Excerpt from Pension Confidential:50 things you don’t know about your pension and investments. By Robert Drummond & Chris Roberts. Reprinted by permission of James Lorimer & Company, Ltd.
Some experts have recommended that Canadians consider reforming our pension system to bring it more in line with the one that was put in place in Chile in the late 1980s. This chapter will explain why we believe this is a bad idea.
In 1981 the government of Chile introduced a major reform in the country’s retirement system. It began to force workers in formal jobs – jobs with clear employers and regular pay – to make contributions to individual private pension accounts. Workers were not just being required to save 10 per cent of their earnings, they were also forced to pay an additional fee for disability and survivor insurance and to pay a fee to the private firms who managed their money. When they retired, workers could use the money they had saved to buy an annuity, or they could simply draw it out in phased withdrawals like a bank account.
If the workers bought an annuity, the amount of money they would get each month depended on the rates set by an insurance company – rates that determine what a company will agree to pay you over time when you give them your savings up front. If they decided to draw out their savings themselves, they would still be relying on the money management firms to continue investing their funds and managing their withdrawals. Government limited the amount retirees could withdraw each month, in the hope that they could prevent people from using up all their savings before they died. But the withdrawal limit does not match the needs of retirees, and there’s still no guarantee that people won’t outlive their money.
Chile had a pension scheme in place before the reform. It was made up mainly of pay-as-you-go plans. In this type of plan, today’s workers pay today’s pensioners, and tomorrow’s pensioners rely on tomorrow’s workers. Most plans had defined-benefits, a known pension related to your years of work, but the benefits were not guaranteed, and the plans were too varied to produce any consistency among workers. The existing scheme clearly needed improvement, but did Chile choose a good alternative? The government chose private accounts instead of a public plan, and defined contributions instead of guaranteed benefits. By the time you’ve finished this chapter, we think you’ll agree those were not good choices.
The Chilean model got some fresh attention recently when it was strongly recommended by Newt Gingrich as a replacement for U.S. Social Security when he was running for the Republican presidential nomination. Some Canadians also like the Chilean example. You’ll like it if you believe, like Gingrich, that individuals should be required to compete through their own private accounts –with chances for big gains but with the risk of big losses – rather than co-operate in a public scheme to produce a secure retirement income. Remember that the Chilean system does not simply give you an opportunity to gamble with your own retirement savings. It requires you to pay a money manager to gamble for you.
Mind you, the Chilean model is not as unregulated by government as those who favour it sometimes imply. What protections does the government of Chile provide? First, the government requires that firms managing pension funds guarantee a minimum rate of return. As a result, most managers hold similar portfolios of stocks and bonds. They’re not gambling as much with your money, so how do they justify the fees they charge? Required contributions with a minimum guarantee are similar to what we call a “hybrid” plan in Canada, and we treat such arrangements as defined-benefit plans. Workers probably hope to retire with a pension well above the minimum, but that may not happen. But at least they have a small measure of security in a system that otherwise makes them take all the risks. Of course, Chilean workers’ ultimate benefit is still not guaranteed – only the rate of return on their funds. They still have to deal with annuity rates or phased withdrawal limits when they retire.