Among the most dramatic and controversial economic transformations pursued in any country was that launched in Chile after the 1973 coup that brought General Augusto Pinochet to power. The civilian administrators he entrusted with the nation’s economy went about turning it into a neoliberal experiment. Their reforms included a restructuring of the country’s dated pension system. While the success of the new system is disputed to this day, the reforms were no doubt consequential for Chile’s financial system, which thereafter became one of the most large and successful in Latin America.
The Old System
In the early 20th century, several South American governments introduced comprehensive social security systems mimicking only slightly older European models. Chile was among the first, establishing a state pension system in 1925. However, the structure was so fragmented that it could hardly be called a ‘system’, a term which implies an order and coherence the Chilean arrangement lacked. In the country, there were separate public pension funds established for workers in different industries and prior to its eventual reform in the early 1980s, there were over 100 different pension schemes run by 32 institutions and governed by more than 2,000 laws.
That said, as with many new pension schemes, the system was not difficult to finance at first because it had many contributors for each pensioner. Workers would contribute to their specific fund and after paying benefits to the limited number of recipients, any surplus was handed over to the government to invest. This allowed benefits to grow over time. Nonetheless, the favorable demographics were not to last and the ratio of contributors to pensioners fell in the middle of the century. This led to increases in required contributions which would range from 22.5% to 42.0% of a worker’s salary.
The pension system covered 70% of the population but with levies so high, contribution evasion was widespread. Workers had little incentive to contribute early in their lives since it was only the contributions made in the last few years of their careers that were factored into benefit calculations. Further, increasing unemployment in the 1970s also put strain on the system and Chile’s government increasingly had to backstop the pension schemes by direct grants.
In September 1973, a coup replaced the leftist government of Salvador Allende with one led by General Augusto Pinochet. The new government, though led by the military, was keen on reducing the role of the state in economic management. The regime was certainly influenced by the ideas of the American economist Milton Friedman who personally met Pinochet in 1975.
However, most of the neoliberal influence was indirect, through Chilean economists educated at the University of Chicago as part of an exchange program with the Universidad Católica de Chile. This program was established in 1956 and funded by the United States Agency for International Development (USAID). Many of these American educated economists returned to Chile to hold academic posts and eventually were recruited to craft economic policy by the new administration.
The new government first focused on controlling inflation, its immediate priority, and here turned to monetarist ideas, cutting spending and limiting the growth in the money supply. On the pension front, the government raised the retirement age by five years and reduced the ability of workers to earn an income from more than one pension program. This had been possible due to the pension system’s relatively low years of service requirement which made it possible for someone to string together benefits from two or three pension schemes. The country also eliminated the employer’s contribution to the social security system in an effort to encourage employment growth.
The pension system was in need of deeper reform. By 1980, there was one pensioner for every 2.5 contributors as compared to 12.2 in 1955. Further, some resented the lack of meaningful connection between workers’ contributions and their benefits; this is believed to have encouraged contribution evasion. In 1981, the old structure, with its myriad of distinct programs, was finally replaced with a pension system based on individual accounts managed by private investment managers. The new system was organized by one of the Chilean economists educated in America, albeit at Harvard, José Piñera. After his academic career at the Universidad Católica, Piñera served as Minister of Labor in the government.
Piñera’s reform would be the world’s first conversion of an unfunded ‘pay-as-you-go’ pension system into a system of funded private accounts. It was not a straightforward transition, especially when it concerned something as sensitive to ordinary people as their pensions. To encourage participation in the new system, which was made optional for those already in the workforce, the government set a low minimum contribution rate for the new accounts.
Further, workers who had already made contributions to the old system had a special bond, a Bono de Reconocimiento, deposited in their private account should they choose to convert. The bond would mature upon retirement and allowed for a one-way conversion of benefits accrued under the old system, which were really just a promise of the state rather than a portfolio of ‘real’ assets, into the new accounts. The marketing of the new structure was a success and by 1990, more than 70% of workers switched to the new pension system.
However, convincing workers to migrate to the new scheme was not the most difficult challenge the government faced. Transitioning to the new system was also very expensive. Following the pension reform, contributions to the old system decreased considerably, eliminating the revenue paid to pensioners continuing to receive payments from that system. Because the state had to continue supporting the old system, this was a drain on the public finances. That said, Chile’s fiscal health was strong at the time with the government running a budget surplus of 5.5% of GDP.
Nonetheless, the pension reform continued to put pressure on the public finances, especially following the recession of the early 1980s. This downturn was very severe in Chile, which had recently pegged the peso to the U.S. dollar. When the monetary authorities in America began to increase interest rates sharply, Chile was affected because it tied its monetary policy to that in America.
The crisis sent unemployment to over 25% and materially reduced government revenues. It also provided plenty of fodder to critics of Chile’s pension reforms and its larger adoption of neoliberal economic policies. Since then, financing the pension transition has been a large but gradually diminishing drag on the state’s fiscal condition.
After the transition, the new program was made mandatory for employed workers but optional for the self-employed. For the formally employed, the required contribution was set at 10% of workers’ salaries and the contribution is tax deductible. This was less than the typical pre-reform contributions which required an average of 25% of worker pay be directed to funding the pension system. Under the new approach, workers were invited to make voluntary contributions on top of the 10% requirement and these excess contributions were also made tax deductible up to a cap. In either case, once retired, the pension income was made subject to ordinary taxes on income.
