The Latin American Experience

with Pension Reform

by

Salvador Valdés-Prieto*

Annals of Public and Cooperative Economics – Vol.69 No4 – December 1998

* Professor of Economics, Institute of Economics, Universidad Católica de Chile, fax (562) 562 1310, email:

svaldes@volcan.facea.puc.cl. I am grateful to Estelle James for having incited me to write this paper, and for excellent

advice and corrections. Augusto Iglesias and Rodrigo Acuña provided access to the innovative “Statistical Report on

Private Pension Systems in Latin America.” I am grateful for the comments by Estelle James and Julio Bustamante.

All remaining errors are mine.

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Introduction

This paper surveys the Latin American experience with fully funded privately managed

second pillars, introduced in radical pension reforms following the Chilean reform of 1981. As of

late 1997, the Latin American second pillars had 26.7 million members and 15.6 million

contributors. Four countries have now had four or more years of experience with their new

systems -- Chile, Peru, Colombia, and Argentina. Four more recent reformers, Bolivia, Mexico,

El Salvador, and Uruguay are excluded from this survey because their new systems started only

in 1996-1998. Table 1 provides descriptive statistics for the new funded second pillars in the four

selected countries.

This paper attempts to answer the following questions: First, why did many Latin

America countries embrace the radical approach to pension reform pioneered by Chile? Second,

what are the major obstacles to such reforms and how they have been dealt with? Third, what are

the main pitfalls to avoid in such complex pension reforms?

Section 2 of the paper approaches the first question. It presents a brief history of social

security in Latin America, with the purpose of explaining the main elements of the demand for

pension reform. Section 3 identifies three major potential obstacles to pension reform at a

theoretical level, while sections 4 to 7 apply this framework to Chile, Peru, Colombia, and

Argentina. Section 8 summarizes the lessons learned and identifies some of the pitfalls in this

type of pension reform.

2. The Latin American demand for radical pension reform

This section seeks to lay out the reasons that have led policy makers in several Latin

American countries to consider seriously a radical reform of their pension systems, in the

direction of privatization and increased funding.

The Social Security Tradition in Latin America

Social security was adopted in Latin America in two waves: the Southern Cone countries

(Argentina, Chile, and Uruguay) were early adopters, mandating contribution to collective social

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security institutions before the Great Depression of the 1930's (Mesa-Lago, 1989) and before or

simultaneously with several Western European countries. The second wave of adoption happened

in the early post war period, when Mexico (1943), Venezuela (1940), Costa Rica (1941), Peru

(1962) and Colombia (1965) started state-managed social security schemes. The pension systems

in this set of countries enjoyed an abundant cash flow surplus right up to the 1980's, because

population growth was much faster than in the Southern Cone and in addition they were 30 years

less mature.

During the 1960's and 70's a serious problem developed: a significant proportion of

members found that their benefits were much smaller than expected. For example, in Colombia,

the average pension in 1992 was only 1.23 times the minimum salary; in Chile in the late 1970's,

70% of pensioners were receiving the minimum pension. This outcome occurred for many

reasons, such as intended redistribution, unintended reduction of benefits through inflation (see

the case of Venezuela in World Bank, 1994, page 154), legislated caps on benefits, etc. In many

cases individual replacement rates were much below the theoretical levels advertised, feeding

anger and frustration among the middle-class old. These feelings were shared by a growing

proportion of the active workers, who found that they had to support their aged parents even

though they had impeccable contribution records.

The perception of inequity was exacerbated because a number of special interest groups

had obtained special treatment. For example, in Argentina workers who did not pay their

contributions on time were repeatedly allowed to 'regularize' their contribution record by paying

small fractions of the amount due, thus earning access to full benefits. These exemptions were

perceived to be indirectly financed by the benefit reductions that affected the majority. According

to surveys during 1995, 70% of the Uruguayan population perceived the old system as 'unjust' or

'very unjust', and 68% said that they felt 'unprotected' or 'obtained little protection' from the social

security system (Rodríguez, 1996).

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Causing and coinciding with these frustrations, the cash flow of the pension institutions

deteriorated substantially, creating massive fiscal problems. First, evasion of contributions came

to be seen as legitimate self-defense from an expropriatory system, so it became widespread.

Second, relatively short averaging periods allowed many members reaching pension ages to

increase taxable income artificially in order to increase their pensions. Third, just because of age

the pension institutions of the Southern Cone were reaching the phase of system maturation, in

which the initial cash surplus of pay-as-you-go financing turns into a cash deficit at the low initial

contribution rates. Fourth, the countries of the Southern Cone started their demographic

transition, becoming subject to one of the major weaknesses of pay-as-you-go financing. In the

1960s, Uruguayan pension expenditure reached 15% of GDP and 62% of government

expenditure, while the system dependency ratio fell from 4 in the 50's to 1.4 in the 90's. The case

of Uruguay is extreme because it has been compounded by emigration of the young.

Responses

The deterioration of cash flow in the pension institutions was met initially with

substantial increases in contribution rates, but evasion increased further. In some economies it

was easy to escape to the informal sector which set upper bounds to tax revenues.

The real problem was the inability to reform excessively generous benefit formulae once

system maturation squeezed cash flow. Attempts to reduce benefits faced strong political

opposition because the replacement rates were already seen as very low. Interest groups opposed

the needed increases in retirement ages, which in many cases were extremely low, attempts to

tighten the procedures for disability pensions got nowhere, and more generally, rational benefit

reduction proved politically impossible by explicit means. The resulting cash flow deficit is the

source of the widespread statement in Latin America that 'the old pension institutions are broke'.

In order to meet the budget crisis, the Alfonsín government in Argentina resorted to

illegality in 1986 and authorized unilateral reduction of pensions payments. This backfired when

the Supreme Court supported the pensioners that sued and the government had to confront over a

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million lawsuits. Although pensions began to be paid in full again since 1992, the outstanding

debt related to the lawsuits was estimated in 1996 at some 5 billion US$.

The Emergence of an Alternative: the Chilean Reform of 1980

The emergence of an alternative pension model in Chile, and its 12 years of experience as

of 1992, are, in my view, a major explanatory element of the spread of pension reform in Latin

America during the 1990's. For opinion leaders in other Latin American countries, the most

surprising features of the Chilean reform of 1980 seem to be the following:

a) The pension funds were not stolen by their managers, even though Chile went through

a banking crisis and a very deep recession in the 1980's. Many Latin Americans recall banking

scandals where small savers lost substantial amounts to financiers who escaped the country, so

private financial intermediaries have a tarnished image. The fact that privatized pension fund

managers in Chile did not embezzle the pension funds was considered a remarkable feat of

successful institutional engineering.

b) The pension funds were not used by the government to buy equities in insolvent state

enterprises nor forced to buy state bonds that yield less than market interest rates. This was

surprising for observers who suspected that regulation of pension funds would be used by

governments for that purpose, as happened in the collective pension funds that existed in the

initial stages of all pay as you go Latin American pension systems. To the contrary, recent

research shows that privatized pension fund managers in Chile have resisted political pressures

successfully and even sued a state-owned corporation in connection with the bondholder rights

agreed to in bond covenants (Godoy and Valdés-Prieto, 1997).

c) The high realized rate of return, which reached 12% per annum above inflation during

1981-1993, allowed the expected size of Chilean pensions to increase to generous levels, even

though contribution rates were reduced substantially. The rates of return obtained in 1995-97

were -2.5%, 3.5% and 4.7%, as the local stock market fell. However, during the 1990's the

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domestic bond market has offered CPI-indexed fixed income instruments at prices that imply real

returns of 6-7% for the next 20 years. This is the best estimate of future returns.

d) Even though pension fund investments were highly regulated at the start, they appear

to have contributed significantly to capital market development. In particular, they have improved

liquidity in security markets and have demanded services such as risk rating, which are useful to

other agents as well. They have provided domestic financing for large scale projects, a segment of

the capital market that did not exist previously. They stimulated new legislation designed to

manage and limit conflicts of interest and improve governance at the largest Chilean corporations.

e) It was shown by example that the poor old could be taken care of without using the

redistributive benefit formula offered by conventional pension systems. The provision of tax-

financed targeted benefits to the poor old, via a minimum pension program or via targeted

assistance pensions distributed by the municipalities and financed with general tax revenue,

proved that redistributive aims could be pursued effectively in a privatized pension system.

