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What's Hot in Chile?

Chile's defined contribution pension system has grown significantly since its inception in 1981. Its development has positively impacted the Chilean society by laying down the foundation to attack old-age poverty and adding depth to Chile's capital and financial markets. Stable Value funds may be the next natural step in Chile's ongoing pension reform. Addition of Stable Value funds would offer several key benefits:

• First, an increased spectrum of funds enhances the power of investment choice and the ability to match investment profiles to individual needs. Currently only two types of funds are offered: a plain fixed income fund and a balanced fund of equity and fixed income investments.
• Second, the reduced volatility of Stable Value products provides a sense of security in reliable income to those approaching retirement age.
• Next, the consistent returns of Stable Value funds can help boost confidence in, and thereby contributions to, the pension system to increase coverage.
• Fourth, the use of Stable Value products will encourage investment managers to diversify their portfolios. This will lead to great added value from asset management.
• Finally, the low volatility and consistent returns can help ease pressure on the government to guarantee a minimum return.

Growth of the Chilean Pension Market

Chile's old pension system encouraged early retirement and discouraged labor force mobility. A new model was developed with the goals of (i) improving sustainability through economic and political cycles, (ii) easing fiscal pressures, (iii) reducing old-age poverty and (iv) strengthening financial markets, all of which promote economic growth. Pension reform was necessitated by the unsustainability of its under funded but over-generous defined benefit system. Rather than the aging population problem faced by more developed countries, Chile's old system was plagued by bad management and political manipulation. The new pension model is characterized by mandatory individually capitalized contributions to personal accounts and the ability to choose a private fund manager and the type of pension distribution upon retirement.

While 20 years is too short a time to determine whether the reformation is a success, Chile's progress can be tracked by examining a few metrics, such as growth in pension assets, the extent of pension coverage and the contribution of the pension plan to economic growth.

Pension fund assets increased substantially at an average annual rate of 29 percent to US$37.8 billion in December 2000 from only US$300 million in December 1981. Pension assets are forecasted to grow to over US$175 billion by 2023. The increase in volume is attributable to the mass transfer of workers from the old pension system, a high average investment return, a high ratio of contributors to pensioners and general economic growth (with the resultant positive impact on real wages and employment) during the period. The importance of the pension fund system to the general economy is apparent when looking at its increased weight of 54.6 percent of GDP in December 2000 from only 0.9 percent of GDP in 1981. It is expected to reach nearly 88 percent of GDP by the year 2023.

The degree of coverage, meaning the ratio of contributors to the pension system to the total number of those employed, has been less impressive. This leads to concerns that old-age poverty may not have been effectively reduced. The coverage ratio, driven by large-scale transfers of workers from the previous system, peaked at 61 percent in 1997. It leveled off to approximately 60 percent in the following three years. These numbers lag the 86 percent maximum level achieved in the 1970s under the old system. The relatively low coverage ratio under the new pension program is due to the very low proportion of self-employed workers' participating. As of June 2001 self-employed contributors accounted for a mere 2.5 percent of all contributors to the new plan, even though they represented 24.7 percent of total workers in the country.

Labor force mobility was improved through the establishment of personal accounts with investment managers who must place all securities with one authorized institution. Previously, rewards for long service were a hindrance to labor force mobility and to recruitment of new employees. Shifting away from a defined benefit to a defined contribution eased the barrier to changing jobs.

The implementation of the new system eased some fiscal pressure on the state and public budget. The old system ran at a loss. The government was obligated to finance the deficit. The new system funds pension liabilities through mandatory individual contributions.

The implementation of the new system eased some fiscal pressure on the state and public budget. The old system ran at a loss. The government was obligated to finance the deficit. The new system funds pension liabilities through mandatory individual contributions.

The creation of the new pension system coupled with social and economic reforms at the time profoundly affected Chile's capital markets. The resultant increased supply of long-term funds and increased liquidity of the stock market is evidenced by the increase in bond issuers and issuance amounts, the increase in stock listings of registered companies, and the expansion of the mortgage loan market.

While the reforms have brought about much needed improvements for the Chilean society, Chile must still address the limited extent of the plan's coverage. The pension system is accessible primarily to workers in the formal labor sector, which is generally characterized by a higher skill or education level, steady full time jobs, and minimum wages. Stagnant coverage levels are worsened by the shrinking formal sector, resulting in a declining number of potential contributors. The sinking number of active contributors, even within the pool of potential contributors, further adds to the coverage problem. The pension system also excludes the self-employed. Compulsory participation would be difficult to implement without any incentive, since contributions would reduce net income. In addition compliance is difficult to ensure, as the self-employed do not pay income taxes.

Limited contributors and contributions will lead to a limited portion of future retirees receiving adequate pensions. Unless the commitment to contribute is extended to the currently excluded, such as the self-employed, or the share of formal working sector eligible for pension is expanded, the problem of old-age poverty will remain. Other policy options include lowering other barriers to participation in pension systems, educating workers about saving for retirement, and redesigning minimum benefits guaranteed by the government.

The Need for Stable Value

Pension plans have not taken advantage of the increased supply of asset classes. Currently pensioners have available a narrow selection of funds with low diversity and high concentration in government bonds from which to choose.

As of December 2001
Source: International Federation of Pension Fund Management

Investment managers are not compelled to diversify their portfolios due to the current method of assessing performance. Fund returns are compared against the industry average return for similar funds. If a manager falls too far below, it must compensate for the difference through reserves. If the manager is unable to pay, the government guarantees a minimum level of return. This creates a herd mentality and limits investment options available to plan participants.

Stable Value wraps will smooth returns and will help investment managers ride out periods of high volatility. This encourages investment managers to strive for value-added portfolio performances that exceed the benchmark. Additionally, investment managers are not motivated to engage in price competition. This results in higher fees and lower total returns on the funds. Better long-term performance through Stable Value wraps may intensify competition and stratify the quality of management.

Costs associated with running the old pension system hurt government finances and jeopardize the potential fiscal benefits of implementing the new system. The new system adds to existing fiscal liabilities by guaranteeing a minimum level of pension and discourages workers from continuing contributions to the fund. Stable Value products provide reliable returns and should reduce fiscal pressure on the government's guarantee. Currently the government guarantees a fraction of average wage as a minimum level of pension, as well as a minimum return on assets if the investment manager's reserves are inadequate. Stable Value products also encourage workers to participate by growing their contributions instead of settling for a minimum pension level. Education of workers and establishment of a benchmark may also help eliminate or reduce the need for the government guarantee.

Relaxing stipulated asset allocations may increase diversification, reduce risks and increase returns. A shift from the current emphasis on local government bonds to a more balanced portfolio of domestic and international bonds and equity, presents opportunities for wealth creation and further development of financial and capital markets and the ability for pensioners to cater their investments to their individual needs

Governance over the pension system should be tightened and make provisions for Stable Value products. Governance continues to remain weak and to finance the government's deficit through large concentrations of government bonds held by the pensions. Tighter governance would be positively reflected in the quality of investment management and regulations to support economic stability and protect pension value.

Important steps have been put in place to develop an effective viable pension system. But reform needs to be revisited and continually evaluated to adapt to changing economic and political climates. Incorporation of Stable Value products will be an important step in establishing a sustainable pension system.

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