Pensions around the world blog series: Chile

We’ve written in the past about some of the positive aspects of the Chilean pension system and what the UK can learn from how it is designed. Its approach to DC decumulation is set up to drive greater value for savers when taking an income from their fund and there is a lot to learn from this aspect of the system. The Chilean pension system has, though, been seriously challenged as it has not provided adequate outcomes to the bulk of retirees. This has led to both protests and a gradual swing back to a tax funded first pillar pension.

Replacing a pay as you go pension system with DC pension saving

Chile is one of the earliest examples of a country to embrace DC pension saving. Under the Pinochet dictatorship, it abolished its pay as you go pension system, replacing it with a system of individual DC accounts. This took place in the early 1980s, as part of a much wider programme of liberalisation and privatisation. It was retained after Chile’s return to democracy following the 1988 plebiscite on the continuation of Pinochet’s rule and the subsequent 1989 elections.

The overall results from the DC system have been disappointing. Average replacement rates from the Chilean DC system lag behind the bulk of the rest of members of the Organisation for Economic Co-operation and Development (OECD), often by some margin. Also, forecast replacement rates are projected to be low. OECD analysis suggests an average replacement rate of roughly 30% in 2060. While the system is sustainable, it has arguably achieved sustainability at the expense of delivering adequate pensions.

Why has the Chilean pension system struggled?

As usual, when a system struggles over time, there is usually more than one cause.

1. The first is that Chile completely replaced its pay as you go pensions system with individual DC accounts, rather than reforming its pay as you go system and augmenting it. This effectively withdrew the welfare safety net for retirees who were not in a position to save.
2. Second, minimum contributions totalled 10% of employee earnings, without an employer contribution. This is too low to generate an adequate retirement income, especially in the absence of state backed first pillar provision.
3. The third is broken contribution histories. With a much higher level of informal working and self-employment than the UK, it was (and is) common for working Chileans not to be contributing into a DC account for large proportions of their working lives. Coupled with the impact of lower than assumed investment returns and increasing longevity, it’s not a surprise that the system has not delivered adequate incomes.

The result of this has been protests and a move back over time to a first pillar pension, funded collectively through taxation. In 2008, the Chilean government introduced a first “solidarity” pillar pension, which operates on a pay as you go basis. It is currently payable to men over the age of 65 and women over the age of 60, who have incomes in the lowest 60%. In addition to the means test, there is a residency requirement – Chileans need to have been resident for 20 years and for four out of the last five years prior to claiming in order to be eligible.

What we can learn from Chile

We can pull two main lessons out of this. First, DC can only function as a main pension entitlement if the system covers the overwhelming bulk of the population and contributions are regularly reviewed to ensure they target an adequate income. Given that this is very difficult for policymakers to achieve, some form of combination of a pay as you go first pillar that guarantees a minimum income in retirement and a DC top up seems sensible. We think that the Chilean experience broadly validates the UK’s policy mix – a split between a first pillar set around the poverty line and a quasi-compulsory DC top up.

The second lesson is that, in a democracy, pension systems have to be politically as well as economically sustainable. If a system is not producing adequate outcomes then those affected may vote themselves a more generous pension, or take to the streets. Or, as in the Chilean case, both. This should be borne in mind by countries that are further behind on the DC journey than Chile. Pensions are boring until they become interesting and when they become interesting it’s usually a sign that something is seriously awry.