Another advantage of the new system was that it provided workers with several distribution options at retirement. A new retiree may choose between buying a life annuity from an insurance company using funds from their individual account or may opt to receive scheduled monthly withdrawals from the account. There is also a limited ability to make a lump sum withdrawal and a worker could also choose to keep the money in his fund and continue contributing. Any balance at death could be left to an heir.
Fondos de Pensiones
The firms given the authority to manage the new pension programs were called Administradoras de Fondos de Pensiones (AFPs). They were private asset managers and program administrators, able to charge fees on contributions and withdrawals to fund their operations.
However, they differed from a typical pension fund in many respects. For one, AFPs had to provide a minimum return to investors based on a percentage of industry average returns. Any shortfall had to be made up by distributions from a reserve account funded in years of better performance. This structure had the effect of smoothing investor returns. The AFPs also offered disability and life insurance funded by a separate worker contribution of roughly 3% of wages and could provide health insurance for a further 7%.
The Chilean government continued to play an active role in the pension system even after privatization. The state continues to regulate what AFPs can invest in, setting maximum exposures to most asset classes. Since 2002, the system has transitioned to allow funds of varying levels of risk but are still tightly controlled with respect to investment selection.
The government also provides several guarantees to pensioners under the new system. So, the privatization of fund management did not necessarily result in an elimination of risk to the fiscal system. The government guarantees a minimum distribution to pensioners who contributed for at least twenty years. It also guarantees a minimum return if an AFP’s portfolio underperforms and guarantees the annuities received by pensioners who opt for that distribution option. The first of these guarantees in particular has allowed for a continued incentive to evade contributions since the government guarantees a minimum pension so long as twenty years of contributions have been made.
The goals of the pension reform were to shift some responsibility for the system to the private sector, increase the savings rate, develop the local capital markets, and contribute to Chile’s economic growth. The reform succeeded in developing the country’s capital markets through its effect on savings. The country’s savings rate rose to 30% in 1989, the highest in Latin America and the AFPs became major Chilean investment firms. Their assets under management grew from nothing when the system was launched, to 10% of GDP in 1985 and 39% in 1996.
Due to regulations imposed on the AFPs and the sophistication of Chilean capital markets, the majority of pension funds accumulated under the new system were invested locally. The AFPs’ purchases of local shares facilitated the government’s privatization efforts, another link between the pension reforms and the broader neoliberal shift pursued in Chile during the Pinochet years.
Pension money was also invested in local mortgage bonds, increasing the availability of mortgage financing for home buyers and further contributing to make Chile a country of investors. In this way, while fiscally costly, there is an argument that the new pension system has been responsible for the growth of Chile’s well-developed financial system.
That said, concerns about the pension system remain and perhaps to an even greater degree than elsewhere, pensions remain a politically charged subject in Chile. The system is marred by high administrative charges, driven by marketing and sales costs, and limited price competition by AFPs.
Also, privatizing the pension system did not eliminate risks to the public finances given the extensive guarantees still provided by the state. There is also the issue of coverage rates which have worsened over time. Many workers, the self-employed and informally-employed in particular, only occasionally contribute to the system during their working lives. They often fail to accumulate even the required number of years of contributions to qualify for the minimum pension.
In any case, the system implemented by the reformers brought to power with Pinochet’s coup remain. Chile returned to democracy in the 1990s but today even left-of-center parties have upheld the reforms while in government. In fact, the system has been the subject of frequent study, particularly in the Americas, and is admired by many.
Chilean-style pension reforms have been implemented in Bolivia, El Salvador, Mexico, Peru, and Colombia and are recommended by the World Bank. More generally, the establishment of ‘defined contribution’ (as opposed to ‘defined benefit’) pension programs has grown, in Latin America and beyond. That said, other nation’s schemes have focused on cutting administrative costs which have been cited as one of the major remaining faults in the Chilean system.
Chile stands out in Latin America for its peculiar transformation in the late 20th century and the subsequent success of its financial system. To be sure, many countries reassessed old assumptions and embarked on neoliberal economic reforms in that era but few, at least in Latin America, were as extensive and enduring. Today, Chile is known for its sophisticated financial system and this is at least partly the result of pension reforms undertaken in the early 1980s. These reforms have been the subject of acclaim and criticism, attention which attests to their importance.
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1. Borzutzky, Silvia. From Chicago to Santiago: Neoliberalism and Social Security Privatization in Chile, vol. 18, no. 4, 2005, pp. 655–674.
2. Buchholz, Gregory J., et al. “The Chilean Pension System at 25 Years: The Evolution of a Revolution.” Journal of Economic Issues, vol. 42, no. 3, 2008, pp. 633–647.
3. Committee on Financial Markets. “Chile: Review of the Financial System.” Organisation for Economic Co-Operation and Development, Oct. 2011.
4. Ferguson, Niall. The Ascent of Money: a Financial History of the World. Penguin Books, 2019.
5. “Maintaining Prosperity in An Ageing Society: the OECD Study on the Policy Implications of Ageing.” Organisation for Economic Co-Operation and Development: Aging Working Papers, 1998.