Peter Jones, ContributorHOW DOES IT WORK? - UNDER CHILE'S social security system, what determines a worker's retirement benefit is the amount of money he accumulates in his PRA during his working years. Neither the worker nor the employer pays a payroll tax. Nor does the worker collect a government-funded benefit. Instead, 10 per cent of his wage coming from the
previous payroll tax is deposited; tax free, by his employer each month in his own PRA.
The 10 per cent rate was calculated on the assumption of a four per cent average real return on a PRA during a whole working life, so that the typical worker would have sufficient money in his account to fund a retirement benefit equal to approximately 70 per cent on his final salary. A worker may contribute up to an additional 10 per cent of his wage each month, also deductible from taxable income, as a form of voluntary savings.
The return on the PRA is tax-free. Upon retirement, when funds are
withdrawn, taxes are paid according to the income tax bracket at that moment.
2 A worker may choose any one of the private pension fund companies (called Administradoras de Fondos de Pensiones, or AFPs) to manage his PRA. A key provision is totally free entry to the AFP industry, for both domestic and foreign companies (foreign companies can own up to 100 per cent of an AFP)
in order to provide competition and thus benefit workers. Those companies can engage in no other activities and are subject to strict supervision by a government entity, the Superintendency of AFP that was created to provide highly technical oversight to prevent theft or fraud.
3. Each AFP operates five mutual funds, with different bond/share proportions (the original scheme allowed only one fund for each AFP). Older workers have to own mutual funds highly invested in fixed income securities, while young workers can have up to 80 per cent of their funds in shares. Investment decisions are made by the AFP, but the worker can choose both the AFP and, within limits, the preferred fund.
The law sets only maximum per centage limits both for specific types of instruments and for the overall mix of the portfolio; and the spirit of the reform is that those regulations should be reduced progressively as the AFP companies gain experience and capital markets work better. There is no obligation whatsoever to invest in government bonds or any other security. Legally, the AFP companies and the mutual funds that is, the workers' investments are not affected at all and only the AFP's shareholders lose their capital.
4. Workers are free to change from one AFP company to another, and from one fund to another. There is then competition among the companies to provide a higher return on investment, better customer service, or a lower commission. Each worker is given a PRA passbook (to use if he wants to update his balance by visiting his AFP) and receives a statement by mail every three months informing him of how much money has been accumulated in his retirement account and how well his investment fund has performed. The account bears the worker's name, is his property, and will be used to pay his old-age retirement benefit (with a provision for survivors' benefits).
5 Individual preferences about old age differ as much as any other preferences. Some people want to work forever; others cannot wait to cease working and indulge in their true vocations or hobbies. The pay-as-you-go system does not permit the satisfaction of such preferences, except through collective pressure to have, for example, an early retirement age for powerful political constituencies. It is a one-size-fits-all scheme that may exact a high price in human happiness.
The PRA system, on the other hand, allows individual preferences to be translated into individual decisions that will produce the desired outcome. In the branch offices of many AFPs, there are user-friendly computer terminals on which a worker can calculate the expected value of his future retirement benefit, based on the money in his account, the life expectancy of his age group, and the year in which he wishes to retire. Alternatively, the worker can specify the retirement benefit he wishes to receive and determine how much extra money he must deposit each month if he wants to retire at a given age. Once he gets the answer, he simply asks his employer to withdraw that new per centage from his salary. Of course, he can adjust that figure as time goes on, depending on the actual yield of his pension fund or other relevant variables (for example, longer life expectancies).
6 All workers, whether employed by private companies or by the government, were given the opportunity to opt out of the pay-as-you-go system. Self-employed workers are not compelled to participate in the PRA system, as they were not in the government pay-as-you-go system, because of the practical difficulties in a country like Chile of enforcing any mandatory system for self-employed people. But the pension reform allows them to enter the PRA system if they wish, thus creating an incentive for informal workers to join the formal economy.
7 The social security reform system maintained a "safety net". A worker who has contributed for at least 20 years but whose benefit, upon reaching retirement age, is below what the law defines as a "minimum pension" is entitled to receive that benefit level from general government revenue sources once his PRA has been depleted. (Those without 20 years of contributions can apply for a welfare-type retirement benefit at a lower level.)
8 The government-run disability and survivors' program, a source of systematic abuse, given the non-existence of incentives to control its fair use, was also fully privatised. Each AFP has to provide this service to its affiliated workers by taking out, through open and transparent bidding, group life and disability coverage from private life insurance companies. This coverage is paid for by an additional worker contribution of around 2 per cent of salary, which includes the commission to the AFP for administrative and investing expenses.
9 A key feature of the reform was the change in the meaning of "retirement". The legal retirement age is 65 for men and 60 for women (those were the ages in the former pay-as-you-go system and were not discussed or changed during the reform process because they are not a structural characteristic of the PRA system). But in the PRA system, workers with sufficient savings in their accounts to buy a "reasonable annuity" (defined as 50 per cent of the average salary of the previous 10 years, as long as it is higher than the "minimum pension") can cease working, begin withdrawing their money, and stop contributing to their accounts. Of course, workers can continue working after beginning to retire their money. A worker must reach the legal retirement age to be eligible for the government subsidy that guarantees the minimum pension. But in no way is there an obligation to cease working, at any age, nor is there an obligation to continue working or saving for retirement benefit purposes once you have assured yourself a "reasonable" benefit as described above.
10 Upon retiring, a worker may choose from three general payout option. In the first case, a retiree may use the capital in his PRA to purchase an annuity from any private life insurance company. The annuity must guarantee a constant monthly income for life, indexed to inflation (there are indexed bonds available in the Chilean capital market so that companies can invest accordingly), plus survivors' benefits for the worker's dependents (wife and orphans under the age of 21).
Second, a retiree may leave his funds in the PRA and make programmed withdrawals, subject to limits based on the life expectancy of the retiree and his dependents; with this option, if he dies, the remaining funds in his account form a part of his estate and can be given to his heirs basically tax-free. In both cases, he can withdraw as a lump sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 per cent of his last wages. And third, he can choose any mix he wishes of the previous two.
The financing of the transition is a complex technical issue that would have to be addressed in Jamaica successfully without raising taxes and that the country must resolve according to its own circumstances. The key insight in this regard is that, contrary to the widely held belief, there is no "economic" transition cost, because there is no cost to GDP due to this reform (on the contrary). A completely different, and relevant, issue is how to confront the "cash-flow" transition cost to the government of recognising, and ultimately eliminating, the unfunded liability created by the pay-as-you-go-system.
Legislators in both the Lower House and The Senate need to consider these issues carefully, if the final result is growth and sustained economic development.
Peter Jones is the Executive Director of The Economic Development Institute a Non-profit Jamaican Economic Development Consultancy. Mr. Jones holds Post Graduate degrees in Economics and Business Administration and is the author of Jamaica: Social, Political and Economic Issues for future development.