The lobbies in favor of pension reform

In the early 1990's a powerful convergence of ideas and interests in several Latin

American countries began to shape a serious demand for pension reform following the Chilean

model. A worldwide tide of ideas began to favor privatization, openness to international trade

and to foreign investment, and these ideas were taking hold among influential political leaders in

Latin America. More specifically, those politicians realized that funded pensions opened the way

to a blurring of the traditional division of citizens between workers (exploited) and capitalists

(oppressors), as workers could be turned into a new type of capitalist through the language of

individual accounts.

Among interest groups, business leaders realized that gaining access to a large pool of

domestic savings could allow them to play senior-league entrepreneurial games with huge profit

opportunities, while at the same time paying good returns to pensioners. More narrowly, financial

intermediaries found that private fund management companies could be a profitable new line of

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business. Private sector interest groups provided the funding for a number of the evaluation

studies of pension systems in Latin America in the 1990s, which in some cases laid the

groundwork for pension reform.

Established economists and multilateral lending institutions encouraged a pension reform

along the lines of the Chilean model. In many cases the multilateral institutions financed studies

needed for actual reforms. Frequently mentioned - but hard to measure - were the positive

externalities of pension funds in the promotion of financial market development and more

efficient labor markets.

However, demand for a radical pension reform has been weak in Brazil. Among the

factors that might explain this difference, we can suggest the following: First, economic policy in

Brazil exhibits a tradition in favor of government intervention, so the worldwide tide of ideas in

favor of privatization has had a delayed impact as compared to Spanish America. Second, the

corporate sector in Brazil already has set up a substantial occupational pension system based on

tax advantages, with assets above 60 U.S.$. billion (more than twice the Chilean pension funds)

and growing rapidly. This industry meets the demand for decent pensions from higher-income

workers and provides corporations with some discretionary investment funds. As the corporate

sector in Brazil has been dominated by state-owned enterprises, the Brazilian private sector has

not financed major reform studies or proposals. Thirdly, the chronic fiscal deficits in Brazil

during the 90's have been a major obstacle to increases in the degree of funding of the existing

state-run pension system. Brazil is now considering a different type of reform, based on a

notional defined contribution scheme (see paper on Sweden in this volume).

3. A framework for considering country case studies

The previous section has shown how a demand for radical pension reform took shape in

many Latin American countries. However, implementation problems of a technical or political

nature can prevent the satisfaction of this demand. This section identifies three major objections

to pension reform, which will be used below to guide the country case studies.

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Objection 1: Fiscal constraints

Any pension reform that diverts contributions from the old system towards a new system

deprives the old system of the resources usually directed to pay pension benefits. If the old

system has no significant financial assets to sell, as is the case in most of Latin America, the old

system has to resort to its guarantor, which is the state. The state can raise the funds by issuing

debt or by adjusting its current account, namely increasing taxes or reducing expenditures.

Many analyses of the fiscal constraint stop here. That is a mistake, because a natural

purchaser of eventual debt issued by the government is the new system, which gets the

contribution revenue but has no benefits to pay (yet) because it is just starting. However, the new

pension system may wish to diversify away from government debt. It turns out that this can be

accommodated easily. For example, if the new pension system buys just 60% of the new

government debt, it must devote 40% of its assets to other assets. Then the sellers of those other

assets will have the resources to buy the remaining 40% of the new government debt. Because of

the explicit interest cost incurred when the implicit debt turned into an explicit debt, a complete

wash requires a further policy measure. Workers who gain from the higher (market) rate of return

must cover the higher (market) interest cost borne by the government by accepting an incremental

wage tax (see Valdés-Prieto, 1997). This full debt financing option has been used in Bolivia and

Uruguay, which decided to finance the reform by issuing additional debt, at least initially.

The other countries decided to make some adjustment to the primary fiscal accounts. The

reasons for this are varied, ranging from perceived gains of having the new system invest a

substantial portion in private sector assets, to perceived gains of using the "pension reform

excuse" to increase fiscal and thus national saving, and to constraints imposed by private sector

lenders (or the IMF) when they have failed to monitor the total debt of the government including

unfunded pension liabilities and might interpret increases in the explicit public debt as a signal of

reductions in overall fiscal solvency.

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In general, the maximum potential size of the fiscal obstacle to pension reform that

countries must overcome is the size of the debt implicit in the old public pay as you go system,

i.e. the present value of accrued pension liabilities to both pensioners (still alive) and current

active workers minusing assets that the system has. In this spirit, the OECD has published

statistics that show that the implicit pension debt is above 150% of GDP in most Western

European countries and Japan.

This concept measures a true debt only to the extent that the state is committed to

honoring guaranteed benefits. A debt concept assumes that future governments will not introduce

laws that increase retirement age, raise contribution rates or reduce starting benefits, and will not

take administrative actions that reduce the real value of benefits, such as introducing lags in

benefit adjustment to inflation and failing to provide full indexation of past wages when benefits

are first determined. If such laws and administrative actions are expected, then the pension debt

should be adjusted downwards to include the probability of default and its likely size. Partial

default can be the result of abuse by previously active generations that legislated excessive

pension increases for themselves, the result of abuse by young generations who want to reduce

their tax liability even if this hurts pensioners, or the result of unexpected new developments that

warrant a benevolent reallocation of burdens across generations. This list shows that pension debt

can be quite different from contractual public debt.

Table 2 reports the available estimates of the size of the implicit pension debt in the old

systems in Latin America just before the pension reforms. Table 2 suggests that the "fiscal

constraint" was larger in the Southern Cone countries than in the rest of the reformers. The fact

that all these countries reformed anyway, and that some countries with relatively small debts have

not reformed, suggests that other forces are also at work, hence further delving into the country

cases is productive.

Objection 2: Underdeveloped Capital Market

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For a funded pension system to operate efficiently, some financial markets must be

available. If not, the pension funds are forced to invest in land, urban real estate and private

equity in business firms. A lack of assets with liquid markets and transparent prices exposes

pension funds to substantial transaction costs and uncertainty. Workers become exposed to fraud

by pension fund managers, because supervision of their activities becomes impossible and the

supervisory agency becomes vulnerable to corruption. Some of the failures of the old pension

systems in Latin America originated in underdeveloped financial markets.

This obstacle to reform can be overcome if the country embarks on liberalization of the

domestic financial market, or if up to 100% investment in foreign financial markets is allowed.

However, the liberalization program does not have to be completed before the pension reform

starts. For the first five or seven years the pension funds are small, so modest domestic markets in

bank deposits, government debt and some foreign assets may be enough to start.

