www.econop.org/SS-SocialInsecurityChile.htm#PrivatizationScheme
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Related Link In order to pay for the transition to a fully privatized system, Chile ha d to drastically cut public spending, raise taxes, lower benefits, sell government assets, and issue bonds. Proponents of Social Security privatization often trumpet the Chilean su ccess story. Right wing economists (and the finance industry-funded th ink tanks that sponsor them) spin fabulous yarns about the way the free market transformed Chiles pension system. In doing so, however, they l eave out crucial parts of the plot. Privatization advocates paper over very serious problems with Chiles social security program. While the full impact of privatization cannot be known until the system c ompletely matures, a number of troubling issues have already arisen. Fo r example: * Transition costs have negatively impacted public spending. While this concern is legitimate, we wo uld be remiss if we failed to take note of the results of Chiles 19-yea r social experiment. A Need for Reform By all accounts, Chiles public pension program was foundering in the 197 0s. The system was extremely complex, consisting of over 100 different retirement regimes. Contribution rates, retirement ages, and benefits a ll varied by type of occupation. Inevitably, perhaps, this excessive co mplexity resulted in substantial administrative inefficiency.
The retirement programs funding situation was similarly dire. The syste m was not generating adequate revenue to pay retirees despite payroll ta xes as high as 25 percent.
Even with government general fund s ubsidies equivalent to 4 percent of Chiles GDP, a substantial majority of retirees were receiving benefits at a level below the official minimu m pension.
The programs numerous problems were exacerbated by widespread tax evasio n The pension system lost a significant amount of revenue to unscrupul ous employers who skirted contribution requirements and to workers who j oined the burgeoning underground economy. The fact that the Chilean gov ernment lacked the resources or the political will to adequately police the system no doubt contributed to the situation.
Pinochets Privatization Scheme In 1981, the Chilean government under military dictator Augusto Pinochet took the radical step of phasing out the countrys troubled publicly fun ded social security program and mandating participation in a system of p rivately managed individual accounts. Under this program, workers must contribute 10 percent of their wages, up to a specified ceiling, to a go vernment-approved investment fund. Workers are required to pay another 3 percent to cover term life and disability insurance. Participation is not mandatory for self-employed workers, but they may voluntarily set u p accounts with the same basic features. Individual account contributions are managed by private investment firms (called Administradoa de Fondos de Pensiones, or AFPs). Once a worker s igns on with an AFP, he or she must stay with the investment firm for at least four months before switching. Contributions, including voluntary contributions of up to an additional 10 percent, are tax deductible. U pon retirement, workers have two withdrawal options: they may purchase a n annuity or withdraw money based on a government-determined schedule. At the time of withdrawal, pension benefits are taxable as income.
The Consequences of Social Security Reform The Chilean experience with social security privatization gives much reas on for pause. Major concerns include: the high cost of transition to a privatized system, exorbitant pension fund management fees, non-particip ation in the scheme, the effects on low/middle-income workers and women, and the vulnerability of workers to market risk. These concerns are ex amined more closely in the following sections. High Cost of Transition Transition from a pay-as-you-go social security system to a privatized sy stem entails substantial costs. Under a pay-as-you-go system, the contr ibutions of todays workers fund the benefits of todays retirees. Unde r a newly privatized system, where workers contributions are diverted i nto individual accounts, cash must be found to fund the benefits of reti rees and workers nearing retirement (who paid into the old system but di dnt have a chance to save up an adequate nest egg under the privatized system). Chile funded its transition to a privatized system in five ways: drastica lly cutting public spending, raising taxes, reducing benefits, selling g overnment assets, and issuing debt. The Chilean government has cut social expen ditures, including health and education spending, to help pay the pensions of retired and retiring workers.
In order to cut costs, the Chilean gover nment raised the retirement age for beneficiaries. Prior to reform, retirement ages variedranging from 44 to 65. In order to cut costs, the Pinochet regime standardized retirement at 65 for men and 60 for women. The dictatorship also eliminated special pensions based on years of service.
Transition to a privatized system was par tially subsidized through the sale of state-owned enterprises to the private sector. Government bonds finance approximately 40 percent of t he annual costs of transition. These bonds are sold to AFPs and will be gradually redeemed by the government using general revenue.
Analysts project that costs from the transition to a privatized system wi ll be completely paid by 2050, at which point there should no longer be any beneficiaries in the old system.
Exorbitant Management Fees At first glance, returns on individual account investments in Chile appea r quite respectable. After factoring in management feeswhich currently range from 16 to 20 percent of annual contributionsthe situation can l ook much different. Over certain periods, management expenses dragged rates of return to near ly negligible levels.
These ad justed returns, moreover, do not include the cost of annuitizing retirem ent accounts, which in Chile entails a fee equivalent to 8 to 9 percent of total retirement assets.
A substantial proportion of these fees are used to pay sales staffs and t o cover marketing expenses. AFPs compete fiercely for new enrollees, of fering inducements such as toaster ovens and promising workers higher re turns if they switch plans. Between 1990 and 1997, the AFP sales force in Chile grew from 3,500 to 20,000. The upshot of this intense marketin g is that 50 percent of all enrollees switch investment funds each year.
Of workers who do participate, many und erreport their income in order to lower their tax liabilities. A study by Chilean economist Jaime Ruiz-Tagle, for example, found that workers c ontributing to AFPs earned an average of $1000 in February 1995, but dec lared only $460 for tax purposes.
Effects on Low-Income Workers and Women While actual returns on investments are the same for all contributors to a particular fund, a number of flat fees and expenses siphon off a great er proportion of the contributions of low- and middle-income, than highe r-income, workers. Moreover, individual accounts do not allow for redis tribution of income the way pay-as-you-go systems do. This leaves many low- and moderately-paid workers worse off under a privatized system tha n they would have been under a public system. Chilean womenwho are paid less, work more intermittently (often taking t ime off to give birth and raise children), and live longer than menwill inevitably receive lower benefits than men. While public systems tend to compensate for womens social and economic situations, private progra ms do not. Chilean women, then, are at particular risk under the privat ized system. Vulnerability to Market Risk From the mid-1980s to the early 1990s, returns on AFP accounts were impre ssive (as noted above, returns after fees were less so).
Taking management costs into account, workers ac tually lost a substantial amount of money over this period. ...
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