Case Study: The Chilean

Individual Capitalization
System
Eduardo Fajnzylber
Special Studies Unit
United Nations Economic Commission for
Latin America and the Caribbean (ECLAC)

prepared for the

World Bank Core Course on Pensions
November 7-18, 2005, Washington D.C.

Structure of the Presentation

The Chilean Pension Reform (1980)

Contributions and fees

Pension calculation
The Pension Fund Administrators (AFPs)
Regulations

Transition Costs
Macroeconomic effects
Participation and coverage
Projected pensions
Demand for AFP services
Supply of AFP services

What have we learned in the first 25 years since the reform?

Current debate in Chile

Lessons for countries considering individual capitalization reforms
Useful links

Index

The Chilean Pension Reform (1980)

Prior

to the reform: multiple defined benefits

systems, with increasing financing problems
The 1980 reform introduced a unique
compulsory fully funded scheme, based on
defined contribution individual capitalization
accounts, managed by private sector specialized
firms. Note: no democratic debate and armed
forces special regime still in place.
Transition generation:
Older workers could choose to stay on their
previous system or switch to the new one.
New workers must enter the funded system (the
old system is closed to new entry)

Index

The Chilean Pension Reform (1980)

Acknowledging

previous contributions:

Workers who stay on the old system receive their

pensions under the old rules.
Contributions from workers who switch to the new one
are converted into a recognition bond which is paid
by the government at retirement.
Contribution

rate

The contribution rate was lowered from an average

20% of taxable income under the old system to about
12.5% under the new one.
Under these rules, most workers decided to switch to
the new system (or were compelled to do so by their
employers)
Index

The Individual Capitalization scheme

Contributions and fees

1.

2.

3.

Total deduction ~ 12.5% of taxable income (with a

US$2.000 income ceiling) broken down as follow:
Contributions from dependent workers are deposited on
individual accounts (participation from self-employed
workers is voluntary)= 10% of taxable income
These funds are invested on financial instruments by
specialized Pension Fund Administrators (AFPs), who
charge an administrative fee= on average 1.5% of
taxable income
AFPs charge an additional commission to pay for
disability and survivors insurance= on average 1% of
taxable income

Index

The Individual Capitalization scheme

Pension calculation

At any time after a minimum age (60 women, 65 men),

workers can choose to exchange the accumulated funds
(including recognition bonds) for a pension stream (annuity
, programmed withdrawal, or a combination of both).
No restrictions on continued work after retirement.
If sufficient funds are accumulated, individuals have access
to an early retirement (before the minimum age).
On each case, the benefits are actuarially calculated, based
on accumulated funds and age-gender specific life
expectancy.
No minimum number of contributions but if the worker has
contributed for at least 20 years, he/she has access to a
Minimum Pension (MP around 2/3 of the minimum wage,
paid after the funds are exhausted) guaranteed by the
State (SG).
Index

The Individual Capitalization scheme

Pension Fund Administrators (AFPs)

Public limited companies, whose exclusive purpose is the

management of a Pension Fund, and administering the
services and benefits stipulated in the law.
Collect social security contributions
Deposit them in the personal account of each member
Invest the resources
Take out insurance policy to finance disability and survivorship
pensions
Calculate and pay pension benefits (programmed withdrawal)

Commissions are fixed by each AFP (without price

regulation) and are uniform for all members.
Since 2002, each AFP is required to offer 5 different
funds, differentiated by the proportion of their portfolio
invested in equities (Fund A must have between 40%
and 80% of its portfolio invested in equities Fund E
cannot invest in this type of assets).
Index

The Individual Capitalization scheme

Regulations

Risk management is ensured through a complex set of 97 different

investment limits, structured by instruments and issuers

A relative Minimum Yield for each type of fund (industry average minus X)
is guaranteed by a Yield Fluctuation Reserve, a 1% Obligatory Reserve
belonging to the AFP, and a State Guarantee. This seems to generate some
heard behavior on the investment portfolios of different AFPs (some AFPs
replicate the portfolios of the leader firms).

Conflicts of interests: tighter limits on related firms, AFP Obligatory Reserve

invested in same portfolio as pension funds, voting rules in boards of
companies, etc.

Investment abroad: to meet growing demand for financial assets and risk
diversification. Subject to special regulations and an overall investment limit
(currently 30% of all funds invested by a single AFP)

Others (see Chapter IV, SAFP 2003): Eligible Instruments, Authorized

Markets, Risk Rating, Securities Custody, Valuation of Instruments,
commission structure, Information for members, etc.
Index

What have we learned in the first 25

years since the reform?

Chilean reform involved three main changes to

the structure of the system

1) Pay-As-You-Go Individual accounts

2) Defined Benefits (DB) Defined Contributions (DC)
3) Public management Private management

These changes can have multiple effects on the

economy

(1) Fiscal cost of transition

(1) Financial sector development, savings and growth
(2) Formalization of the labor force, Increased
coverage
(3) Competition should trigger high returns on
contributions and low administrative fees
Index

What have we learned?