Thus, the true nature of this obstacle lies in the ability of the political elite of a country to

manage and complete the transitional phase between the initial conditions and a fully developed

set of financial markets. Although the particulars differ, several reforming countries in Latin

America have substantial reservations about the quality of their capital market institutions. That

may explain why most countries - except Mexico and Bolivia - copied the Chilean approach of

tight investment restrictions coupled with case-by-case evaluation in a state-controlled Risk

Classification Commission (RCC). This approach has the advantage of providing more time for

the capital market to mature, but raises questions about the reliability of such heavy-handed

government intervention, even for a transitional period.

I argue that financial market underdevelopment is likely to force the failure of a reform

that attempts to increase the degree of funding of pension liabilities, unless a large CPI-indexed

long term bond market emerges within a decade. In Latin America it is highly likely that one or

more episodes of inflation and devaluation will reduce dramatically the real value of nominal

bonds over the time horizons for which individuals participate in a pension system. In the absence

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of a substantial supply of CPI-indexed long term bonds, the benefits promised by the pension

system are exposed to catastrophic inflation risk.

Many pay as you go financed pensions have introduced CPI indexation of benefits, taking

advantage of the fact that contribution revenue is highly responsive to wage inflation. Funded

systems can potentially do the same because bank debtors, home owners and corporations that

sell to the domestic consumer market can also issue CPI-indexed debt without suffering serious

mismatch problems. Of course, CPI-indexed debt is subject to credit risk, which is correlated with

monetary and exchange rate turmoil. However, as CPI-indexed debt protects borrowers from the

random wealth losses imposed by monetary turmoil, lenders avoid paying an inflation risk

premium when they place such debt. Few observers have realized the critical importance of this

aspect of capital market development, and up to 1997 no Latin American reformer has a CPI-

indexed debt market except for Chile and, incipiently, Mexico.

Objection 3: Redistribution and Equity

An argument against any reform in which the funded second pillar sets benefits in strict

proportion to individual contributions, is that this approach wastes an opportunity for income

redistribution. A standard response is that the first pillar, which gives subsidies to the poor old,

takes care of distributional objectives. However, if a progressive first pillar cannot be

implemented due to technical constraints, the conventional integrated approach seems to be more

equitable and reform may be rejected.

To assess this obstacle it is necessary to describe the technical constraints to the

development of a progressive first pillar. The tax system in many Latin American countries does

not include individual tax filing - so redistribution through direct taxes is not feasible -. In the

countries where individual tax filing was introduced in the 1930's, its coverage has remained

limited to just a few high earners. For example, in Chile 93.7% of individual tax subjects in 1997

were either exempt from taxes or paid income taxes at a rate of 5%. In addition, many Latin

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American countries do not have institutions capable of independent poverty evaluation or means

testing - so assistance pensions targeted to the poor old are not feasible.

Conventional integrated systems overcome these constraints by using the contribution

histories of members as a proxy for income levels. However, the individual accounts in a second

pillar provide the same information on individual contribution histories, so they have the potential

to be used to perform redistribution at the same coarse level as conventional integrated pension

systems. Thus, it is possible to base subsidies on indicators such as the ratio between the size of

an individual's accumulation and average accumulations at the same age. This is precisely what

the minimum pension guarantee does: it bases a government subsidy on the difference between

the self-financed pension of an individual and a minimum standard set by the government.

Another aspect of the distributional obstacle to pension reform is the source of financing

for subsidies to the poor old. In a conventional integrated pension system the subsidies are

financed with a payroll tax on members, unless the government provides substantial general

funds. Members are a convenient tax base from an administrative point of view, although the

distortions imposed on the labor market may be significant. Similarly, in a second pillar with

individual accounts taxation can also be limited to members, by establishing a solidarity tax on

contributions (as in Peru in 1994-95) or can be targeted to regular contributors (usually higher

earners) by taxing the interest earned by pension funds.

A third aspect of the distributional obstacle to pension reform is the transparency of

financing subsidies to the poor old. In a conventional integrated pension system, taxation is

hidden in the progressive benefit formula. In contrast, frequent reporting of individual account

balances in a second pillar make such subsidies from the first pillar explicit. This can make a

difference for the political equilibrium, but the difference does not relate only to redistribution. It

also relates to transparency and the opportunities for abuse. If a democracy needs redistribution to

be implicit and hidden to survive, then that democracy may be vulnerable to many other

distortions as well, including perverse redistributions (captured by the rich).

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4. Implementation Experience: Chile 1981-97

The fact that Chile solved many implementation problems was a source of ideas and

experience for all the Latin American reforms of the 1990's. Chile did not supply experience in

overcoming democratic political obstacles to a pension reform, because its reform happened

under military rule.

Fiscal Obstacles

The Chilean reform was first proposed in early 1973, before the military takeover, by a

group of Chilean economists trained at the University of Chicago (El Ladrillo, 1992). When the

'Chicago Boys' were called to take charge of some Ministries related to economic policy in 1975,

they started technical work for implementation of their pension reform proposal. They

discovered shortly that the impact of the reform on government cash flow would be substantial,

given their aim to avoid debt financing from the beginning. Given the fiscal problems linked to

the 50% drop in the world price of copper in 1975, then earning a large share of fiscal revenue,

the pension reform was postponed.

Still, the Chilean government continued technical studies of the proposed reform. In

January 1979 this work matured in a comprehensive reform of the old system, which unified and

tightened many aspects of the previously fragmented system such as pension ages and inflation

indexation methods. Apparently, this left the civilian pension portion of the social security

network with a small cash surplus. But the Chicago boys wanted to go further and worked on a

radical reform.

During the 1979-80 period, the Chilean government attacked the cash flow implications

of their choice of zero debt financing in a remarkable way: First, it began building a primary

surplus in the fiscal accounts three years before the reform started1, as opposed to incurring a cash

deficit first and then introducing changes in taxes and primary expenditures to cover it. Two facts

may help explain the selection of this strategy: (a) the military government was able to resist

demands for higher expenditure, in part because of tight control of the media and in part because

13

of the popularity of President Pinochet; and (b) economic growth in Chile was very fast in those

years (real GDP grew at an average of 8% in 1978-1980), raising tax revenue. In this setting real

government expenditure could still be raised by 6% per year to appease growing demands while a

primary surplus was being built.

Second, as the new funded pension system would earn a higher rate of return, the

contribution rate was reduced. The Labor Ministry realized that this reduction created space for

the introduction of a new wage tax, which would not be detected because the combination would

not reduce take-home pay. This wage tax was set at 3% of wages initially, decreased slowly over

the next few years, and it was used in the interim to help finance the transition (Piñera, 1991).

Despite this cautious approach to the fiscal impact of the move to funding, the

International Monetary Fund still opposed the Chilean reform on the grounds that it posed a

danger to sound public finances. As technical work for reforming the pension institutions that

served the Armed Forces had been delayed and was more demanding than the one performed for

the civilian institutions, the IMF was appeased by leaving the military outside the reform. This

meant that the military remained in the old system, under the terms of the reform of 1979.

Capital Market Obstacles

The technical work performed over 1976-1980 had shown that some financial

liberalization was a precondition for successful investment and insurance by future pension funds.

