REPORT OF THE PRESIDENTIAL ADVISORY COUNCIL FOR PENSION REFORM REFORMING CHILE’S PENSION REFORM

1. REPORT OF THE PRESIDENTIAL ADVISORY COUNCIL FOR PENSION REFORM REFORMING CHILE’S PENSION REFORM MARIO MARCEL, Chairman Seminar Reforming Pension Reform Regional Operations Department I, Inter-American Development Bank Washington D.C., November 27, 2006

2. CONTENTS • From the Pension Reform 1981 to the Presidential Council 2006 • The Council’s proposals • Expected results

3. I. From the Pension Reform 1981 to the Presidential Council 2006

4. The 1981 Pension Reform • The 1981 pension reform was a radical change of unprecedented scale. For the first time a private defined-contribution regime replaced a public defined-benefit regime at a national level • Despite the radicality of the reform, transition will last until 2025-2035. Chile is still half way through this transition • Main features of the new regime: • Defined contribution regime • Compulsory and exclusive • Based on individual capitalization accounts • Cap accounts managed by private, single-purpose companies (AFP) • Affiliate free too choose from qualified providers • AFPs manage individual accounts, invest funds, provide disability and life insurance during working life • Government regulates system to minimize financial risk, enhance transparency, guarantees minimum benefit

5. The 1981 Pension Reform • The 1981 reform was justified on several grounds: • Rationalization: replaced an irrational, unfair, expensive collection of sector-based schemes where the most influential groups (government employees, white-collar, banking employees) got better benefits at the taxpayer’s expense • Accumulation: profitability of investments would allow to better pensions at lower cost • Fiscal dividend: end actuarial unbalance and fiscal pressure from old system • Macroeconomics: raise savings and financial deepening to accelerate growth • Microeconomics: fund ownership, incentive for self-employed, affiliates’ choice

6. Two reforms in one • Parametric reform of old system 1979 • Retirement requirements homogenized for all civilian regimes • All under same age-based rule (60 women, 65 men) • Creation of capitalization system 1981 • With some additional parametric adjustments: • Contribution lowered from 24% to 13% of salary • All contributions shifted to employees, with compensating gross salary adjustment • Management of all civilian regimes unified under INP

7. 25 years later … • Individual capitalization regime working properly • Contributions regularly made, AFP fulfill their statutory duties • Pension funds secure, only 2 out of 25 years registered fund losses, no fraud nor bankruptcy • Coverage remains one of the highest in Latin America

8. Pension coverage in Latin America

9. And yet … Projected distribution of pensioners of cohort 2020-2025 according to value of pension Source: Berstein, Larraín y Pino (2006)

10. Why? Changes in the economic and social environment 1980-2005

11. Unfulfilled expectations: coverage Contribution densities by gender Source: Arenas de Mesa, Berhman y Bravo (2004), on the basis of SPS

12. Affiliates’ information Based on Arenas, Behrman, Bravo, Mitchell y Todd (2006)

13. Mujeres Perceived and actual life expectancy

14. Affiliates’ behaviour • The capitalization regime did not change attitudes and behaviour of people that justifies compulsory social insurance in the first place: high intertemporal discount rates, myopia, liquidity constraints • The government did not make any effort at educating the population after the reform of 1981 • The labour market changed: more fixed-term, part-time, seasonal contracts, more women, higher rotation • Labour market had a considerably stronger influence on the pension system than the opposite • Changes will continue over the next 25 years

15. Demographic transition ELDERLY POPULATION 1960-2050 Source: CELADE

16. Expected compensations • Return on investments • Fiscal relief • Efficiency and competition

17. Myth No1: profitability GROSS RETURN ON PENSION FUNDS Unweighted avg 81-05 10% Unweightedmov 5-10 Yr avg: 6% Source: Superintendencia de AFP

18. Myth No1: profitability NET RETURN ON CONTRIBUTIONS

19. Myth No2: fiscal relief PENSION SURPLUS (DEFICIT) WITH AND WITHOUT PENSION REFORM 1981- 2030 Source: DIPRES and Cerda (2006)

20. Myth No2: fiscal relief PV US$ bn: - Expected: 24.5 - Actual: 38.6

21. Myth 3: competition Número de Administradoras y Concentración, 1981-2005 Fuente: Superintendencia de AFP.

22. Myth 3: competition Source: Valdés and Marinovic (2005)

23. Main deviations from original assumptions

24. Affiliates’ views Assessment of pension system and own AFP Source: Mori (2006)

25. Summing up • The 1981 reform created a pension regime that was a true, world-class innovation • This system works normally, no evidence of critical malfunctioning • The 1981 reform promised better pensions at lower costs for workers and the state • The capitalization regime was envisaged for male, full-time, household-head workers. This is no longer representative of the Chilean labour force • This led to a pension system that relies heavily on a contributory regime • Government-sponsored subsidiary benefits (MPG, PASIS) are loosely integrated into the system • This combination of a dominant contributory regime and weak non-contributory benefits will be unable to provide good pensions for all Chileans workers • Families will be unable to fill the gap left by pensions • This reality is perceived by Chilean workers that reveal high anxiety over aging • Even though the capitalization system is not in crisis, something must be done to avert a social crisis once the reform fully matures • Every problem in the system reopens issues of legitimacy • This is the right time for a reform

26. Timeliness of reform

27. From the election campaign to the Presidential Advisory Board • President Bachelet identified pension reform as a prority for her government • Concil convened one week after the new Administration took office • Council due to: • Listen to key actors • Make an assessment of the current standing of the pension system • Make proposals to address weaknesses • Key areas for analysis: • Coverage, density of contributions, self-employed workers • Discrimination against low earners, women • Return on workers’ contributions • Fiscal responsibility • Excluded: • Old pension system • Armed forces’ system

