EconSouth (First Quarter 2008)

This new book explores experts' views on policy issues and assesses pension reform in various countries in the "post-privatization" era.

Governments looking for the best ways to craft viable pension systems for their citizens are looking for inspiration to the Americas, which have been a proving ground for pension reforms during the past 25 years. This article provides an overview of a new book, Lessons from Pension Reform in the Americas, that presents experts' views on a number of policy issues and highlights various countries' experiences.

Well over a century ago, Chancellor Otto Von Bismarck introduced a state-sponsored pay-as-you-go (PAYGO) pension system in Germany to reduce poverty among the aged. This aim remains a primary goal today in many countries even as policymakers struggle to address changing demographics and aging populations amid disagreement about the best path for reform. These struggles have been especially apparent in the Americas, which, since Chile's reforms, have become a laboratory for pension reform whose experiments the rest of the world is observing with great interest.

In 1981 Chile took the unprecedented step of switching from a PAYGO to a substitutive prefunded pension system. It continued to pay benefits promised under the old system by issuing recognition bonds and running budget surpluses during the initial years to finance these bonds. In 1994 Argentina and Colombia followed suit.

With the publication of the landmark study Averting the Old-Age Crisis that same year, individual prefunded accounts were officially encouraged by the World Bank and other leading international organizations. Since then, the World Bank has helped more than 80 countries make changes in their pension systems. Of these, a dozen Latin American countries have passed laws introducing mandatory saving, while a similar number in Europe and central Asia—mainly in the post-Soviet Union transition economies—have also introduced individual accounts.

But the policy prescriptions of the 1980s and '90s are now being reevaluated. With the euphoria of the initial phase of pension reform clearly over and with a decade or more of experience to review, policymakers and scholars have access to important new evidence to analyze the efficiency and equity of switching to individual accounts in this "post-privatization" era.

Putting reforms under the microscope
Beginning in 2004, a fundamental shift in thinking about pension reform became evident in international organizations such as the World Bank as well as in countries such as Chile that have undertaken reform. Chile convened the Marcel Commission in 2006 to draft pension reform proposals. The commission's report was the basis of reform legislation introduced in December 2006. The report addresses the particular challenges that developing countries face with respect to their sizable informal sectors, which comprise over half of the economically active population in developing countries. The informal sector is made up chiefly of people who are self-employed in activities that are not taxed or regulated.

The Marcel Commission report argues that pension reform, instead of "formalizing" the workers in the informal sector, should serve all workers, both informal and formal, and the report proposes a universal solidarity pension aimed at alleviating poverty. Because Chile's reform has been so influential, policymakers throughout Latin America and beyond are closely watching measures that address these policy challenges.

These challenges are all the more urgent given changing demographics over the past three centuries. In the book's foreword, Nobel laureate Robert W. Fogel argues that because of the intense interplay between physiological improvement and technological advances, humans have increased their body size by more than 50 percent in the past two centuries, and improvements in general sanitation, the reduction of air pollution in cities, and higher food intake have increased life expectancy. At the same time, per capita growth of gross domestic product (GDP) has increased dramatically. Fogel suggests that demographers have consistently underestimated the impact of such improvements. Paradoxically, longer life expectancy has had devastating financial implications for already overburdened social security systems and calls for a careful reexamination of social security to ensure future sustainability.

A closer look at prefunded accounts
New data from Chile could have a broad impact on policymaking in countries that have switched to prefunded individual accounts. The first microlevel longitudinal study of worker behavior tests the accuracy of people's knowledge of their own retirement savings, comparing their knowledge with their actual pension records and finding considerable information gaps. Alberto Arenas de Mesa and his coauthors stress that greater financial literacy is essential for enhancing the system. Furthermore, they argue that for the government to make useful budgetary projections, better data are necessary on who is in the system, who is contributing, and who is likely to try to obtain the minimum pension guarantee or social assistance.

In general, defined contribution savings plans require employees to make complex decisions, including how much to contribute and how to distribute contributions among a variety of investment funds. In a chapter examining default options, John Beshears, James J. Choi, David Laibson, and Brigitte C. Madrian provide evidence that refutes a standard notion from economic theory that if transaction costs are small, default choices should not matter. The authors note that the psychology literature has documented individuals' tendency to put off making decisions as the complexity of the task increases, a factor that would tend to lower participation in retirement savings plans.