This link, plus the merits of financial liberalization per se, led the Chilean authorities to assign a

high priority to capital market development. Thus banks were allowed to issue CPI-indexed

deposits and to lend in CPI-indexed terms in 1974, a primary market for Treasury securities was

organized in 1976, the mutual fund law was reformed in 1976, banks were privatized in 1976, a

new securities law copied from the U.S. was adopted in 1978, a CPI-indexed mortgage bond

market was authorized and promoted since 1978, insurance premia and reinsurance were

liberalized in 1980, corporation law and again the securities law were reformed in 1981. The

design and implementation of this set of reforms required a major effort from the government.

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This massive effort failed in the short run because the newly introduced bank supervisory

authority was unable to prevent both massive fraud and sophisticated risk taking that abused the

government guarantee on bank deposits, while the security market's supervisory authorities were

unable to prevent significant manipulation of equity prices, leading to the insolvency of the

banking system in 1982 (De la Cuadra and Valdés-Prieto, 1992).

Although financial liberalization succeeded in the longer term, by mid 1980, the rising

perception of potential bank insolvency fueled significant opposition against pension reform

among a number of Army generals. Privately, those generals argued that no safe investments

were available apart from government paper, short-term bank deposits and mortgage bonds.

Moreover, they argued against privatization of pension management, on the grounds that the

pension managers would be precisely the same dubious financiers that were misbehaving in the

banking and security businesses.

Looking back, it seems possible that the pressure exerted by those generals saved the

Chilean pension reform. To appease them, the reformers led by José Piñera (then Labor Minister)

designed draconian investment guidelines that prohibited pension funds from buying equities and

commercial paper issued by holding companies, and imposed detailed diversification

requirements across groups of companies controlled by any one business group. In addition,

commercial banks were banned from entering the pension fund industry. The establishment of a

relative rate of return guarantee also provided some assurance that dubious fund managers would

be expelled from the AFP industry without losses to the workers.

The investment restrictions prevented the new pension funds from participating in the

massive drop in the Santiago stock exchange from June 1981 to June 1983, and in the huge losses

in commercial paper issued by holding companies in 1982-3. These drops also set the stage for

the subsequent huge returns obtained in equity investments over 1985-1993. The pension funds

participated in the upswing after equity holding was authorized by a reform to the pension law.

15

It is possible that the long horizon gained by the military government in the 1980

referendum was essential for the success of this reform. The reformers had a strong faith that

improvement of the detailed regulations would be possible because the military government

would remain in place at least until 1989. Even in 1985, investment in equities was authorized by

the Military Junta only after the creation of a state-controlled 'Risk Classification Commission'

(RCC), which was granted the power to enlarge and restrict the set of listed securities from which

'privately-managed' pension funds could choose. This list never comprised more than 15 equities

until 1990, so the power of the state in guiding pension investments was enormous. However, just

before the military devolved power to an elected president in March 1990, they passed a law

changing the membership of the RCC so that members chosen by the private pension fund

managers would hold the majority: the military were dismantling their control structure before

power was transferred to a democratic government.

The worst fears of the military, that their reforms would be undone by future democratic

governments, proved to be false. In March 1995, the elected Parliament reformed the set of

investment limits by streamlining them, liberalizing them further, improving disclosure

requirements and introducing new rules to limit conflicts of interest. By the end of 1996, the

Chilean pension funds held equity in 100 different local firms, and held 1% of assets abroad.

Distributional Objections

In the case of Chile, the objection that a defined contribution system is not redistributive

to the poor was faced by extending the minimum pension (in a more generous version) to the new

system. A detailed public scrutiny of social spending and social assistance programs had taken

place in Chile during 1974-80. This had shown that at least 20% of the population had remained

in extreme poverty with virtually no support from society for decades, while unions and the

political parties had limited their attention to income redistribution within the formal sector. In

this setting, providing a minimum pension guarantee as a first pillar was deemed a sufficient

progressive effort within the formal sector, and calls for going further were disregarded.

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The distributional argument reemerged in an unexpected area, which is the structure of

the commissions charged by the private pension fund management companies (AFPs) to workers.

The original 1981 law authorized Chilean AFPs to charge three fees, the first being a flat amount

per account per year (called fixed fee), the second a flat percentage of the taxable income and the

third a flat percentage of assets. In the first years the flat fee was not small - 36 U.S. dollars per

year - and this was given as evidence of the regressive nature of the new pension system. This

objection did not block the reform, as it was first raised the year after the new system was in

operation. However, it was taken seriously by the military government, which decided to exert

informal regulatory pressures on AFPs to eliminate the flat fee. This objective was almost

achieved in the 1990's, as several AFPs found that the other fees cover the marginal cost of

service, provided that the reported wage exceeds the minimum wage. Other countries, such as

Bolivia and Peru, have relied instead on explicit prohibition of flat fees.

5. Implementation Experience: Peru 1993-7

Peru decreed a radical pension reform in December 1992, operations began in June 1993,

and the reform was further reformed in July 1995.

Fiscal cash flow

The fiscal obstacle loomed large in Peru in 1992, as the country was just recovering from

hyperinflation caused by a fiscal deficit that had reached 10% of GDP. In part because of its

limited credibility, the government did not dare to finance the cash flow impact of the reform

with additional public debt. In order to limit the impact of the reform on government cash flow,

the following departures from the Chilean path were adopted:

a) No previous build up of a primary surplus.

b) The armed forces and also some government employees were prevented by law from

switching to the new system.

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c) Young generations entering the covered labor force were allowed to choose between

the old pay as you go system and the new funded second pillar (thus, the old system was not to be

replaced fully, as in Chile).

d) Active workers who chose to switch to the new system were required to pay a higher

contribution rate in the new system than in the old one. This forced the worker and employer to

share an extra burden, reduced the number of people changing to the new system and thus

alleviated the government's cash flow. On the other hand, it threatened the new system's ability to

exploit economies of scale.

e) The pensionable age in the new system is 65 for both men and women, but in the old

system pensionable ages remained at 60 for men and 55 for women. This made the new system

less attractive, so fewer older people switched, further alleviating the government's cash flow

during the early years of the reform.

f) The recognition bond (RB) that compensates switchers for accrued contributions in the

old system has an inflation-adjusted value, but earns a zero real interest rate and its issue value

was capped at 12,000 US$. Moreover, the government did not issue or pay any RB during the

first 18 months of operation of the new system. In addition, the RB just recognized contributions

made until 1992, so if somebody switched later he lost more recent contributions. (A law

approved in November 1996 created an extra RB to acknowledge contributions made between

January 1993 and December 1996, providing the worker switched within 1997).

g) A 'solidarity contribution' of 1% of the wage was levied on those workers who

switched to the new system. The revenue of this tax was paid to the old system for 'social

purposes'.

h) Fees paid by workers to AFPs are subject to the personal income tax, but the implicit

administrative fee charged by the old system is exempt.

i) A separate mandatory health insurance contribution, which must be paid to the state, is

higher for those who switch to the new system.

18

j) The government stopped contributing on behalf of its own workers who switched to the

new system. Arrears built up from December 1993 until mid 1995.

Many of these fiscal decisions had the impact of disadvantaging the new system, therefore

keeping workers in the old system and reducing the financing gap. They had the dual purpose of

dealing with political obstacles. The old system was not reformed, so the old benefit formulae

remained in all their variety and continued serving the established unions and political parties.

