For twenty-five years or so, the privatised pension scheme introduced in Chile under the Pinochet regime by his labour minister, Jose Pinera, has been touted as a model for the world to follow. It’s been particularly influential in the US debate over social security privatisation but has also had some influence in Australia, which has a somewhat similar setup, though we arrived at it by a different route – Chile scrapped its defined-benefit state pension scheme, keeping a basic safety net, Australia started with a means-tested flat-rate pension, but has tried to expand private superannuation since the 1980s
Now the New York Times reports that the Chilean scheme is not delivering the promised benefits . Lots of people are getting less than they would have under the old scheme and large numbers are falling back on the government safety net. Fees have chewed up as much as a third of contributions.
Why has this bad news taken so long to emerge. Complaints about fees have been around almost since the start, but right through the 1980s, they were ignored becuase investment returns were exceptionally high. This in turn reflects the fact that Pinera had the good luck or good judgement to start the scheme when the stock market was at an all-time low, thanks to a financial crisis (in retrospect the first of many cases where financial market darlings got into trouble). The economy recovered and the stock market boomed. Once gross returns fell back to normal levels, the bite taken out by fees became unbearable.
All of this raises the issue of risk. Under a privatised defined-contribution, your returns, and therefore your retirement, depend heavily on timing. 1981 was a great time to start investing in the Chilean stock market, and also in the US market. At least for the US, 2000 was a good time to get out. Anyone who started investing in the US market in the late 1990s (and didn’t manage to outperform it) is well behind where they would have been if they had put their money into government bonds.
On average, returns from the stockmarket are higher. But this is just another way of saying that, on average, investors want a higher return to justify the additional risk. So a switch from a defined-benefit scheme to a private accounts scheme with the same average return and higher risk is a real loss, just as if someone sought to repay a debt contracted in 1981 with the same amount in 2005 dollars.
I’ll have more to say about this soon, I hope.
{ 21 comments }
Nicholas Weininger 01.27.05 at 2:11 pm
IIRC, the Chilean scheme was/is rather restrictive wrt the kinds of investments allowed: you had to pick a single ADP for your whole private account, and each ADP could only offer a single fund.
It’s not really surprising that such a restricted system would limit the sort of competition that drives fees down and hamper people’s ability to diversify their accounts to hedge against market fluctuations. Indeed, the article says that
“Government officials like Mr. LarraÃn and Mr. Scolari acknowledge that “commissions are high and need to come down.” They say that “more competition is needed” to foster lower fees. But existing regulations frustrate the creation of new funds – something that seems just fine to pension funds that have become a powerful political and economic force.”
Regulatory capture strikes again!
Not that this really diminishes the value of the Chilean story as cautionary tale, since the Bush plan in the US is clearly vulnerable to the same sort of capture. But it does suggest that the problem is not with the principle of privatization per se so much as with the way it’s done.
Darren 01.27.05 at 2:18 pm
An argument for scrapping fiat currencies, perhaps?
Kevin Donoghue 01.27.05 at 2:23 pm
When you do return to the topic, please discuss future real returns on assets in general. AFAICT both property and equities offer lousy returns. Is that simply an illusion fostered by doing my sums in euros? Combine that with longer life expectancies and it seems the only solution is to work longer and accumulate more wealth. Shunting the problem from the public sector to the private sector solves nothing, particularly since the financial services industry can buy a lot of influence over the process.
Darren 01.27.05 at 3:00 pm
“Combine that with longer life expectancies and it seems the only solution is to work longer and accumulate more wealth.”
But it is important what you choose as a vehicle to store the accumulated wealth. If you choose fiat currency you are at the mercy of whoever controls the printing press. The wealth that you have taken a lifetime to accumulate can erode 20 – 30 % within a short space of time. Look at the dollar and it’s inevitable collapse. To say that this isn’t relevant is to be accused of not paying close enough attention to the tunes played by Nero.
andrew cooke 01.27.05 at 3:10 pm
i don’t know what an “adp” is, but i pay half of my contributions (i am in chile) into a low risk fund, and half into a higher risk fund. both are with the same (private) company.
there is already significant competition – several different companies provide pensions, and i recently switched from one to another because i was unhappy with what i was getting (with relatively few problems – no more than normal for doing anything in s america). however, it’s difficult to compare performances and/or costs, in my experience.
andrew cooke 01.27.05 at 3:13 pm
incidentally, the culture here is very much spend now/pay later; everyone has very high credit and i suspect hardly anyone contributes more than the legal minimum.
and why on earth does posting take so long here? it’s been broken for ages. fix the damn thing!
