Pension reform in Chile

The Associated Press reports that the Chilean government is preparing to roll out a significant reform of the country's pension program, which after its introduction in 1980 served as model for reform in Latin America and elsewhere in the world, and has been proposed as a reform model in the U.S. Given this, it makes sense to some of the issues involved with Chilean pension reform as they relate to the U.S.

The biggest problem with the personal accounts pension system in Chile, as with the traditional defined benefit program that preceded it, is incomplete coverage. In the U.S. coverage under Social Security is practically universal (less than 5% of workers aren't covered), and the vast majority of those not covered under Social Security take part in another pension program. In Chile, by contrast, the self-employed, who have never been mandated to take part in their pension program, make up almost 40% of the workforce.

For that reason, even though average replacement rates for full-time workers under the Chilean pension plan are quite high -- around 85% percent, versus around 45% under U.S. Social Security -- a large number of self-employed workers would reach retirement with insufficient savings.

In response, the Chilean government has maintained a minimum pension benefit for individuals with 20 years of participation in the accounts system. The minimum benefit is equal to around 25% of the average wage. In U.S. terms, this would make for a minimum Social Security benefit of around $10,500. (Using the Gemini model, I estimated the benefits for 1941 birth cohort, individuals who would turn 67 in 2008. Among those who had claimed benefits, 67% had an initial benefit lower than $10,500. This gives some perspective on how relatively high the Chilean minimum is.)

Since the Chilean minimum pension is means-tested, lower-wage workers have very little incentive to participate in the personal accounts system once they have reached 20 years of coverage. The minimum pension is relatively generous so they would lose much or all of what they saved in their accounts. It is almost certain that the presence of the minimum pension -- designed to assist low-wage workers -- has aggravated the problem of low participation.

What are the lessons of this for U.S. Social Security reform? Probably quite few. No existing reform plans allow workers to effectively opt-out of Social Security, as the Chilean system allows self-employed workers to do. As a result, even in personal account plans that contain a guarantee of current law scheduled benefits, this type of moral hazard problem would not express itself. (There may be other moral hazard problems with such plans, such as the incentive to invest in risky assets, but that is a separate issue.)

For a good summary of the Chilean system and its strengths and problems, see this paper from Mauricio Soto of the Center for Retirement Research at Boston College.