The reform of 1995 and subsequent regulation

Fortunately, Peru experienced very fast economic growth in 1994-1997, increasing fiscal

revenue. The government took the opportunity to eliminate many of the initial handicaps imposed

on the new system that had put the reform in trouble2. In July 1995 it adopted the following

measures:

a) The government paid in full its contribution arrears (on behalf of state employees),

although RBs are still pending.

b) The contribution rate to the old system was raised from 8.5% to 13%; the contribution

rate to the new system was reduced temporarily from 10% to 9%; and the 'solidarity contribution'

of 1% of the wage of those who chose the new system was eliminated. Given that administration

and insurance charges in the new system add another 4% of wages to costs, this combination of

moves eliminated the incentive for employers and workers to prefer the old system, as the total

cost was equalized at 13% of wages in both systems.

c) The retirement age was raised in the old system to the same level as in the new system

(65 for both men and women), helping to equalize the incentive for workers to choose between

the systems.

d) Upon formal employment new workers are assigned to the new system unless, within

10 days they choose the old system, which they must do in writing. It is clear that the old system

is being eliminated over time.

19

An interesting question is why anybody was willing to invest in the Peruvian AFP

business under the original restrictive conditions listed above, which raised the risk of large losses

for fund managers. In practice, the only willing investors were local business groups and Chilean

AFPs. The latter felt confident to operate under such conditions and realized that this could be a

profitable business. In addition, they could gain by promoting pension reform in other Latin

American countries, and they realized that the best publicity would be a successful start under

democratic conditions.

Solidarity and redistribution

Redistribution has always been a concern in Peru because of widespread poverty. But

fiscal constraints, limited administrative ability, and political obstacles have meant that there is no

social assistance pension in Peru, nor did the old system guarantee a minimum pension before the

reform. A large portion of the labor force works in the uncovered sector (37% in Lima). Under

these conditions, a minimum pension that requires a significant contribution record (such as 20

years) would just benefit the middle classes, while a low requisite contribution record (such as 5

years) would be too expensive.

The introduction of the new system in 1993, which did not include a minimum pension

either, increased political pressure for explicit redistribution. In legislation passed in July 1995 a

minimum pension was introduced in Peru for the first time (although as of 1997 it was still not

operating). This suggests that a pension reform may actually help in introducing an explicit and

targeted first pillar.

Capital market development

During the initial years, the obstacle related to capital market development has been less

significant than in the Chilean reform. Peruvian banking did not experience a crisis during these

years and the country did not suffer a debt crisis. However, during the first two years, the

instruments available in the Peruvian capital market were limited largely to government bills and

debt securities issued by banks and other financial firms (Aporte, 1995). Portfolio options

20

improved markedly in the next two years. As of March 1997, 0.5% of the aggregate portfolio was

invested in government bills, 28.8% in time deposits, 35.5% in corporate bonds, 34.7% in

corporate equities and 0.5% in mortgage bonds (Primamérica, 1997). During this period a risk

classification scheme was adopted.

The obstacle raised by limited capital market development has not been overcome yet,

because investment options remain limited and do not include long-term fixed income

instruments in CPI-indexed terms. The absence of CPI-indexed bonds means that pensioners are

exposed to inflation surprises. Although the U.S. dollar can operate as a substitute safe haven,

there is no local supply of long term bonds denominated in dollars. While up to 5% of the pension

funds can be invested internationally, this limit has not been approached.

6. Implementation Experience: Colombia 1994-7

As in the other countries, pension reform was seen in Colombia as part of a wider

package of policy reforms, pushing for free operation of markets and privatization. However, the

Colombian reforms were also presented as part of a package of political reforms, which promoted

civic rights, citizen participation, decentralization and social protection, including improved

social security (Ayala, 1995).

Fiscal cash flow

When discussion of the pension reform began in Colombia, it was agreed that a single

institution financed with the pay-as-you-go method would perform both redistribution to the poor

old (by paying a flat universal pension) and an earnings-related pension, as in the past. A

mandatory funded second pillar would provide a second layer of earnings-related pensions, so

that savings and insurance would be supplied by both institutions together, as in Switzerland.

However, fiscal considerations overturned that initial agreement. Simulations found that

the universal pension in the mixed institution would be too expensive in the long run. Given

political restrictions on retirement ages and the level of the universal pension, a high contribution

rate was required for the pay-as-you-go system. However, political constraints on total

21

contribution rates implied that the contribution rate to the funded pillar would be too small to

justify it. Thus, politicians in Colombia were faced with the choice between no funded privately

managed second pillar (continuation of the old system, albeit improved) versus a radical reform

in which the existing system was replaced completely by a privately managed second funded

pillar complemented with a minimum pension (Ayala, 1995).

The political agreement reached in Colombia was that two systems—a straight pay-as-

you-go system and a multi-pillar system that included a privately-managed funded second pillar

plus a minimum pension first pillar would coexist permanently, but each individual would have to

choose between them. This deal preserved a low contribution rate and assured the existence of an

option with more perceived solidarity (the old system).

Another essential element of the political agreement in Colombia was that the old system

was allowed to continue in a relatively unreformed state, purposefully avoiding adjustments of

the benefit rules, retirement ages and contribution rates to levels that would assure financial

equilibrium in the long run. The reason offered was that the growth in coverage and the growth of

GDP allowed ample time to introduce further reforms later on, if needed. The concept of a

hidden pension debt which would continue to grow faster than GDP was ignored here (Ayala,

1995).

In Colombia, transition costs were financed by:

a) Issuing more public debt, part of which would be bought by the new pension funds.

b) As there are many fiscally decentralized regional units in Colombia which have at least

some responsibility for existing pension obligations, the cash-flow effect for the national

government was cut by transferring part of the debt to these regional units.

c) The contribution rate for old age, disability and death has been raised from 6.5% in

1992 to 13.5% in 1997, both for the old and the new systems. Given current demographics, this

allows the old system to accumulate a large surplus during a transitory period (it will incur a

22

deficit later on). This surplus, plus initial reserves close to 900 million US$, will help finance the

cash flow deficit expected for the next decades.

d) Although government workers were allowed to switch to the new system, their

benefits continued to be so attractive that a low rate of transfer was assured. As these groups are

responsible for 54% of the implicit pension debt, their virtual exclusion from the new system

reduced fiscal pressure substantially but it also reduces the long run gain from the reform (Ayala,

1995).

The actual cash deficit generated by the reform has been above expectations as many

workers have switched (Ayala 1995). Although the old system institution spends heavily on

advertising, the pension fund management companies that operate the new system have done the

same and had obtained 45% of the potential market as of June 1996.

Capital market development

The objection to reform raised by capital market underdevelopment was not considered

critical in Colombia. Starting in 1990, Colombia adopted a thorough reform of its capital market,

privatizing some commercial banks, improving bank supervision and opening up the securities

markets. Colombia has significant equity and bond markets, modest exchange controls and most

financial prices are freely determined by market participants. Therefore, limited portfolio

regulations were imposed on the new funded second pillar: up to 45% can be invested in federal

debt, while investment in equities and foreign securities was authorized from the beginning.

There is no Chilean-style 'Risk Classification Commission', due to the existence of respected

private risk-rating companies, but a minimum relative rate of return regulation was introduced.

However, Colombian pension funds are unable to reduce their exposure to inflation risk

because few long-term CPI-indexed bonds are available.

