The Chilean prescription will worsen US social security ills

Jośe Piñera, former minister of labor under Pinochet and the “father” of pension privatization in Chile, as well as a promoter of that approach throughout the world, has recently discussed his conversations with and encouragement to President Bush to apply the Chilean prescription to cure U.S. social security ills (New York Times, December 1, 2004, A81).

He states that pension privatization have had “no economic transition costs, because there is no harm to gross domestic product (on the contrary there is a huge benefit).” In fact the fiscal cost of the transition in Chile has risen from 3.8% of GDP in 1981 to 6% in 2003. A key source to finance that huge burden according to Piñera is "a budget surplus deliberately created before the reform” and steadily thereafter; “the need to finance the transition [was used] as a powerful argument to contain increases in government spending." In a new book assessing ten years of pension reforms in Latin America, the World Bank explains the Chilean success in coping with fiscal transition costs—in contrast with the failure in Argentina—precisely because of that surplus. But the United States currently endures a $400 billion fiscal deficit that is rapidly growing, and Mr. Bush privatization plan would add from $1 to $2 trillion over 20 years, because the shift of workers ‘contributions from the social security system to individual accounts will reduce income in the former and accelerate the time when the system will create a deficit.

It is true that private pension funds in Chile had accumulated $50 billion at the end of 2003 tantamount to 65% of GDP. And yet when fiscal costs are annually subtracted to such accumulation, the outcome has been negative, averaging from -1% to -3% of GDP. Mr. Piñera argues that pension privatization contributed to the doubling of the growth rate in the Chilean economy from 3% to 6% in 1985-1997. He conveniently ignores the first three years after the reform was implemented (1982-1984) when GDP declined at an average rate of -3%. Factors other than the pension reform have been mainly responsible for high growth rates in Chile.

Piñera argues that recent problems such as increased unemployment and short-term labor contracts have reduced “participation” in the pension system. In fact coverage of the labor force based on active contributors decreased from 79% in 1973 (the year of the coup) to 62% in 1975 and 58% in 2002, still lower than the pre-Pinochet level.

He suitably omits that in addition to the 10% deducted from the worker’s salary going to savings, there is another 2.3% for administrative costs, tantamount to 23% of the amount saved. Such costs have declined little from the 2.4% charged in 1981, and other countries in the region charge 3.5% to 4%. Two key questions are how Mr. Bush's proposed individual savings are going to be managed and at what cost to workers.

It is correct that capital returns from the invested pension funds have averaged 10% annually, but are lower after subtracting administrative costs. Furthermore such returns have exhibited significant volatility and a declining trend: 13.8% in 1981-1994 and 4.4% in 1995-2002, with negative returns in 1995 and 1998. A worker who retires in times of boom is going to collect a good pension but one that retires during a severe recession would get a poor pension’. In Argentina, because of government manipulation of investment, the crisis and the devaluation of the peso, the pension fund decreased 65% in 2001. In six Latin American countries, from 57% to 82% of the pension fund is invested in government debt, helping to finance the fiscal costs of the transition but creating a dangerous dependency on state-fixed interest rates. Mr. Bush has not explained whether workers would be allowed to choose stocks with a potential for high returns and risks or only certain instruments with lower risk and returns, and what role the government would play.

Private pensons "are the primary sources of security for retirement,” states Piñera. But it is estimated that half of the current affiliates to the Chilean private system will not accumulate enough funds in their individual accounts and only receive the minimum pension paid by the government. He assures us that “workers cheer the stock market's surges rather than resenting them.” A survey conducted by the University of Chile in 2002-2003 found that 90% of participants ignore the administrative commissions charged and the capital returns yielded by the invested pension funds. Lack of knowledge and skills to make proper decisions by investors of social security funds would be the norm rather than the exception under Mr. Bush plan. 

The predicament of US social security has been largely caused by the Federal government use of its funds to help reduce its own fiscal deficit. If in the last 70 years contributions had been invested in the market instead of Treasury bonds, the fund would be solvent for many more decades to come. The solution to the future problem should be to raise the ceiling on contributions (that benefits the higher- income group and generates regressive effects) and gradually increase the age of retirement in tandem with growing life expectancy. Voluntary savings and complementary pension programs of various types should be encouraged by tax incentives (typical no only in most Western European countries but also in Brazil where they amount $80 billion, 60% more than in Chile) but not at the cost of the solvency of social security and the welfare of millions of pensioners.