Barry 01.27.05 at 3:26 pm
“Regulatory capture strikes again!”
That presumes that the system wasn’t set up to rip people off to begin with.
“But it does suggest that the problem is not with the principle of privatization per se so much as with the way it’s done.”
Well, look at who is urging this. I don’t want my retirement to get “Iraq’d”.
Barry
Brock Sides 01.27.05 at 3:35 pm
On average, returns from the stockmarket are higher. But this is just another way of saying that, on average, investors want a higher return to justify the additional risk.
Does this mean you think the equity premium is an illusion?
abb1 01.27.05 at 4:34 pm
On average, returns from the stockmarket are higher.
Average don’t mean a thing, as usual. Avrage return of any particular subset of investors (CEOs, Senators, people with income less than $100K) can be much higher or much lower or negative.
BigMacAttack 01.27.05 at 4:48 pm
Does the equity premium exist? When answering this question transaction costs must be considered. No fair saying the market sux because it does a poor job of allocating capital if we ignore transaction costs.
The study I saw did not seem to take transaction costs into account which leads me to believe any such premium is over stated if it exists.
(And yet I have my little bit of money in stocks)
If it does exist would an inflow of capital eliminate it? Or is it a magic money making machine that defies supply and demand?
It would it isn’t.
But I don’t think bribing people with higher govt returns or scaring them with vision’s of lower private returns is such a good approach.
It never happens to them. It always happens to some other stupid sucker. Just try explaining the random walk or the dividend value theory of stocks to someone during a boom.
In an appeal to greed Bush might just PT Barnum it up and win. Buy out today’s old people with trillions of bonds and lure younger voters with the higher stock returns they KNOW they are going to get.
Also, I don’t think claiming privatization would fail because x% would still need govt assitance is all that convincing. Some folks might conclude that x% is still less than 100%.
This NY Times/Krugman approach really isn’t that convincing I am hoping this just your opening and you will deal with all these issues.
Nicholas Weininger 01.27.05 at 5:42 pm
andrew cooke: I stand corrected. “ADP” should be “AFP” and stands for “administradora de fondos pensiones”. I may have misread my sources, e.g.
http://www.worldbank.org/html/dec/Publications/Workpapers/WPS1700series/wps1791/wps1791.pdf
which dates from 1997 since which time the rules may have changed.
Jack 01.27.05 at 6:31 pm
The UK has made similar reforms and is less trumpeted because everyone knows that it has similar similar problems.
For example we can show what an infation linked pension looks like twenty years on and we can show what private accounts do in a developed economy. Neither is pretty.
The state will be expected to take care of the elderly poor one way or another and in the UK inflation does not cut it as a way of keeping track of the appropriate level.
The regulatory capture line is Utopian nonsense. Not only are bad regulatory effects harder to avoid than that phrase implies, no regulation is not an option. Unregulated financial services are a fraudsters paradise.
The fundamental problem is that it takes people a long time to realise when they have made a mistake by which time it is too late to make a more informed choice.
Regardless of the existence or otherwise of the equity premium (Don’t ask Japanese investors what they think and remmeber that long horizons don’t apply to substantial parts of the investment) relying on equities to provide the security net is going to be a let down for a significant number of people. What to do for them?
bma’s argument about the effectiveness of this point is a good one. Perhaps pointing out that costings don’t include the money to take care of these people and either some randomly chosen people are going to be left old and broke or there is a big bill on top of the costings. That bill will be big because you have to bale out a lot of people in the first place and then you have to deal with the effects of extra risk taking by those who know they are going to be baled out if it goes wrong. Then there will be means testing and that will reduce investment further and so on.
Oh and UK private pensions are hideously expensive. Most of the money goes on marketing costs, as opposed to potentially value adding management services, which is the closest thing to a tangible harberger triangle I’ve come across.