Redistribution and poverty

The Colombian second pillar is accompanied by a minimum pension guarantee (equal to

one minimum wage, which is now close to 55% of the median wage) financed by the general

23

treasury, as its first pillar. In addition, during the negotiations for this reform, Colombia agreed to

create its first non-contributory pension for the poor old. To help finance redistributions a special

'solidarity tax' of 1% was imposed on the excess of taxable salaries above 4 minimum wages,

regardless of the system chosen. The revenue is used to finance subsidies to the accounts of poor

workers in the new second pillar and minimum pension top-ups for those in the old system. This

shows that pension reform can be an opportunity to improve social protection, provided the

administrative capacity and political will are available.

The new funded pillar allows early pensions to every worker who accumulates enough

funds to finance a pension equal to 110% of the minimum salary (which is also the minimum

pension). This rule implies that the new Colombian system does not attempt to produce pensions

that are proportional to past wages or contributions. It merely aims to force savings up to the level

needed to finance poverty level pensions, which is close to 140 U.S.$/month. Because early and

normal age pensions do not have to meet a target replacement rate above this level, Colombia's

second pillar is only a weak instrument of forced saving and insurance.

Sustainability of the Colombian reform

The financial sustainability of the Colombian reform has been jeopardized by a bizarre

switching option. Colombian workers are allowed to switch back and forth between the old and

the new systems, provided at least 3 years have passed since the previous switch. This option

implies that workers might wait until pension age to choose the system that pays them the highest

pension. These strategies may be very expensive for taxpayers in the long run.

In the case of members who switch from the old to the new system, the transfer value is a

pension (recognition) bond. For example, if a man finds that he suffered a reduction in his real

wage from ages 52 to 62, he may prefer to claim his 'pension bond' (recognition bond) from the

old system and switch to the second pillar, because the latter gives more weight to investment

returns. However, if he switches at age 62 the pension bond will be called immediately, draining

the cash flow of the old system. This may impose a heavy strain on the fiscal balance.

24

For switches back to the old system, the transfer value is the accumulated account

balance in the second pillar. For example, if asset prices drop (maybe because of tighter monetary

policy), people about to get a pension in the second pillar may switch back to the old system. The

heavy cash infusion enjoyed by the old system may encourage the political system to increase the

generosity of the pension formulae, attracting even more switches. In addition, the switches

would force the AFPs to liquidate part of their investment holdings, a factor that might reinforce

the initial drop in asset prices and also reinforce the initial switching process. Thus, the new

funded second pillar may be subject to unexpected contractions and may disappear in a prolonged

recession, compromising the solvency of the old system in the long run.

As both systems require the same contribution rate (13.5%), the difference is shown

directly in the benefit levels. In the old system, the replacement rate is 85% of the average real

taxable salary during the previous 10 years or the entire lifetime, whichever is larger. In the new

funded system the replacement rate is governed by the expected net investment return (after

commissions). Unless the real rate of return is extremely high it is unlikely that an 85%

replacement rate will be achieved.

From the ex-ante point of view of a young worker who is choosing between systems, as

in Peru or Argentina, the financial incentive is governed by the difference between the expected

rates of return, risk and liquidity in the two systems. However, Colombian workers have been

granted the right to choose ex-post, at pension age. Thus, the government has granted them a put

option on lifetime investment returns, whose exercise price is the benefit in the old system. As the

old system has not been reformed, the exercise price of this put option is high, so the guarantee

appears to be extremely expensive. A rational worker would join the new system when young,

knowing that he could always switch back at the end if the old system turns out to be superior.

This helps explain why many workers have joined.

Most analysts in Colombia agree about the need to withdraw this guarantee. However,

the current arrangement is the product of the political deal that individuals would be granted the

25

right to choose between the two pension systems. This cannot be renegotiated easily because any

deal would imply large losses for some groups.

In my view, there exists a compensating factor that may reduce the fiscal cost of this

guarantee substantially, which is the higher liquidity offered by the new funded system. The new

funded second pillar offers an early pension as soon as the worker has enough funds to pay for a

pension equal to 110% of the minimum pension, while the old system requires waiting until age

62 (men). It is likely that many middle-income workers will prefer the early pension in the new

system. But once they do this, they lose the option to switch back to the old system and pick up

the guarantee. Only lower income workers would stay in the old system, but this does not

influence the fiscal cost because they are likely to get the minimum pension in any case.

More generally, the Colombian reform appears less likely to succeed than the other

reform cases reviewed here because the government has not supported the new funded system.

After the Gaviria government yielded power in June 1994, the Samper government publicly

supported the old system over the new, although it did not initiate further legislation3. The lack

of government support also shows up in the absence of an independent and well-staffed

Superintendency for the new funded second pillar. Supervision is in charge of a division of the

Superintendency of Banks. No detailed statistical information on the new system was provided by

this body during the first 4 years of operation.

7. Implementation Experience: Argentina 1994-7

The Argentinean Congress approved a pension reform in September 1993, and operations

began in July 1994. Contrary to Colombia, Argentina requires each worker to participate

simultaneously in two pillars: (a) the redistributive pillar that pays a flat universal pension; and

(b) a second pillar that pays pensions related to individual contributions. In the second pillar

workers can choose (initially up to twice in their lifetime, now only once) between a funded

second pillar similar to the Chilean one and a pay-as-you-go financed public pillar with a

conventional benefit formula. The contribution to the first pillar is by the employer and initially

26

was set at 16%; the second pillar consumes a contribution of 11% from the worker, regardless of

the option4.

Fiscal cash flow

The major obstacle to the Argentinean pension reform was the decision to limit the use of

public debt to cover the fiscal cash flow impact of the reform during the transition. In 1990

Argentina was coming out of a decade of hyperinflation, so fiscal stability was and continues to

be a critical issue.

In an influential study presented while discussion was taking place in Congress, Schultess

and Demarco (1994) argued that the fiscal obstacle could be dealt with in the following way:

a) The reform would reduce evasion, and this would increase contribution revenue

without increasing expenditures for a few decades. This effect was expected because the reform

tightens considerably the link between individual contributions and benefits. However, the link

after the reform would be still be far from tight, due to the 16% contribution to the first pillar.

b) Economic growth would be increased by the pension reform, providing new tax

revenue that would help cover the cash flow impact of the reform. This would be compounded by

higher efficiency in the tax system.

c) The remaining portion of the cash flow deficit would be financed by issuing public

debt at market interest rates, which in turn would be bought voluntarily by the new pension funds

in the funded second pillar.

Three more measures were taken to cover the impact on cash flow:

d) Military personnel and the police were excluded from the reform. The employees of

provincial and municipal governments were also excluded initially, but they would be

incorporated once the federal fiscal authorities agreed to special financing and transition plans

with those governments. Those plans were negotiated during 1995-6 and those groups were

brought into the new system.

27

e) Compensation to those who switch to the new system in mid career was reduced as

compared to the 'recognition bond' model used in Chile. Argentina created instead a

'compensatory pension', paid by the old system over time once the individuals gets pensioned.

The amount spent on the compensatory provision was reduced by (i) excluding those who get

disabled, even if they switch, (ii) imposing a ceiling on the total replacement rate, (52.5% of the

average revalued salary during the last ten years of work); (iii) a ceiling on the amount of the

compensatory pension (for workers with 35 years of contribution, this is 38.5% of the average

taxable wage).

f) A substantial implicit wage tax was levied by imposing a 16% contribution rate to the

first pillar, which is significantly larger than required for the first pillar alone in its early years.

