Should Canada reform its pension system to mirror Chile’s?

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.

We're told that one of the benefits of private accounts is that they'll earn you higher returns on your investment than a public plan. But once the commissions of fund managers are taken out, the returns on investment in the Chilean system are not higher than average. Over the long term, leading up to retirement and subtracting the fees retained by the money managers, the returns are in the range of 4.5 to 6.5 per cent per year.

We're also told that another benefit of multiple private plans is that money managers will compete with one another to attract customers. As it happens, there are very few firms managing pension accounts in Chile, and they mostly charge very similar fees. These fees are set as a percentage of the amount invested, and the firms have to charge all investors the same percentage rate. That means firms do best by getting large contributions from investors. So rather than offering lower rates to attract customers, most managers try to increase their profits by attracting funds from workers with higher, more stable incomes.

When the new scheme was introduced, the Chilean government made some arrangements to ease the transition. For example, it guaranteed a minimum pension to low-income workers who had contributed to the existing system for at least twenty years. It paid for the minimum pension out of regular taxes. It also introduced a means-tested "welfare" pension for the poor elderly, amounting to about half the minimum guaranteed pension and also paid for out of taxes. Later it converted these anti-poverty measures into a basic, universal pension.

In Chile – and more and more in Canada – a significant number of workers do not have regular, formal employment. Some are self-employed, and many are employed irregularly or in informal situations without secure wages or hours of work. What does the Chilean model provide for them?

Those who are self-employed, or who are outside the formal labour market, can contribute to a separate voluntary system. Those who are regularly employed and make the 10 per cent contribution to the mandatory system may make additional contributions, if they are able and willing, to this voluntary system as well. The number of firms managing voluntary pensions is greater than the number in the mandatory sector, so there's somewhat more competition for customers. Still, the voluntary contributions come mainly from better-off workers. As with Registered Retirement Savings Plans in Canada, the tax benefit is greater for higher-income workers, and those workers obviously have more disposable income to invest.

The Chilean system has some aspects that are not so different from the current Canadian system. Where it does differ from the Canadian system, it creates problems that make it less attractive in meeting the goals of a good retirement income program.

In what way is the Chilean system like our Canadian one? First, the mandatory accounts are similar to the Canada Pension Plan, except that there are no mandatory contributions from employers. And the accounts are separate and privately managed. Second, the original minimum guaranteed pension had a function like the Old Age Security pension, except that it was available only to those who had paid into the pension system. Third, the means-tested welfare pension was like the Guaranteed Income Supplement, available to those with extremely low income, regardless of work experience.

How does the Chilean model differ from our system? First, the accounts, though heavily regulated and managed by very few firms, are invested by private companies who charge a significant administrative fee for their services. Second, pensions are not adjusted to account for years spent out of the labour force (while raising children, for example, or improving your education). Money managers charge high fees, and unemployment weakens pension accounts. Therefore the Chilean system – at least as it was originally designed – did not prevent high levels of poverty among the elderly.

In 2008, the government of Chile made some changes to improve the system. Ironically for those people who think we should bring the Chilean model to Canada, many of those changes have made the system in Chile more like the one we currently have here. The Chileans replaced their minimum guaranteed pension and their welfare pension with a basic pension, payable to everyone at age sixty-five, regardless of work experience. Like the Canadian Old Age Security pension, it's funded out of general tax revenue and is taxed back from those with high incomes. Chile also undertook some changes to make the operation of individual accounts better and to subsidize the pension contributions of low-income workers. Yet private management fees remain and annuity rates are still set by the private market.

So what lessons does the Chilean experience have for us here in Canada? First, even though the management of pension funds is private, the Chilean government has been called upon to regulate these funds so that workers do not face investment risk and longevity risk without protection. Second, Chile, like Canada, has not trusted an unfettered private market to prevent poverty among the aged. It too has introduced a basic pension paid from general taxation. Both countries have apparently agreed that it's desirable to make a modest redistribution of income by taxing the better-off to pay pensions to those less well-off. Third, the fees charged by private money managers are supposedly justified by higher investment returns at the same level of risk. The Chilean example suggests that the returns from private managers are not higher if any measures are taken to reduce risk.

We should explain why that last point is important. Some advocates of the Chilean model for Canada argue that the Chilean results are distorted because their money managers are restricted in the range of investments they can make. Reduce the restrictions, they say, and the returns will be higher. That's fine, except restrictions on money managers are generally intended to reduce investment risk. Most of us would probably say it's okay for individuals to take risks voluntarily when they can afford to do so, in order to seek higher rewards. But most wage earners don't have the flexibility of high income to take such risks. Shouldn't they have a good chance to secure their retirement income with reasonable returns and less risk?

The way to do that, of course, is with a scheme that requires contributions from both employers and employees, makes some provision for years out of work, and combines many workers or "investors" in one plan. In that way, the risks and gains are shared, and the ups and downs in both are smoothed out.

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.