High Transition Cost

As workers switch to new system, two things happen,

that generate the transition cost to the new system
(3.9% of Chilean GDP for the first 30 years)
Their contributions to the old system are no longer received.
The difference between the pensions that are still being paid
and the (lower) contributions to the old system is the
operational deficit
Contributions made to the old system are acknowledged by
Recognition Bonds, which must be paid at the moment of
retirement

This costs should disappear around 2040

This deficit adds up to the cost of non-contributory
pensions and the payment of the Minimum Pensions
(MP) guaranteed by the State (SG).
Index

Government civil pension deficits

during transition period
Transition Cost of the Chilean Reform, (1980-2010)
6%

Non contributory
pensions

Minimum
Pensions

4%

Recognition bonds
3%

2%

Operational deficit from the old system = Pensions paid Contributions received
1%

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

0%
1981

Government deficit as % of GDP

5%

Index

What have we learned?

Macroeconomic effects

Important

impacts, in terms of financial

development, savings and growth have been
attributed to the Chilean pension reform (0.49
% points of growth between 1980-2001, Corbo
y Schmidt Hebbel, 2004).
Experience from other reformed countries
suggest the importance of other factors to be
present: sustainable financing of the transition
costs, macro stability and other reforms to the
financial sector seem to be required for the
macro effects to take place.
Index

What have we learned?

Participation and coverage

Participation in the system

has stagnated at around
58% of the labor force or
63% of the active workers,
due to low participation
among self-employed and
workers in small firms.
Lifetime density of
contributions is
heterogeneous, and much
lower than predicted
(50%), implying low
replacement rates,
especially for women
(designers expected an
average 80% density)

Never
contributors

Permanent
contributors

Source: Berstein et al (2005)

Index

What have we learned?

Projected pensions

First

projections are
being made, based
on administrative
longitudinal data,
suggesting that
about half the
population will not
be able to finance a
Minimum Pension
(MP) AND will not
have access to the
State Guarantee
(SG)

Above MP
SG

Below MP, without SG

Source: Berstein et al (2005)

Index

What have we learned?

Demand for AFP services
The

system is based on a number of choices:

choice of system, AFP, type of Fund, retirement
age and pension type. In practice, surveys show
little financial literacy and understanding on how
the system works.

Econometric

studies show little response to

relevant variables (price and returns). Most
choices are driven by default options (type of
fund) or the action of salesmen and gifts (choice
of AFP)
Index

Demand for AFP services

Sensitivity to salesmen

Number of
salesmen

Number of
AFP
switches

Source: Berstein and Ruiz (2004)

Index

Demand for AFP services

Importance of default options

Fund type choices by age and Income level
Fund E
(less
risky)

Default options

Fund D

Fund C

Fund B

Lower tercile

Medium tercile

Higher tercile

Fund A
(riskier)

20-24

25-29

30-34

35-39

40-44

45-49

50-54

55-59

60-54

>=65

Age group

Index

What have we learned?

Supply of AFP services

Evidence

suggests presence of important

economies of scale in the production of AFP
services (probably because of high fixed costs)
Marketing costs (especially salesmen) can take
up a large share of total costs. In absence of
price sensitivity, these costs tend to translated
into higher commissions.
Tendency towards concentration of industry
No entry in last 9 years, despite high return on
assets (on average 53% per year between 1999
and 2003, Valds and Marinovic, 2005)
Index

Scale and average costs

Average Cost (thousand $)

Number of contributors per AFP

Source: Mastrngelo (1999)

Index

Increased Concentration of the AFP

Industry
25

90%

78%
21

79%

79%

80%

79%
80%

74%

20
67%
64%
62%
60%

59%

61%

65%

66%

67%

69%

19

69%

69%

70%

61%

Share of
3 largest

16

57%

15

14
13
12

12

12

12

12

13

13

13

60%

50%

13

12

11

40%

10

Share of 3 largest

20

Number of AFPs

78%

9
8

30%
7

7
6

Number of AFPs

20%

10%

0%

0
1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Index

Current debate in Chile

Pension

reform is currently an important issue

among presidential candidates (December 2005)
Reform debate around 3 areas
How to increase coverage?
Attract

self-employed workers through incentives?

Expand non-contributory pensions

How to increase competition?

Let

local banks create AFPs?

Increase demand sensitivity, aggregating contributors and
auctioning their membership to the lowest commission?

Simplify investment limits, increase investment abroad?

Index

Lessons for countries considering

individual capitalization reforms
Careful

consideration of transition costs;

Transition can be smoothed through mixed systems

(Costa Rica, Uruguay)
Defined contributions can be introduced through
notional accounts, without transition costs and
preserving PAYG structure

Defined

contributions do not solve coverage

problems; importance of non contributory pillars
Consider separation of operative functions from
investment functions (see Swedish PPM model)
Macro effects require adequate financing of
transition costs, macro stability, and other
reforms to the financial sector.
Index

Useful links about the

Chilean AFP system
ECLAC

Special Studies Unit, Development

Financing Series: http://www.eclac.cl/ues/
The Chilean Pension System, Chilean
Superintendency of AFPs (SAFP)
http://www.safp.cl/sischilpen/english.html

SAFP

Research Department Working Papers

Series: http://www.safp.cl/doctrab/
Social Protection Survey
http://www.proteccionsocial.cl

Index

Case Study: The Chilean

Individual Capitalization
System
Eduardo Fajnzylber
Special Studies Unit
United Nations Economic Commission for
Latin America and the Caribbean (ECLAC)

prepared for the

World Bank Core Course on Pensions
November 7-18, 2005, Washington D.C.