In practice, the rosy predictions of an increase in coverage and a reduction in evasion has

not materialized. In February 1996, the government reduced the 16% contribution rate to some

12% on average, and even less in 1997-8 (the reduction differed between regions) with the

avowed purpose of reducing labor costs to stimulate employment. The fiscal impact of this

measure was to be met by increasing other taxes, such as a VAT. This suggests that in the final

analysis, the cash flow impact of the transition will be absorbed through an increase in the

primary surplus.

Capital Market Development

The obstacle to reform stemming from capital market underdevelopment has not been

significant in Argentina up to now. As of September 1997, 46% was invested in government debt,

23% in domestic equity, 2.8% in long term private debt, 0.02 % in foreign paper (directly), 2% in

open ended mutual funds and the rest in short term bank liabilities. The only substantial change

from 1994 to 1997 was the growth in the equity share at the expense of the bank deposit share.

Argentinean pension funds held 33 different domestic equities as of September 1997.

Argentina does not allow CPI-indexed bonds. Proposals to introduce them are rejected

because the required deregulation might be interpreted by the financial markets as a weakness of

28

the monetary authorities in their resolve to keep the fixed exchange rate regime introduced in

1991 forever, regardless of the costs in terms of unemployment. Thus markets for peso-

denominated long-term debt and CPI-indexed debt do not exist in Argentina; however some

dollar-denominated mortgage loans have been introduced recently.

The wisdom of a policy against CPI-indexed debt should be questioned. First, even if

the Argentinean peso remains fixed to the US dollar forever, if the United States experiences just

5% inflation in a single decade in the future, the value of Argentinean pensions will erode

significantly. Second, the credibility game should not be overrated. The universal basic pension is

indexed to the average of covered taxable wages5, and nobody interprets this as a weakness in the

exchange rate regime. Third, If Argentina devalues the peso and experiences inflation, the real

value of any long-term debt might be severely eroded, and the fully funded second pillar may be

seen as a failure.

Redistribution and solidarity

The first pillar is rather complicated in Argentina. The universal basic pension (paid to all

workers with at least 30 years of contributing service) pays a fluctuating benefit, of 2.5 times the

average contribution registered in the previous semester to the second pillar, which implies 27.5%

of the average taxable wage or 187 US$/month in 1996. This benefit is revalued annually

according to the increase in nominal average contribution. Any worker with the right to a full first

pillar pension must get more than this as total pension, because this worker has contributed also

to one of the second pillars, so must have earned the right to a second layer of pensions. The

effective first pillar is given by another section of the law6, which guarantees a minimum to the

sum of pensions obtained from the first and second pillars. This minimum is 40.3% of the average

taxable salary or 275 US$/month.

An objection to having the basic universal pension is that the government loses a major

opportunity to improve its cash flow: if the basic universal benefit is reduced, but the 40.3%

minimum remains as it is, then poor pensioners would not be affected but higher income workers

29

would face reduced total benefits. The government could use this surplus to reduce the 16%

contribution rate paid by employers (increasing the competitiveness of Argentinean production),

gaining political support from those whose taxes were reduced by more than the reduction in

benefits. However, there might be a political loss involved if a substantial middle class faces a

reduction in benefits larger than the reduction in taxes.

Although the first pillar appears to be very progressive, in practice its redistributive

impact is uncertain because (a) poorer workers tend to move more frequently into self-

employment, so the requirement of 30 years of contribution is less likely to be met by the poor,

and if it is not met this pillar pays zero; (b) there is a minimum taxable wage equal to 33% of the

average taxable salary. The poor whose actual wage is lower contribute on the basis of the

minimum taxable wage, so they face a higher proportional reduction in take-home wages; (c)

higher income workers tend to get a larger share of their compensation in forms different from a

wage, so the 16% contribution tends to be less than 16% of their compensation; and (d) the

maximum taxable income (6.6 times the average taxable salary) caps the 16% contribution paid

by the higher paid workers.

Given these problems, it is fortunate that in addition to the first pillar, Argentina has

maintained its historical tradition of paying non-contributory pensions to the poor old, financed

with general revenue.

Other Political Constraints

As in other countries, an important political constraint was the constitutional right

acquired by members of the original pension system to remain in the old system. To adapt to this,

Argentina gave workers of all ages the right to choose the second pillar (funded versus pay as you

go). The law favors the funded second pillar, as it presumes the worker has chosen the funded

second pillar unless he or she declares the opposite in writing. However, as in Peru, the political

compromise was to grant this choice to new generations of workers as well, when they enter the

labor force.

30

In Argentina the state showed its technical and administrative capacity by proposing a

simultaneous major reform of the state-run pay-as-you-go financed second pillar. Benefit rules

were tightened and retirement ages were raised gradually so that by year 2001 they will be 65 for

men and 60 for women. The Menem government has managed to unify the benefit formula for

old age and disability, eliminating a host of special programs that had evolved in response to

interest group pressures. Administration was unified under one institution (ANSES).

This aspect of the reform required a direct confrontation with powerful interest groups.

According to interviews, the opposition from unions and some political parties to the Argentinean

reform dissolved noticeably as soon as it was agreed that they could own and operate pension

fund management companies (AFJPs), as either profit or non-profit organizations.

Groups built around government unions objected to a complete privatization of the

management of the new funded second pillar. This was dealt with by requiring the state-owned

commercial bank, Banco de la Nación Argentina, to set up a pension fund management company

(AFJP). This state-owned AFJP was granted a special competitive advantage - its pension fund

would guarantee a rate of return set by law. Initially this guaranteed interest rate was equal to the

US Dollar LIBO, even though this opened a major fiscal risk. A few months later, the Menem

government passed a regulation linking the guaranteed rate to the interest rate paid on saving

deposits in pesos, which is much lower and eliminates foreign exchange risk.

The privately owned AFJPs feared subsidized competition of AFJP Nación. This fear was

allayed while simultaneously accommodating another source of political pressure, by requiring

AFJP Nación to invest at least 30% of its portfolio in debt issued by provincial governments,

which paid a low interest rate. As of September 30, 1997, AFJP Nación managed just 6.6% of the

aggregate funds and had 8.2% of all members of the new system. In the year to June 1996, AFJP

Nación obtained a rate of return 3.61 percentage points below the average of all funds (second

lowest out of 23), but its performance improved in the following year7.

8. Conclusions

31

Any descriptive survey of the Latin American reforms is likely to argue that they diverge

considerably from the Chilean one. This paper seeks answers to three questions: First, why did

many Latin America countries embrace the radical approach to pension reform pioneered by

Chile? Section 2 of the paper finds that existing state-managed pension systems failed to meet the

expectations that justified them in the first place, of providing significant security to their

members. This frustration pervades public opinion in Latin America and might be shared in

Eastern Europe and the former Soviet Union, but seems to be absent in Western Europe and

Japan. The other factor in explaining a demand for reform is that an alternative was developed in

Chile over 1973-1992. This alternative pension approach offers the prospect of higher and more

reliable pensions for a lower contribution, while also providing a number of positive side effects

on national saving and capital market development. Other Latin American countries therefore had

a reform model that could be adapted to their needs.

The second question examined was: what are the mayor obstacles to such reforms and

how have they been dealt with? Section 3 identified three major objections to pension reform

towards fully funded, privately managed second pillars, which were used later to guide the

country case studies. The three objections are fiscal constraints during the transition phase, the

underdevelopment of the domestic capital market and the inability of such pension systems to

provide income redistribution.

The objection regarding fiscal constraints has been frequently misunderstood. The paper

argues that the size of the fiscal obstacle is given by the size of the planned adjustment to the

fiscal balance sheet, not by the size of the cash deficit imposed by the reform of the old system.

