Though Since its inception in 1981, over a quarter of a century ago, Chile’s private pension fund system (the AFPs), has attracted a lot of international attention, mainly as a “great pioneering success”. This has permitted many Chileans to make a good living as “miracle consultants”, advising governments and multilateral agencies on how to reform other state pension systems. As is usual with anything to do with Chile’s international image, most foreigners have gullibly taken on board the concept without querying the fundamentals or looking at the figures. Now that the Republic of Armenia has joined the group of nations thus threatened with “the Chilean model” for pension reform, I have to make a stand and man the barricades. Our people have sufficiently suffered over their history without needing this additional blow. Many of the aspects mentioned below have previously been covered in other papers, but for the first time I am putting all the counter-arguments together and updating the facts. Of outside observers, only the International Labour Office and a courageous visiting Polish minister have so far had the audacity to criticise the AFP system.
Let us imagine that I were an aspiring mountaineer, and after going up some minor peaks, had been the first man to have a go at Everest. Without even reaching the top, I slip, break several bones, and years afterwards, I am still limping. Would I have the cheek to set up shop in Kathmandu and credibly offer my services to all the world’s alpinists as “an expert consultant on Everest?” Surely not. Does anyone remember the first attempts to cross the Atlantic by air? There were several. They all disappeared at sea, but everyone remembers Charles Lindbergh, because he was the first SUCCESSFUL one.
To take someone’s advice just because he is a limping pioneer is unprofessional. Analysis, whether of countries, sectors or companies cannot be an emotional cri du coeur. It has to be based on hard facts and figures, even if a little well-used intuition also helps. Otherwise, you fall into what I would describe as the “Citizen Kane” syndrome. Just because it used some new techniques (such as the “off “commentator voice), and described a type of press baron that has long ceased to exist in the civilised world, it is a “great” film. In fact, the whole movie is mediocre and passé, whatever some listings otherwise claim. Claude Lelouch, years later in “Un Homme et une Femme”, used the « off » technique much better, and considering the staying power of the subject matter (love and sacrifice), Casablanca is a much greater movie than Citizen Kane. This week, at an auction, the Oscar statuette Orson Welles received in 1942 for “Kane” found no bidders. Pioneer is not synonymous to “best”.
At the end of the day, the main judgmental criteria is what people will be receiving in their pockets. The purists will say that it would be better to compare it to what people would have received in another system. That is only partly true. If you go through a major upheaval such as pension reform, you should deliver something worthwhile in absolute terms at the end of the day.
It may sounds obvious, but you cannot have high pensions if you have low salaries. In Chile, the average wage as of end October 2007 was around U$ 676 per month, only 130 % more than the minimum wage.
If we take the average pension received by the 634,523 persons who were claiming it as of end October 2007, it amounted to a mere U$ 323 per month, 48 % of the average wage and just 10 % more than the minimum wage. If you live in Chile, you will know that it is not exactly a fortune. Ah, those old-system pensions. Those who stayed in them to the end are receiving a higher average pension. So there! In case you are interested, according to the Central Bank of Armenia, the average wage there in August 2007 was U$ 240, a bit over a third of the Chilean level, though I cannot vouch for the comparable methodology. I assure you the cost of living there is not a third of the Chilean level.
If you are having a hard time making ends meet, and you are relatively young and struggling, you do not worry about your old age, even less so in a developing country with no tradition of saving (Asians are thrifty, Latins are not, that is why you cannot have single-measure systems in these things, they have to be adapted to local conditions and psyche. This does not just apply to Political Economy. Many successful European companies bit the dust when entering the US market because they could not be bothered to check out the differences). Armenians may have been thrifty at some stage, but the economic and financial upheavals accompanying the end of the USSR wiped off the value of the local currency, including savings and pensions from Soviet times.
In Chile, many workers are glad enough to work in the black economy, or contribute on only part of their real salaries, in order to have a bit more money at the end of the month. Sure, they are affecting their future pension returns, but it is a hard choice to decide if to let your children go without meat tonight, or contribute more to an AFP (Chileans and many other Latin Americans also have a long experience of seeing savings wiped off, sequestered or devalued).
Unless someone can tell me otherwise, Chile is the only country where all the burden of pension and medical cover contributions fall on the employee, with the employer’s only responsibility being that of deducting and paying to the relevant funds. The only exceptions are unemployment insurance and special cover for dangerous activities, the cost of which is partly borne by the employer.
