Taking a Hard Look at Chile’s Privately Managed System

SANTIAGO, Chile

All business and bustle, Elizabeth Aravena prowls for customers at the gates of a factory that makes diapers. She sells the future.

Aravena wears a gray skirt-suit on a hot afternoon thick with traffic fumes and industrial smells. Rings glitter on her fingers, and gold glints in her exuberant smile. During the afternoon shift change, workers flock to a tree-shaded bench to chat, flirt, ask financial advice and hit her up for free candies and pens bearing the logo of Provida, the biggest of 13 companies that administer pension funds here.

“I am their advisor, their confessor, their psychologist,” Aravena said. “I listen to all their personal problems.”

Aravena belongs to a 20,000-member legion of salespeople employed by Chile’s fully privatized social security system. It is a uniquely Chilean institution that admiring conservatives want to reproduce in the United States, where they say it could ward off the demographic crisis menacing Social Security.

Chile’s approach is disarmingly simple. Workers deposit a percentage of their salaries into accounts managed by the private company of their choice. The pension management company in turn invests the funds in ways that, it hopes, will maximize returns. Pension benefits depend on its success.

Mexico, Argentina, Peru and Bolivia have enacted reforms based on the Chilean model. Russia, China, Croatia, Poland, Britain and Germany are among the many nations studying it.

“It is no longer a laboratory experience, it is a reality, and the results have been positive,” said Julio Bustamante, superintendent of the agency that regulates pensions. “We are not surprised that this model is being considered by many nations trying to reform social security. This has become our nontraditional export.”

Retired workers in this nation of 15 million receive about 80% of their salaries, as much as double the old public pensions. An accumulated $33 billion in pension funds has bolstered the economy, whose 7% annual growth rate leads the region. Chile now has Latin America’s highest savings rate--and the most financially savvy work force on the continent.

But the market forces that are the strength of the concept are also its weakness, as the global crisis of recent months has alarmingly illustrated. Annual returns earned by management companies on the workers’ deposits have plummeted from a onetime peak of 12%.

The international financial markets crisis even caused some worried Chileans to postpone retirement in hopes that a recovery will replenish their suddenly shrunken nest eggs. In general, though, the presence of millions of long-term investors in pension funds makes Chile less vulnerable to stock fluctuations and speculation than its neighbors. Moreover, the Chilean government has proposed new rules in response to consumer resentment of exorbitant sales commissions, aggressive marketing and creeping corruption that divert about 25% of benefits into administrative costs.

By comparison, about 2% of Social Security contributions in the U.S. goes to administrative costs.

“For the companies and employers, it is a great business,” said labor leader Jose Ortiz. “For workers it is uncertain. Don’t forget, this was imposed by force during a military dictatorship when workers did not have liberty to express themselves, when unions had been demolished.”

Those who want to adopt the Chilean model must remember that, as with other free-market innovations here, pension privatization took place figuratively at gunpoint. It is the product of a 17-year dictatorship that claimed an estimated 3,000 lives and forced hundreds of thousands of people into exile.

The arrest in London of former dictator Augusto Pinochet, who awaits the outcome of a Spanish extradition request, served as a reminder that his regime’s economic experiments had a dark side.

Radical surgery in Latin America is one thing, because social security bureaucracies have been pillaged and mismanaged to the point of collapse. But for the U.S., it’s a different story. The political and economic costs of privatizing its efficient and egalitarian system could be formidable.

Nor has privatization entirely cleaned up Chile’s pension system. Regulators say commission-hungry salespeople commonly lure clients into jumping to different plans by offering cellular phones, TVs and outright cash bribes.

“It used to be a cleaner business,” Aravena said. “Now there’s bribery, dishonest salespeople.”

Bustamante, the regulator, wants to reduce the number of middlemen, allow clients to negotiate lower commissions and provide incentives to stay with a single fund. He hopes to chop administrative costs in half.

“Looking at it on a macro level, these problems do not endanger the quality of the system,” said Luis Larrain, who helped build the system and is now an economist at a conservative think tank. “Yes, they are a nuisance. However, the system should not be measured by its costs, but by its benefits.”

Chile created its pay-as-you-go retirement system in 1925, 10 years before the United States. As in many other nations in the region, though, the system had grown costly and ineffective. The dictatorship’s technocrats decided to junk the whole thing, except for a few safeguards. Retirees continued to receive government checks. Active workers could stay or switch to the new, private scheme. New workers had to go into the private system.

Today, most of the 5 million Chileans formally in the work force belong to the private system. Military personnel exempted themselves from the experiment and continue to receive handsome public pensions.

There are no payroll taxes in Chile and few private, 401(k)-type retirement plans based on joint employer-employee contributions. Instead, employers set aside at least 10% of wages--and up to 20% if workers choose optional savings plans--in tax-free, privately managed funds that are invested in the market. The funds accompany workers when they change jobs.

The big hurdle to any privatization is the transition as the government loses revenue from workers who shift their wage deductions into the private sector. The military government solved this problem by refinancing debt and slashing social programs rather than raising taxes. Democratic governments have less political space in which to maneuver. That may explain why other Latin countries have implemented schemes in which public and private systems coexist.

And critics on the left have another basic philosophical objection: The mentality eliminates the ability of pensions to redistribute wealth to the poor. “This works well for the people on top,” labor leader Ortiz said. “Managers and executives will have nice pensions.”

Most of Chile’s retirees seem to prefer the private system, although not as enthusiastically as the technocrats.

Teresita Rubio, 60, cashed in her fund for about $100,000 and retired after 40 years as a high school literature teacher. She used about $60,000 to buy an apartment as an investment. She collects a monthly pension of about $400, and the rent on the apartment lifts her income to middle-class standards.

She admits that global stock market gyrations, combined with a financial scandal affecting a company in which her pension management company had invested heavily, make her nervous. She estimates that her $40,000 pension fund lost $2,500 in value in less than a month.

Just a cyclical phenomenon, the company’s financial advisors assured her. But the psychological damage had been done.

“I felt very happy with the company. They painted me a very pretty picture of what retirement would be like,” she said. “And there was a time when the returns were very good. But now I’m not so sure. I guess no matter what the system, today it is very difficult to live a very stable life.”