Contrary to expectations, the paper finds that even countries coming out of hyperinflation, such as

Peru and Argentina, have managed the fiscal constraint reasonably well by issuing implicit public

debt for an extended number of years, during which the primary fiscal balance has been gradually

improved. Of course, as this process takes many years, it has yet to be seen whether faster

economic growth will allow these countries to pay their way out of the debt implicit in their old

32

pension systems. Among the countries included in this study, Argentina is the most vulnerable,

because of the high initial level of public debt, explicit and pension-related. This implies that

pension reform is easier when adopted before system maturity and before population aging sets

in.

As expected, the objection relating to the underdevelopment of the domestic capital

market has been minor during the first few years after reform, due to the small size of the pension

assets in the first few years. Thus, it remains to be seen if each country will be able to upgrade its

financial markets to meet this objection. The main challenges ahead in this area are developing

sound and efficient banking systems, reaching enough liquidity in the secondary markets for the

main local equities and bonds, the creation of a substantial market in long-term CPI-indexed debt

and international diversification.

Up to date, the only country that has overcome most of these challenges is Chile,

although aided by some luck. Chile experienced a massive banking crisis in 1982-85, when the

pension funds were small, but subsequent reforms left banking in a solid situation while

providing low cost intermediation services to institutional investors. The Chilean pension funds

escaped the 1982-85 crisis unscathed due to tight investment regulations, but such foresight by

the authorities cannot be counted upon for the future. A market for long term CPI-indexed debt

has been growing since 1978 and by now is substantial, allowing some 60% of pension fund

assets to be CPI-indexed. However, Chile has not yet undertaken international diversification in

the expected scale. Chilean pension benefits continue exposed to the vagaries of local booms and

recessions, which have been acute in the past.

The other countries have thus far failed to develop a market for long term CPI-indexed

debt or liquid secondary equity markets. The solvency of the domestic banking system has

improved in most of the reform countries during the 1990's, after substantial efforts by the

authorities. However, the very modest scale of international diversification undertaken up to now

by Latin American second pillars implies that their pensions continue to be exposed to highly

33

volatile local business conditions. The political nature of the constraints that prevent stronger

international diversification suggest that capital market underdevelopment continues to be a

major obstacle for reform and may even undo them in some future recession.

Finally, the objection that funded second pillars prevent desirable income redistribution

has been proved false. The paper finds that the new systems have not hindered - and on the

contrary, in Peru and Colombia have stimulated- the introduction of tax-transfer schemes in favor

of the poor old, increasing solidarity and the scale of income redistribution.

On the basis of these findings of the previous sections, Table 3 offers a summary of our

evaluation of the extent to which each reform has overcome the three objections to reform

analyzed in this paper. The table suggests that most of the reforms are not yet solid outside of

Chile, although Argentina comes close. This is not surprising, given the small number of years of

experience. In our view, a similar evaluation of the Chilean reform circa 1985 would have led to

a similar conclusion, so this result may be due simply to the youth of the new systems. An

important lesson of the Latin American experience is that reform is an ongoing process that

continues long after it is first implemented.

The final question posed by this paper is what are the main pitfalls to avoid in radical

pension reforms? In our view, the danger of failing to foresee the intricate connections between

different aspects of complex reforms is a major potential danger. One way to reduce this risk is

to simplify the design of the new pension system as much as possible.

The Colombian option to switch between the pay as you go and the fully funded systems

every three years is difficult to comprehend for most economists, let alone the members. This

feature of the Colombian reform appears to introduce substantial dangers of fiscal solvency, as it

grants a put option on investment risk. In the longer term it is likely that most members will learn

how to exploit the arbitrage opportunities opened up by this free option. In this case, complexity

got out of hand and closing the gap is difficult because the full political compromise may have to

be renegotiated.

34

35

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Diamond, P. and S. Valdés-Prieto (1994) "Social Security Reforms", Chapter 6 in The ChileanEconomy, edited by Bosworth, B., R. Dornbusch and R. Laban, The Brookings Institution,Washington, D.C.

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Mesa-Lago, C. (1989) Ascent to Bankruptcy: Financing Social Security in Latin America,University of Pittsburgh Press.

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1 This point has been reported by Juan Carlos Méndez, Budget Director at the time.2 Law 26,504, approved in July 1995 to take effect from August 1, 1995.3 According to Bustos (1995).4 This covers old age, disability and survivorship benefits, and also fees and administrative costs.5The pensions paid by the PAYG second pillar may be adjusted over time according to what the annual budget lawindicates.6 Article 125 of Law 24.241.7 Sources: Memoria Trimestral Nº 8 (April-June 1996), and Nº 13 (July-September 1997), Superintendencia de AFJP,Buenos Aires.

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TABLE 1: Funded and Privately-managed Second Pillars in Latin America(as of September 1997)

Country Peru Colombia Argentina Chile

Date operations started Jun 93 Apr 94 Jul 94 May 81

Contributors as of Sept. 97(switchers plus new entrants to the labor force)

(millions) 0.6 1.6 3.2 3.2

Members as of Sept. 97(number of accounts)

(millions) 1.7 2.4 5.5a 5.7

Contribution Revenue, annual(Millions of US$) 412 485b 3,593 2,963

Aggregate Pension Fundas of September 97

(Millions of US $) 1,423 1,216 8,393 31,050

Return above Inflation 12 mo. up to Sept. 97(% per year) 8.0% 12.6%c 24.8% 2.9%

Nº of Fund Management. Co.(as of Sep. 1997) 5 8 20 13

Notes: (a) The official figure is 6.1 million, but recently the Superintendency of AFJPannounced that 0.6 million would be erased from the registries shortly. Other lawsprevented those workers from joining the new second pillar, so their employers nevermade a contribution on their behalf; (b) estimate; (c) for the 24 -month period ending inAugust, 1997.Sources: Statistical Report on Private Pension Systems in Latin America, December1997, issued by Primamérica (1997); other sources.

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Table 2: Accrued Pension Liabilities in Latin America

(% of GDP)Reformers covered in the textArgentina 305Chile (1981)a,b 126Colombia(1994)a 56Peru (1991) 45

Other reformersUruguay 289Bolivia 31Mexico (1994) 73El Salvador 9

Sources: Uthoff and Bravo (1998) provide simulation results based on aggregateparameters for Argentina, Bolivia, El Salvador, Perú and Uruguay, in Cuadro 2, pageC37, based on data for 1991-92; Other sources are Arrau (1992) for Chile, Ayala (1995)for Colombia, and Cerda and Grandolini (1997) inTable 2 for Mexico.Notes (a): It is important to note that the assumptions, definitions and methodologies arenot uniformin all these studies. To illustrate how this matters, using a different approach,Informe Técnico (1979) estimated the debt to pensioners in Chile at 48% of GDP in1979.

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TABLE 3: Implementation of Second Pillars

( S = Objection Solved; P = Problem Remains)

Country Peru Colombia Argentina Chile

Years of experienceas of late 1997: 5 4 4 17

Objections to reform1. Fiscal impactduring transition P S P S2. Underdevelopment of domestic capital market S S S S3. Inability to provide incomeredistribution P S S S

Long term prospect of reform1. Threats to long term fiscalbalance due to missing reform of the 'old' system P P S S2. Threats to long term fiscalbalance due to coordination ofnew and old system rules S P S S3. Political consensus aboutnew system achieved S P S S Source: Own elaboration