WASHINGTON—Chile scrapped its bankrupt Social Security system in 1981 and replaced it with personal retirement accounts like those that President Bush is proposing for Americans.
Today, Chile's experience offers Congress and the Bush administration three important lessons:
_ It's terribly expensive to move to a privatized retirement system.
_ It's dangerous to let the private sector manage retirement funds without close regulation.
_ Privatized pension funds can bring retirees higher returns than they'd get from the government.
When Chile scrapped its old system, it faced the same problem the United States has: It eventually would owe retirees more than it could reasonably expect to collect in taxes from active workers.
Chile, then a right-wing dictatorship, essentially forced citizens to be savers. It stopped collecting payroll taxes—like the 6.2 percent that's collected from U.S. workers and matched by their employers. Instead, Chile began taking a straight 10 percent from salaried workers' pay. The deduction goes into a retirement account that's managed by one of six private pension fund-management companies.
Over the program's first two decades, returns averaged a healthy 10.9 percent. That's lower than the 16.51 percent average return that Chileans might've earned if they'd invested in Wall Street's S&P 500 stock index between 1980 and 2000, but it's well above the 4 percent return that the system's architect, then-Labor Minister Jose Pinera, anticipated.
The true success of the system won't be known until the late 2020s, when the first workers who've spent their entire careers in the privatized system begin retiring. They're all but certain to earn more than the 20 percent of annual earnings that retirees averaged under the old system and are widely expected to earn at least 40 percent, roughly the U.S. Social Security rate. The most optimistic studies suggest that some Chilean workers could retire with benefits at 70 percent of earnings.
Critics of the Chilean model note that it isn't universal like the U.S. system and workers must pay into personal accounts a full 20 years to receive benefits. Also, participation by Chile's self-employed and temporary workers isn't required, and less than 3 percent of them participate.
Bush is expected to propose within weeks a two-tiered plan to rescue Social Security, whose anticipated shortfalls are at least 13 years away. That's when the Social Security Administration expects to be paying more to retirees than it's taking in from active workers in payroll taxes.
To avoid that shortfall, Bush is expected to suggest an accounting change that indexes future retirees' benefits to the rise in prices. Currently, benefits are calculated based on wage increases, which historically have risen faster than prices. That's led some critics to suggest that the government is "overpaying" retirees and others to charge that Bush would be cutting benefits.
With a shift to price indexing, benefits would rise more slowly, deferring the funding crisis.
To offset that reduction in benefits, the president is expected to propose allowing young workers to divert into Chilean-style personal retirement accounts as much as 4 percentage points—about two-thirds—of what they now pay annually in payroll taxes, up to a limit of $1,000 per person per year.
"A child born today can expect less than a 2 percent return after inflation on the money they pay into Social Security," Bush argued in a radio address Jan. 15. "A conservative mix of bonds and stocks would over time produce a larger return."
That's true for Chile so far, but flat or falling stock markets could yield lower returns. Barry Bosworth, a senior economist with the Brookings Institution, a Washington policy-analysis group, said Chileans initially enjoyed the advantage of high-yield government bonds, intended to attract domestic and foreign investors. In recent years, he said, Chile's return rates have been dropping.
"We will not have those (high Chilean) rates of return," Bosworth predicted.
Chile's experience also proves the political sensitivity and high cost of switching to a new system, and demonstrates a need to tightly regulate companies that manage retirement accounts.
In its transition, Chile honored pension obligations to citizens who already were retired in 1981. It also provided special indexed and interest-bearing bonds payable upon retirement, to effectively buy out active workers who already were vested in the old system. Those commitments left it owing an amount roughly equivalent to 130 percent of its gross domestic product, the broadest measure of a nation's goods and services.
To meet those obligations, Chile's dictatorship handcuffed future governments when it came to domestic spending on such needs as roads, schools and health. Chile needed as much as 7 percent of its GDP annually to pay off the old system. The figure is now down to around 3 percent but it'll limit Chile's spending options until the 2030s.
Funding Bush's partial privatization could lead to a U.S. debt equivalent to 1 percent to 2 percent of GDP, economists suggest. Bush's budget chief, Joshua Bolten, said Friday that a partial privatization would require at least $2 trillion in government borrowing, in a time of record federal-budget deficits, to finance the transition. Many Democrats charge that a Chilean-style switch would deepen the growing deficit and inch the country toward an economic crisis.
What has impressed Bush is that, starting from virtually zero some 24 years ago, Chilean pension-fund administrators now manage more than $35 billion in retirement money. Proponents of Bush's plan predict that it could divert $5 trillion in new investment to U.S. equity markets by 2040. They point to U.S. Individual Retirement Accounts and 401(k) plans, which managed $92 billion in 1984 and $1.9 trillion last year.
The rapid growth in money under management in the Chilean system led to some initial flaws that serve as a cautionary tale to Washington. In 1999, a Federal Reserve Bank researcher who was testifying before Congress warned that the success of Chile's pension returns was overstated. When commissions and fees were factored in, return rates of 12.7 percent between 1982 and 1995 were actually 7.4 percent. Although still a healthy return, a good chunk of workers' retirement savings was turning into fund-manager profits.
Regulation has since been tightened and pension fund fees have fallen to less than most U.S. mutual funds charge investors.
On another matter, Bush and Chile's former labor minister may both be wrong. That's the idea that privatizing retirement gives workers what Bush calls an ownership mentality about their assets.
Not so, according to a University of Chile study. It found that more than half of workers didn't know what percentage of their wages was going into the plan. Nine out of 10 didn't know how much their plans' fund managers were charging them.
(c) 2005, Knight Ridder/Tribune Information Services.
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