CHILE'S PRIVATE PENSION SYSTEM


The Bipartisan Commission on Entitlement and Tax Reform projects the United States' Social
Security system will be paying out more in benefits than it receives from payroll taxes by the year
2013, and the Social Security Trust Fund will be bankrupt by the year 2030 if current tax and
benefit schedules are maintained.

The South American country of Chile was faced with similar problems. Rather than trying band-
aid solutions such as increasing the retirement age or raising social security taxes on current
workers, the Chilean government took the bold step of privatizing the system to protect Chile's
future retirees.

In 1981 when Chile replaced its government-run social security system with a private pension
system, workers who had been contributing to the government-run system could choose to
remain in the old system or join the new pension plan. All individuals who joined the workforce
after 1981 had to participate in the private pension plan.

For workers who made the switch from the old system to the new, the government issued "recog-
nition bonds" to recognize the contributions made to the old system by those workers. The
bonds pay four percent annual interest, and may be cashed in by the workers upon their retire-
ment. During the transition to a fully private pension system, many workers will receive their
retirement benefits from a combination of the new system and the recognition bonds.

Under Chile's private pension system, employees are required to contribute at least 10 percent of
their income to their pension plan, and may choose to contribute up to 20 percent of their in-
come. The contributions are deducted from the workers' taxable income. Unlike the old Chilean
system (and the current U.S. Social Security system), employers are not required to contribute to
the new pension plan through a payroll tax. The entire pension contribution is made by the
worker.

One of the benefits of the new system is that workers no longer view setting aside funds for
retirement as a tax; rather, they view it as a contribution to their own retirement. And that contri-
bution is not surrendered to the government (to be used as the government sees fit) during the
individual's working years. A worker in Chile owns his or her retirement portfolio and decides
how the funds will be invested.

Workers' retirement contributions are invested in a security portfolio, similar to a mutual fund.
The portfolios are managed by administrators of pension funds (known as AFPs). Many AFPs
compete, and workers choose the AFP they prefer to handle their retirement contributions.
Employees may transfer their fund balance to a different AFP up to four times per year.

AFPs are private organizations, regulated by the government to guard against individuals invest-
ing their retirement contributions with less-than-reputable or highly-risky administrators. Gov-
ernment regulations establish the percentage of retirement plan funds that must be invested in
private companies and in government bonds, require diversity in the plan's investments, and
ensure that all companies in which funds are invested have a good credit rating.

Moving to a privatized pension system has reduced the administrative costs of the pension
system. Eliminating the payroll tax for employers has caused a large reduction in costs. The
private AFPs may charge investors administrative fees for their services, but the competition
among the different AFPs ensures the fees are reasonable.

In Chile, the minimum retirement age is 65 for men and 60 for women. Upon retirement, a
worker uses his or her pension funds to purchase an annuity from a private insurance company.
The privatized pension system provides greater freedom to Chilean workers to choose the age at
which they wish to retire. A worker who wishes to retire before reaching the minimum retire-
ment age may do so if the pension he or she will receive is at least 50 percent of the worker's
average earnings over the last ten years and is at least the legal minimum monthly wage. Many
AFPs provide clients and prospective clients with a computer program which allows workers to
calculate the percentage of income they should be contributing to their retirement fund in order to
retire at a particular age.

Chile's transition from a government-run pension to a private pension system has been a success
so far. Chile's government recognizes the burden it has taken on, but also realizes the burden will
gradually decrease as more of the population is participating in the new system and fewer Chil-
eans draw their retirement from the old system. The pension reforms have contributed to a high
savings rate in that country. The savings rate is currently close to 27 percent of Chile's Gross
National Product (GNP).

Several other countries have begun to make reforms in their pension plans based on the Chilean
system. The United States should study Chile's efforts to get the government out of the retire-
ment system when considering how to reform our own Social Security system. Replacing the
tax-and-spend ponzi scheme we now have with true savings accounts for U.S. citizens would be
a tremendous boost to our economy and the security of Americans' pensions.

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