Within the contribution paid (around 12.5 % of gross wages), a not unsubstantial amount goes into the pocket of the AFPs, for whom it is a very nice business, thank you very much. In the first nine months of 2007, the 6 Chilean AFPs made a net profit of U$ 240 million, an increase of 33.6 % over 2006. Their return on equity improved to 26.3 %. They received U$ 705 million in commission income.
To the extent that most Chilean companies do very well (and not just the listed or public ones on which we have figures), they could share the burden with their employees, or help increase the final pension by adding further contributions. The top 600 Chilean companies made U$ 16.26 bn in January-September 2007. The current situation is not just unfair, but it also encourages evasion by employees and fraud by employers. I am dealing with the latter separately. It is not even a saving to the state, which not only will bear the cost of the minimum pension guarantee it offers, but nearly 3 decades after inception, still spends U$ 5 million per DAY on the “Bonos de Reconocimiento” that are transferred to the private system from old schemes
For a system that was meant to be universal and compulsory for salaried workers, and has a 26-year track record, the fact that only 51.7 % of the 7.91 million accounts at AFPs were up-to-date as of last September 30, is not exactly an achievement worth imitating.
Though participation by independent workers is voluntary, if the system was really attractive, it would attract more volunteers. When after a quarter of a century, only 5% of the potential universe of non-salaried workers has joined, there must be a reason.
This includes not just self-employed lawyers and doctors, (in fact many of those are incorporated into limited companies to take advantage of the ludicrously low level of corporate taxation in Chile, and appear as salaried workers). The definition encompasses from shoe shine boys to small farmers, and many more.
NO REAL COMPETITION
At one time, there used to be up to 26 AFPs. Through merger, takeover and even the odd foreclosure, the number is down to 6. This puts in context the incredibly silly theory that if there was more competition in the market, there would be better performance and lower commissions.
If things were bad when they were 26, it is going to do nobody any good to double the existing number, whether it is a state-owned venture operated through BANESTADO, or the arrival of banks or insurance companies as AFP managers. We currently still have 26 banks in Chile. This has not meant low interest rates. Just more credit to people who cannot afford it. It is the difference between falling from the 15th or the 25th floor. The end-effect is the same.
People are also not sophisticated enough to differentiate between one or other AFP. Until the practice was banned a few years ago after it got out of hands, the AFPs employed thousands of people to aggressively lure people from one fund to the other every few months, with cash incentives or other gifts (some even say sexual favours from attractive marketing girls). It was the gift rather than the management quality or performance that attracted the customers. Now they have a much longer compulsory waiting period, and the salespeople have been dismissed (not before they rioted in violent protest in the streets of Santiago).
In terms of the performance of the actual funds, there was little differentiation up to recently as they all put similar amounts in similar investments (including a Santiago stock market where the available float is only 20 % of the U$ 215 bn capitalisation). As of end November, 15.8 % of assets were invested in domestic shares. Geographical diversification has helped, with the new authorisation limit for investing abroad (as from December 18), being 40 % (as of end November they already had 35.8 % of their portfolio abroad, most of it in mutual funds).
The most effective way has been the split of alternatives in each AFP into five degrees of risk, with funds heavier in stock, and conservative ones mainly invested in bonds. The impact on performance differentials is dramatic, particularly if you look at the turbulent months since November 2007. In January 2008, even the most prudent type of investment segment barely managed to keep its value (+0.55 %), whereas the riskiest variety lost nearly 10 %. Total funds under management reached around U$ 112 bn as of end January 2008.
ABUSE & IMPUNITY
And now we come to the piece de résistance of the whole argument: the unpunished theft of contributions by employers. To the extent that the employer acts only as an agent, deducting the AFP dues from the wages and paying them in during the first 10 days of the following month, if he pockets the money instead, he is acting exactly like a bank teller to whom you hand a deposit slip, but who puts the money in his pocket rather than in your account. I did publicise this in the Chilean media some years back, attracting letters either accusing me of “knowing nothing about the subject” (interestingly, exactly the same remark made by the chief Chilean consultant to Armenia, when I offered him my ground knowledge and 35 years of financial experience at the start of his assignment), or others who said that the alternative to not paying the contributions was to sack the worker (Management by Blackmail, the title of one of my previous papers). If you think Chilean bosses are ruthless, you should hear some of the stories I have collected in Armenia!
