Pension System Reform – Coverage and Risk

Chile has changed its pension system. This is big news, considering how controversial the current system was when it was introduced in the early ‘80s and how vaunted it has become, being emulated around the world.

Earlier Chile had a so-called PAYGO or pay-as-you-go system, in which today’s workers contribute to the system and those contributions are (for the most part) paid out for today’s retirees. One major problem with PAYGO systems is demographic bulges in which more people retire than enter the workforce, creating imbalances in the ratio of persons being “supported” by current workers. Increasing life expectancy exacerbates that problem further. In the individual account system that Chile adopted, workers contribute to their own accounts, investing those contributions in government-approved and –regulated funds and earning a return to be paid out upon their own retirement. (Somewhat similar to 401(k) or IRA funds that Americans are used to.)

When the Chilean system changed, workers who had been in the old system received credits for switching to the new one. Employers became exempt from their mandatory contributions to the system and in return were required to increase wages comparably to ensure that overall compensation levels didn’t drop. There were other idiosyncrasies and terms, of course, and by and large the system came to be viewed as successful. If you’re interested in the in-and-outs of the accompanying fiscal policies, national savings plans, actuarial projections, safety net minimums, and ROI information, etc, the Congressional Budget Office has a pretty straightforward summary here.

As other countries adopted or adapted the approach, many of their debates centered not just on the technicalities of the system but also on the fact that they had been undertaken by an autocratic regime (Pinochet’s) and therefore did not face the kind of public scrutiny and give-and-take policy discussions that democracy demands. Thus democratic countries perceived a higher hurdle in introducing such changes to wary publics and feared that various interests would dilute reform proposals to the point of damaging the benefit. That was certainly the case in Hungary in the mid-90s when I was there and CIPE was cooperating with local groups, the World Bank, and USAID on pension reform proposals there.

Over time, the Chilean experience delivered, however, and a diversity of countries adapted similar systems. This week’s change is the first major change to the system since. It covers a big hole because it extends to self-employed, housewives, vendors, farmers, and others who were not in the pension savings system. The change will cost Chile an estimated $2 billion per year and affect about 600,000 people – most of whom are in the informal sector that still represents some 30 percent of Chile’s economy. That’s big change. Fortunately, Chile is in a strong economic position to tackle this. And evolutionary policy that adapts to changing public needs is a healthy reflection of Chile’s democratic reform as well. In making this change, elected leaders are being responsive, as they should be.

The question that bugs me, though, is whether this is not a band-aid for the problem rather than a fix. If the change is necessitated by the fact that so many folks are in the informal sector and thus uncovered, wouldn’t it be better to extend coverage by facilitating their entry into the formal system–which would extend a host of other benefits as well–rather than by jerry-rigging coverage by increasing government expenditures? Chile may not be able to afford those increased government expenditures in leaner times, yet it might further extend its growth by helping businesses thrive legitimately. The band-aid helps in the near term, but I hope the underlying infection isn’t riskier in the long term.