Social Security privatization: what we can learn from Chile

Though it remains a heavily debated idea in the States, privatized Social Security and pension systems have existed for many years across the globe. Chile became the first country to adopt a privatized system in 1981, followed by Bolivia, El Salvador, Mexico, Poland, and Sweden, to name a few. These systems can be fully privatized individual accounts or a combination of individual accounts and a public pension.

The Chilean system, in particular, captured the attention of several American advocates for Social Security privatization, notably former President George W. Bush in 2005 and GOP presidential candidate Herman Cain in 2012.

During his presidential run, Cain supported a total adoption of Chile’s Social Security system in the United States, speculating if workers had access to personalized accounts, the money they’d invest into our traditional system could be invested in high yield stocks and bonds. To Cain, privatized Social Security gives every worker greater control over how his money is invested and the potential for higher returns than he could expect from his benefit check.

All of that sounds great in theory–but how does that system actually play out in Chile?

The architect of Chile’s privatized pension system, José Piñera, Minister of Labor and Social Security under
President Pinochet, called it a “free market solution that works.” Under the new Chilean system, workers were given the option to stick with the pay-as-you-go state-run system (a system Piñera calls a recipe for bankruptcy) or deposit their contributions into an individual account.

With personal accounts, workers could form a diverse and personalized investment portfolio in the private sector, safe from political risk and government benefit cuts, and reap the potentially high rewards and the compound interest on their investments.

And initially, that system appeared to work beautifully. As many as 93% of Chilean workers made the switch to the private accounts, and in its first years, the system provided large returns to investors.

But by 2000, investment firms charged fees so high they ate up to 50% of what a worker contributed–a feature of creating a captive market of retirement investors. The high gains of the first years had all but disappeared, along with the bull market behind those returns. And the large surplus built from the previous pension system was gone–used up entirely to finance the high cost of transitioning from a traditional Social Security system to a new one.

Not 20 years after adopting a private retirement account system, retirees were seeing returns of $400 on average. Nearly half of retirees were collecting substantially less. To make matters worse, the required 10% wage contribution was just too high for many low-income workers.

Elaine Fultz, former Director of the International Labor Organization office for Russia, Eastern Europe, and Central Asia offered her thoughts on the three dangers of this kind of privatization–all of which may be seen in the Chilean example:

  • As previously stated, creating a captive market of investors mandated to contribute 10% of their earnings into a handful of approved private investment firms leads to exorbitantly high management fees. These firms are assured clients by law–there’s no reason to compete or keep fees low.
  • Retirees’ investments may be safe from government cuts and interference, but they are completely susceptible to the ebb and flow of the market. This not only puts workers at risk to receive low or no returns, but also creates a huge variation between what two workers in the same job making the same salary can receive. A worker retiring during a boom one year could make quite a lot, but a worker retiring the next could lose everything in a recession. No matter how mindfully a worker invests and prepares, everything could be gone in a snap due to economic circumstances out of his control.
  • The switch from a public system to a private one is insanely expensive. Those working during the switch have to fund both their own private accounts and the benefits of the last retirees on the public system. It’s this outlay in cost that quickly drained the pension surplus of the Chilean government.

By 2007, 60% of Chilean workers had pensions. Those who did had an average pension lagging far behind that of other nations. And in 2008, the pension model was heavily reformed under the first term of President Bachelet to extend pension coverage to many who previously fell outside of the system.

While Chile is the first and oldest example of a privatized Social Security system, there are many more from which we can learn in Europe and Central America. But as our elected officials continue the calls for a similar system in the States, it’s important to study the effects of the Chilean model, now in its 36th year.

In the States, we are well aware of the danger a volatile market can have on even the best-planned retirement accounts. The Great Recession of 2008 destroyed 401(k)s and IRAs, with Fidelity reporting average account losses of $19,000.

Social Security is by no means perfect, but it provides a valuable safety net for people of all incomes who work hard. Beneficiaries know what to expect each month–and though it may be low, retirees are still able to plan and rely on their benefits each month.

The primary difference between our Social Security system and the privatized system sought by so many is summed up best by Matthew DeBord on The Breakdown blog:

“The Chilean Model shifts risk from the government, which can easily absorb it, to the private citizen, who can’t.”

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