Adam Kotsko 01.27.05 at 6:35 pm
I’m glad we’re thinking of modelling our pension system on that of one of the great monsters of the 20th century. Maybe we could adopt other effective policies of his, too.
Barry 01.27.05 at 7:53 pm
Adam, when I think of the phrase “Pinochet’s minister of labor”, I shudder.
Barry 01.27.05 at 7:55 pm
Adam, when I think of the phrase “Pinochet’s minister of labor”, I shudder.
panglos 01.27.05 at 7:56 pm
The problem with competion and prices is that it is very hard for investors to tell what they are getting but they are easily convinced that there is more than just price at stake. Under these conditions it is easy for fund managers to switch the focus of competition away from price. There is very fierce competition in the UK but the result tends to be marketing spend competition for positional goods mindshare. This wouldn’t be so bad if it was more clearly related to customer information but the very vagueness of the services delivered means that very little is conveyed other than that the company has a lot of money or good ad people.
What useful do you learn froma picture of a zebra or a slogan like “live your dreams”?
T Rowe Price and Vanguard try to compete on price in the US but in general pressure on prices is hardly huge.
The cost issue is fundamental and not easily tractable without a higher level of wisdom than the current debate suggests is available. At the very least there is no tried and tested route around it.
Australia and Sweden are interesting but I don’t know enough to tell whether or not they really work well. Anyone know more?
andrew cooke 01.27.05 at 9:08 pm
since which time the rules may have changed.
ah, ok. afp’s offer a range of funds now, but it think the selection is also defined by law (they look very similar from company to company – five, iirc, different funds with increasing amounts of volatility). this probably did change recently – i vaguely remember that being one of the problems with comparing performance. a bigger problem was finding printed figures for comparison; it’s accepted practice for companies to employ salespeople to give you information “personally” (labour is cheap here, but the range in quality of these people is large and it can be difficult to get hard numbers out of them).
most investments are in chile, incidentally – again, this is fixed by law. if you want to find out the latest info, and speak spanish, try the govt web site – if it’s a chilean law, it’s probably on the web somewhere.
Hal Lewis 01.27.05 at 11:56 pm
The military in Chile was not included in the “private account” plan. The people have complained but the govenment will not move. I wonder why?
derrida derider 01.28.05 at 5:32 am
Management costs are an issue in Australia, but so far not a huge one because of an accident of history. When we set up compulsory private accounts it was at the unions’ urgings (don’t ask, its a long story – suffice to say the prospect of cushy jobs as trustees was not absent from the union bureaucrats’ minds). Most workers do not have a choice of fund – their contribution often goes into “industry” funds, set up jointly by employer bodies and unions. So there are no marketing expenses and the fund managers don’t get paid according to how many suckers – er, investors – they attract. So management costs are low.
So far the obvious potential in this for corruption (kickbacks, non-arms-length investments, etc) hasn’t been fulfilled – perhaps we’ll discover it in the next recession.
In any case, the current conservative government is determined to give workers choice of funds – mainly, one suspects, to kick the unions rather than to help the workers. No doubt we’ll see management fees shoot up quickly then.
derrida derider 01.28.05 at 5:33 am
Management costs are an issue in Australia, but so far not a huge one because of an accident of history. When we set up compulsory private accounts it was at the unions’ urgings (don’t ask, its a long story – suffice to say the prospect of cushy jobs as trustees was not absent from the union bureaucrats’ minds). Most workers do not have a choice of fund – their contribution often goes into “industry” funds, set up jointly by employer bodies and unions. So there are no marketing expenses and the fund managers don’t get paid according to how many suckers – er, investors – they attract. So management costs are low.
So far the obvious potential in this for corruption (kickbacks, non-arms-length investments, etc) hasn’t been fulfilled – perhaps we’ll discover it in the next recession.
In any case, the current conservative government is determined to give workers choice of funds – mainly, one suspects, to kick the unions rather than to help the workers. No doubt we’ll see management fees shoot up quickly then.
Tom T. 01.28.05 at 1:34 pm
Adam Kotsko, the Chilean pension plan may be associated with Pinochet, but the first Social Security plan, after which ours and others were modeled, was developed under Otto von Bismarck.
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