28. The work of the Council • Advisory Council joined by 15 specialists with different professional and political backgrounds • Worked during 110 days to meet deadline imposed by President • Consultation stage (one month) included: • 49 hearings, with 73 organizations, 250 leaders and experts • International Conference with 14 world experts • Webpage visited by 18.800 people, downloaded 29.000 files, posed questions and answered survey • Three opinion surveys • Reports contains detailed assessment in 14 areas • 70 proposals for reform • Most of the report consensual, only 10 minority votes on secondary issues, none of them challenging main approach, conclusions, recommendations

29. II. The Council’s proposals

30. Reform targets

31. Main proposals • New solidarity pillar • Inclusion of non-wage earners • Gender equity • Pension fund management • Institutional strengthening

32. New solidarity pillar • Assessment: current non-contributory benefits weak, loosely integrated • Proposal: create new solidarity pillar to replace current MPG and PASIS • Related goals: universal coverage, prevent poverty at old age, increase replacement rate, reduce replacement rate gaps • Main aim is to integrate all Chileans to pension system and to support those with lower capacity to contribute

33. New solidarity pillar • Elligibility: poorer 60% households, 5 years of residence • Based on Universal Basic Pension of maximum value of US$ 140/month, gradually withdrawn as self-financed contributory pension increases • Withdraw rate (35%) designed so that total pension always increases in response to higher contributory effort • UBP completely absorbed for contributory pension of US$ 370/month

34. New solidarity pillar Pension values SP support PF: Pensión final PMAS Pensión máxima con aporte solidario PBU Pensión básica universal PAFE Pensión autofinanciada estimada

35. Inclusion of non-wage earners • Assessment: asymetric treatment of wage and non-wage earners; non-wage earners do not contribute voluntarily • Proposal: integrate non-wage earners to the capitalization regime with same rights and obligations • Related goals: universal coverage, increase replacement rate, reduce replacement rate gaps • Main purpose is to give all workers same treatment on pensions

36. Inclusion of non-wage earners • Provide equal access to benefits: • Child benefit, work injury insurance • Old age, disability benefits • Equal tax treatment of contributions • Compulsory affiliation: • Requisite for benefits • 5 year transition to apply incentives, educate, facilitate contribution • Pension fund contribution of unemployed while claiming unemployment insurance • Government subsidy of 50% of social security contributions for the first 24 months of effective contribution of low-income new affiliates

37. Gender equity • Assessment: cultural, family, labour markets, pension regulations widen pension gap to men • Proposal: eliminate discriminatory treatment of women in the pension system • Related goals: universal coverage, increase replacement rate, reduce replacement rate gaps • Main purpose is to ensure that same fund at same retirement age generates same pension

38. Gender equity DISTRIBUTION OF WORKING-AGE LIFE

39. Gender equity

40. Gender equity • Pre-school child care as benefit to working women in social security • Maternity bonus equivalent to one year contributions over minimum wage per child for women belonging to 60% of poorest households • Male spouse as beneficiary of life insurance • Allow division of pension assets upon divorce • Allow cross-contributions within households • Separate disability insurance contracts by gender to eliminate cross-subsidy from women to men • Evaluate unisex mortality tables for annuities • Equal the maximum age for disability insurance at 65 • Equalize retirement age of men and women on the basis of a 20-year transition period • Eliminate discrimination against domestic employees in minumum contributory wage

41. Strengthen capitalization pillar • Assessment: weak competition due to barriers to entry, overregulation of investments, reduce return to affiliates’ contributions • Proposal: enhance competition over both price and profitability • Related goals: increase replacement rate, ensure sustainability • Main aim is to change key drivers in the dynamics of industry, open room for new business model for AFPs

42. Strengthen capitalization pillar • Separate –through contracting out– the core fund management function from service platform functions (contribution collection, account management, branch management, information) to lower economies of scale • Organize annual tendering of new affiliates to AFP offering lowest fee. Tendered affiliates should remain in winner AFP up to 18 months with fee guaranteed • Allow fidelity discount on fees based on effective permanence • Simplify investment-limit regulations. Exchange statutory limits in law for administrative procedure on the basis of recommendations by Investments Technical Council, on the basis of risk profiles only • Eliminate limit to overseas investments • Change limits, reserve requirements to allow more competition over profitability of investments • AFPs more accountable for investment policies

43. Institutional strengthening • Assessment: weak governance of pension systems, distributed responsibilities, lack of participation of key stakeholders • Proposal: restructure institutionality to suit multi-pillar system, enhance legitimacy of pension system • Related goals: ensure sustainability, transparency and predictibility

44. Institutional strengthening • Unify in a single Superintendency all regulation of pension system • Superintendency of Pensions structured in three divisions dealing with each pillar • Create a committee of stakeholders, with representatives of workers, pensioners, employers and fund administrators, in charge of information, education, and as advisory board • Allocate responsibility for management of solidarity pillar to public agency created from restructuring of INP • Create accounting system for public pension commitments, including solidarity fund • Develop actuarial model to keep track of goals of reformed system • Create a pension education fund with contributions from AFPs and government

45. Proposed institutional structure

46. III. Expected results

47. Expected results

48. An integrated system

49. Financial effects ANNUAL FINANCIAL FLOWS, % of GDP

50. Next steps • Positive reponse of main stakeholders to Report • Inter-ministerial committe to analyze proposals, establish priorities, design transition, prepare draft laws • Government committed to send draft legislation to Congress before end-year • Equalization of legal retirement age discarded by President, most other issues to be included • Pending definition on legislative strategy, expected timing • Government’s high stakes at pension reform • Pension Reform might be approved during current Administration’s mandate