Examples: Case Studies on Personal Accounts
CHILE: The Trailblazer
Chile was the first country to tap the power of the market to correct the grave problems of its original social security system.
By 1980, Chile’s workers and employers were paying over a quarter of their salaries toward payroll taxes, but the system faced mounting deficits and potential insolvency. Led by a group of young free-market economists, including many who had trained under Milton Friedman at the University of Chicago, the government in Santiago proposed the first national-level personal account system in the world. This new system would end up being successful beyond anyone’s most optimistic dreams.
On May 1, 1981, every Chilean in the workforce was given an option: Remain in the traditional social security system, or transition to a personal account system. Under a personal account system, the burdensome payroll taxes would be waived, and in its place every worker would contribute 10% of his monthly salary into an account. Anyone who entered the workforce after this date had to opt for the new system.
These accounts were not abstract entities that could be modified, manipulated, or wiped away by some politician or bureaucrat. Rather, the Chilean workers who opted for the new system enjoyed full property rights over these accounts – the accounts were theirs, not the government’s.
The government’s role is instead to solicit and approve private-sector management firms, which create and manage investment funds for these new personal accounts. Chileans are given the choice to invest in about twenty different funds managed by experienced private-sector firms, called AFPs (Administradora de Fondos de Pensiones).[1] These AFPs include a diverse array of firms, from globally-recognized investment houses to local firms affiliated with labor unions.[2] The Chilean government regulates these funds to ensure that portfolios are properly diversified and safe, though some funds carry higher risk than others; some are heavier on stocks, others on bonds, etc.
In addition to this regulation, there are a number of built-in safeguards required by law. All funds are required to provide a minimum return on personal account investments. Furthermore, the government provides a guarantee that every Chilean retiree who opts for the personal account will earn at least about 40% of his average wages, which is slightly more than Social Security pays average income workers in the U.S.[3] If the personal account for any individual were to fall below this 40% level, the government will cut this person a check from general revenues to make up the difference. In the three decades since instituting this guarantee, the government has not had to make a single payment on the guarantee – even in the midst of the worst financial crisis since the Great Depression.
The Chilean system is driven by consumer choice. Workers do not need to be experts at investing in order to make informed decisions – every Chilean has access to world-class investment management companies. Workers can switch between funds quickly and easily, so the management firms have incentives to compete for customers and build the most attractive portfolios.
The AFPs are separate legal entities from the funds that they manage, so even if a particular management firm suffers difficulties, the personal accounts are shielded.[4] If necessary, the government will step in and reallocate the personal accounts to other AFPs based on consumer preferences – though this option has not been exercised once in three decades of the new system.[5]
Chileans also enjoy options about how to receive their returns once they reach retirement age. They can opt for an annuity that pays out a determined amount from their personal account every year. Alternatively, retired Chileans can withdraw from their accounts as needed (these withdrawals are subject to some restrictions based on the life expectancy of the worker and the needs of eligible dependents). Upon the death of the account-holder, the account can be passed to the retiree’s family or other designated heirs.
The new personal savings accounts were hardly a tough sell to Chileans fed up with the old system. By the end of May 1981, a quarter of the workforce had decided to transition to the new system. Within a year and a half, a whopping 93% of workers had opted to become investors instead of pensioners.[6]
At the time of the transition, the biggest advocates of reform anticipated a 4% real annual return on the accounts, an upbeat though still modest goal.[7] For the average worker, this would translate into annual retirement benefits equal to about 70% of pre-retirement income. For reference, our Social Security system pays out an average of about 40% of pre-retirement income in monthly benefits.
Even the biggest proponents were proven overly pessimistic. Workers pay 10% of wages into the system for retirement benefits. The real rate of return averaged an astounding 10.2% by 2004.[8] Payroll taxes were half as much, but benefits grew to twice as much: With such a strong rate of return, Chileans were on par to retire with almost 80% of their average late-career income.
Personal Accounts in America: The Success Story in Galveston
Until 1983, a loophole in federal law governing Social Security allowed state and local government employees to opt-out of the traditional program.
In 1981, employees in Galveston County, Texas decided to take their retirement into their own hands, and voted to ditch Social Security for a new defined-contribution plan. Under this unique plan in Galveston (which was subsequently adopted by a few neighboring counties in 1982), payroll taxes were dropped, and 9.737% of the employees’ salaries was put into this private account ever year. Houston-based First Financial Benefits bank houses these accounts, and lends out the funds to well-regarded investment firms in exchange for a guaranteed minimum interest rate for the employees’ accounts. Since 1981, the average rate of return has been between 7.5% and 8% for the account-holders, resulting in benefits much higher than traditional Social Security.
In fact, the projected benefits at just a 5% real return were twice or more what Social Security promises:[9]
–A lower middle income worker retiring at age 65 would get $1,007 per month from Social Security, but $1,920 from the defined contribution plan.
–A higher middle income worker averaging about $51,000 per year in income retiring at age 65 would get $1,540 per month from Social Security, but $3,846 per month from the defined contribution plan.
–A low income worker retiring at 62 would get $547 per month from Social Security, but $1,035 per month from the defined contribution plan.
But a later study using the actual, higher investment results under the plan concluded that workers participating in the Galveston plan for their entire careers would retire with benefits over three times as large as those promised by Social Security. For example, a career low-income worker earning $20,000 per year would receive retirement benefits of about $2,740 per month from the Galveston Plan, compared to $775 per month from Social Security.
These plans were so attractive that the federal government ended the opt-out provision in 1983, fearing that too many taxpayers nationwide would flee traditional Social Security for the dynamic new system.
Galveston employees, however, were grandfathered in and still enjoy this system today.
The Galveston experience mirrors that of Chile: A system that transfers control of retirement decisions from bureaucrats to workers, and ultimately yields much higher returns than traditional Social Security could ever provide.
[1] Jose Pinera, The Success of Chile’s Privatized Social Security, Cato Policy Report, Vol. XVIII, Number 4, Cato Institute, Washington, DC, August, 1995.
[2] Jose Pinera, Empowering Workers: The Privatization of Social Security in Chile, The Cato Journal 15.2-3 (1997).
[3] Pinera, The Success of Chile’s Privatized Social Security;Pinera, Empowering Workers.
[4] Id.; Pinera, Empowering Workers
[5] Pinera, The Success of Chile’s Privatized Social Security.
[6] Pinera, Empowering Workers; Jose Pinera, Retiring in Chile, Transform the Americas, www.transformamericas.org, 2001.
[7] Jose Pinera, Retiring in Chile.
[8] Research Department, The AFP System Myths and Realities, The Chilean AFP Association, August, 2004, p. 4
[9] Testimony of Don Kibbedeaux before the Senate Committee on Finance, Subcommittee on Securities, April 30, 1996; Merrill Mathews, No Risky Scheme: Retirement Savings Accounts That Are Personal and Safe, Institute for Policy Innovation, Policy Report No. 163, January, 2002.
