension Liabilities in Latin America
(% of GDP)Reformers covered in the textArgentina 305Chile (1981)a,b 126Colombia(1994)a 56Peru (1991) 45
Other reformersUruguay 289Bolivia 31Mexico (1994) 73El Salvador 9
Sources: Uthoff and Bravo (1998) provide simulation results based on aggregateparameters for Argentina, Bolivia, El Salvador, Perú and Uruguay, in Cuadro 2, pageC37, based on data for 1991-92; Other sources are Arrau (1992) for Chile, Ayala (1995)for Colombia, and Cerda and Grandolini (1997) inTable 2 for Mexico.Notes (a): It is important to note that the assumptions, definitions and methodologies arenot uniformin all these studies. To illustrate how this matters, using a different approach,Informe Técnico (1979) estimated the debt to pensioners in Chile at 48% of GDP in1979.
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TABLE 3: Implementation of Second Pillars
( S = Objection Solved; P = Problem Remains)
Country Peru Colombia Argentina Chile
Years of experienceas of late 1997: 5 4 4 17
Objections to reform1. Fiscal impactduring transition P S P S2. Underdevelopment of domestic capital market S S S S3. Inability to provide incomeredistribution P S S S
Long term prospect of reform1. Threats to long term fiscalbalance due to missing reform of the 'old' system P P S S2. Threats to long term fiscalbalance due to coordination ofnew and old system rules S P S S3. Political consensus aboutnew system achieved S P S S Source: Own elaboration