According to latest statistics, there were U$ 820 million of unpaid contributions as of September 30, 2007. This is just the money owed on behalf of workers with identified contracts, and obviously excludes the informal sector or the notional shortfall of those who only contribute on part of their real salary.
The thing is that despite several efforts by the authorities, the sum has doubled in 5 years. To be fair, the efforts were modest, as if obliging employers to obey the law (put more crudely, not to steal), was a pusillanimous task. The most extraordinary steps where two episodes of “carrots”, where delinquent employers were forgiven interest and fines if they brought themselves up to date. They were even offered state money on favourable terms to do so. To the extent that the unpaid money was not the government’s but the employees’, the state had no authority to forgive a debt to a third party. In any case, there were few takers (only 21 employers applied for the special loans!), which means the practice was not due to temporary cash flow problems, but is an organised extortion racket.
If the worker realised that he was being fleeced, his only choice up to recently was to go to court against his employer. You can imagine who had more experience and could afford better lawyers in this litigation exercise, and in any case it created a tense relation that often ended up in the dismissal of the employee (Chilean labour law, still largely based on legislation adopted during the military government, has a catch-all clause for summary redundancy “necessity of the company”).
To try to circumvent that, a law was passed in 1999 forbidding the firing of any employee to whom contributions were owed. Unfortunately, it did not apply to lower sums and incomes, so many employers still managed to escape through that net.
The latest measures involve the setting up of special sections of labour courts to deal with the problem, as well as the withholding of tax reimbursements to the employer, and a fine to the AFP if it does not take the employer to court after the statutory six months period of grace, as it is now its responsibility to do rather than the employee victim to undertake judicial action. Guilty employers will also be prevented from receiving funds under certain programmes.
The measures are still in their beginnings or at the planning stage, and it is too early to judge their effectiveness, though historical experience is not good, as the unscrupulous always find a way out. Some employers take advantage of the 6-month grace period from prosecution to shut down and re-open under another name and registry, so when it comes to sue them, there is nothing and nobody to sue.
If the Chilean system was so great (and I hope this paper so far has convinced you that it is not), why was its reform one of the cornerstones of Mrs. Bachelet’s campaign platform? Serious discussion on the proposals on the congress floor is yet to start, and with just 2 years left for the next elections, it is touch and go if something will come out of the tortuous congressional process, even though detailed discussion is about to start.
There is to be a guaranteed minimum pension for those who never contributed. This is a worthy gesture, but unfortunately its amount is nearly the same (about U$ 150 a month by July 2009) as the state guaranteed minimum pension for AFP members whose low income or contribution records would not allow them to get as much as that. It does not take a genius (maybe a Chilean consultant or two) to realise that if you will get the same paltry sum from the state whether you contribute or not, there is no incentive to be in the AFP scheme for low wage earners.
To this argument, the authorities retort “AFP contributions are compulsory”, to which I would say, “Oh yeah? So why are half the accounts past due?”. As for encouraging the independents to contribute, (they manage to convince a visiting OECD mission that they would “oblige” them), you can start forgetting about the shoeshine boys for a start.
Competition from banks and possibly insurance companies is another facet of the reform, about whose details I do not wish to dwell upon too much, because in Chile, any important legislation is like the big fish in Hemingway’s ‘The Old Man & The Sea’. What is brought onshore is very different from what was initially caught.
Though it is currently outside the AFP debate, the expensive pension burden (now entirely assumed by the state at a yearly rate of U$ 1.2 bn) of military and police pensions will also have to be tackled at some stage. Measures so far have just tinkered with the existing system (which is far more generous to the beneficiaries than the AFPs).
The myth that switching to private pensions relieves the state from their financial burden holds no water. The 2008 budget sets aside U$ 5.6 bn in pension expenses. Of this no less than U$ 2 bn are for “Recognition Bonds”, the sums that the state transfers to private pension funds on behalf of beneficiaries who are making the transition from the old state system.
As for the Chilean consultants, they would do well in concentrating on getting it right in their own country, before infecting others (“Tie up the knot of your underwear”, as the Turkish saying goes). London’s International Consulting Economists’ Association, to which I belong, proposed a slogan for consultants: “I came, I saw, I invoiced”.