To assess the effect of defaults on retirement savings, the authors examine the effect on worker savings when employers automatically enroll their employees and when workers must actively opt into a retirement savings plan. Among their findings, Beshears and his colleagues note that when automatic enrollment is the default option, participation rates are much higher than with opt-in enrollment. Furthermore, many individuals view the employer default savings option as an implicit endorsement of both the contribution rate and the distribution of funds. The authors find that default choices are not neutral but play a role in every stage of the lifetime savings cycle, including savings plan participation, contributions, asset allocation, rollovers, and the spending of assets in retirement. Default choices become even more crucial as pension fund plans introduce more investment options. Because default options carry such significant consequences for retirement saving, policymakers have been scrutinizing these options more closely and have sanctioned them in recent pension legislation in the United States.

Righting the wrongs of gender inequities
Gender issues are just now beginning to appear on policymakers' radar screens; as The Economist put it April 2006, "Forget China, India and the internet: economic growth is driven by women." But the role of gender in pensions is still not getting the attention it deserves. Chile's President Bachelet commented that the Chilean pension system to some extent "discriminated against women," and the Marcel Commission agreed.

The commission found that women receive annuity benefits equivalent to only 42 percent of what men receive because of a variety of factors, including women's differential participation in the labor market (with lower wages), the division of household work, demographics, pension system regulations such as the option to retire earlier with reduced benefits, and the fact that insurance companies are permitted to use differential mortality tables. The Marcel Commission's frank assessment of pension reforms' effect on women has brought about policy prescriptions—including subsidized childcare and a measure that would pay women retiring at age 65 a bonus for each child they have borne—that are the first of their kind in Latin America and are destined to receive considerable attention from other countries that have followed Chile's path.

Learning their lessons
The wide range of pension reforms in Latin America provides lessons. In the book's epilogue, Olivia Mitchell notes that politicians have often focused on the "front end" of the reform so that accounts are set up and funds begin to accumulate, deferring, and sometimes neglecting, tax, health care, and capital market reforms. She argues that it is important for governments to follow through with necessary complementary measures after the adoption of major pension reforms. For example, reformers have often failed to put adequate legal rules and regulatory frameworks in place to support reforms, as is the case with investment rules that led to overreliance on domestic government bonds in Mexico or lax disability and survivorship rules in Brazil.

Clearly, pension reform is an ongoing project. Economies and labor markets evolve over time, requiring an effective response to changing conditions. Since 1981, Chilean policymakers have continually modified the country's pension system, changing investment rules and adding worker choices; the system is now moving toward a basic solidarity pension and improved gender equity. Unfortunately, for practical political reasons, political leaders are likely to pass reform measures piecemeal and to postpone the most politically costly measures, even if this approach undermines reforms. The critical question is whether policymakers will accept the challenge of continuing and deepening the reform process, with its many costs and obstacles, even after the front-end reforms have been implemented.

In some instances, however, governments may choose to return to state-sponsored PAYGO systems at the expense of individual accounts. This process appears to be taking place in Argentina, where in 2007 the legislature approved measures that would raise the benefit in the state-run system, allow workers to return to the public system from the private, place a ceiling on commission costs, and steer new workers who neglect to choose a pension fund into the public rather than the private system. Economist Rafael Rofman notes that these measures could result in a smaller private pillar limited to providing complementary benefits to a relatively small percentage of upper- and middle-income workers.

Making pension reforms a priority
In the Western hemisphere, many policymakers are clearly putting pension reform at the top of the agenda. In some countries, a movement toward retrenchment has occurred with respect to recent pension reforms after the election of administrations that opposed, or at least did not support, systems of individual accounts. Besides Argentina, proposed measures to retrench individual accounts have surfaced elsewhere in the region, including Bolivia and Uruguay.

Chile, which pioneered individual accounts, is engaged in its most serious attempt yet to correct the perceived shortcomings in its system of individual accounts and to universalize coverage to incorporate the significant percentage of workers who fail to accumulate sufficient funds in their accounts. Just as other policymakers in the region turned to Chile for inspiration when developing their reforms in the first place, they will no doubt watch Chile's ongoing reform efforts closely.

From the broad scope of pension reform in the region providing a wide range of policies and rules that affect pension adequacy, coverage, competition, costs, and minimum guarantees, governments have many choices of lessons they can learn from their neighbors.

This article was written by Stephen J. Kay, coordinator of Latin American analysis and of the Americas Center at the Atlanta Fed, and Tapen Sinha, the ING Comercial America Chair Professor in the department of actuarial studies at the Instituto Tecnológico Autónomo de México (ITAM) in Mexico City. Kay and Sinha are the editors of Lessons from Pension Reform in the Americas (Oxford University Press 2008). The article was adapted with permission from the book's overview, written by Kay and Sinha.