CODEL MCCONNELL DISCUSSES CHILE'S MIXED SUCCESS

UNCLAS SANTIAGO 000227

SIPDIS

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN EINV PGOV CI
SUBJECT: CODEL MCCONNELL DISCUSSES CHILE'S MIXED SUCCESS
WITH PENSION REFORM


1. (SBU) Summary. Chile,s privatized pension administration
(Administradoras de Fondos de Pensiones--AFP) superintendent
Guillermo Larrain briefed Codel McConnell on the strengths
and weaknesses of Chile,s pension system at a January 13
meeting in Santiago. Chile,s three-pillared pension system,
instituted in 1981, now covers a majority of Chile,s
workers. Larrain said the creation of the AFP had also
served as an enormous catalyst for the development of Chile's
capital markets, greatly assisting businesses and consumers
in obtaining credit. However, Chile,s pension system faces
a key challenge as its system is mandatory but not universal.
According to Larrain, this means that up to 25 percent of
Chile's workforce -- primarily the sporadically and
self-employed -- was outside the AFP. This segment of the
population would continue to depend on public sector budget
transfers for retirement funding. Larrain said several
foreign countries had adopted variants of the Chilean model
to reform their own pension systems, with Sweden the most
similar in his opinion. End summary.


2. (U) Meeting participants:
-- U.S.: Senator Mitch McConnell (R-KY),Senator Mel
Martinez (R-FL),Senator Richard Burr (R-NC) and Senator John
Thune, Ambassador Craig Kelly, Professional Staff members Reb
Brownell, Thomas Hawkins and Paul Grove, Military Escort Col.
Chris O,Connor, Embassy chief economic officer and Embassy
notetaker.
-- Chile: Guillermo Larrain, Superintendent AFP, AFP Chief
of Staff Manuel Aylwin.

Three Pillars
--------------


3. (SBU) At a January 13 meeting in Santiago, AFP
Superintendent Larrain told Codel McConnell that Chile,s
pension system has three pillars:
a) Mandatory, set contributions for most workers, held in
privately-managed accounts with five portfolio options
available;
b) Voluntary additional contributions to retirement
accounts, which increase benefits at retirement; and
c) A minimum safety net for Chile,s poorest seniors, which
is financed by the government.

Larrain touted the national benefits of Chile,s pension
system, such as the huge infusion of capital into Chile,s
financial sector through pension fund investments. At the
same time, he admitted that Chile,s system remained only
partially-implemented after 25 years. He said the AFP
currently faces major challenges as it seeks the right
balance of reform and incentives that will bring Chile,s
marginally or informally employed (20-25 percent of all
workers) into the system.

First Pillar: Mandatory Savings
--------------


4. (SBU) Larrain explained that workers in Chile, except for
the self-employed and members of the military, automatically
contribute to mandatory individual AFP pension accounts,
which are in turn invested in portfolios. Workers choose
from among five portfolios, each offering varying levels of
investment risk. Workers can choose from six investment
companies to manage the portfolio they choose. For the
mandatory pension accounts, management companies can only
offer the five portfolio options designated by Chilean law.
However, under the additional voluntary savings plans there
are other investment vehicles offered by the management
companies, as well as by banks and insurance companies.


5. (SBU) The AFP system, instituted by the Pinochet
government in 1981, has served as an enormous catalyst for
the development of capital markets since its inception,
Larrain noted. The growth of Chile,s financial markets has
greatly eased credit for businesses and consumers. Chilean
homebuyers can purchase property without a downpayment with a
mortgage term as long as 40 years. Pension fund managers, as
the largest institutional investors in Chile, are a key
contributor to Chile,s economic progress and stability.


6. (SBU) Larrain said that financial institutions face legal
restrictions on the use of pension funds and percentage caps
for investment in any particular sector. He said one of
AFP,s main reform objectives was to loosen these

regulations. These restrictions had limited further progress
in the pension funds, role in underpinning and expanding
Chile,s capital markets.

Large Informal Employment Sector
--------------


7. (U) While the privately-managed funds have an impressive
10 percent annual real return, Chile,s pension system faces
a key problem: 20-25 percent of the Chilean workforce is
informally employed or only sporadically employed. Larrain
explained that AFP studies had shown informally employed
workers generally saved little, made no pension contributions
and did not pay taxes. For this segment of the workforce,
the AFP,s mandatory contribution system could appear like a
tax, with informally-employed workers often not understanding
the difference between a tax and pension contributions. The
fact that Chile,s "mandatory" pension system was still not
universal meant a significant segment of the working
population would continue to depend on a government safety
net, whose financing could be a drag on the economy.


8. (U) The short-term economic needs of these lower income
workers nearly always trumped retirement savings, Larrain
continued. The result was a large percentage of Chile,s
population not participating in the country,s pension system
at all, thus having no retirement savings, since the AFP
accounts are funded by the employee, not the employer or
government. The U.S. did not have this problem, he said, as
all workers -- even those receiving unemployment compensation
-- must pay Social Security.


9. (SBU) Larrain said that a large infusion of government
money would be needed to bring Chile,s informal workforce
into the pension system. Incentives such as government
matching contributions would likely be needed to encourage
them to fund their own retirement accounts. He said a
large-scale cash fix would not be a responsible or effective
solution, however, if much of the infusion were to go into
the pockets of fund managers rather than workers, pension
accounts. In this regard, Larrain explained that private
managers often charge fees higher than fees charged by banks.
As an alternative to the higher fees, he asserted, the
pension system could meet its long-term goals with lower
returns than it currently enjoys by shifting pension funds
into instruments with minimal management costs, such as
savings accounts.

Aging Population Also Challenging
--------------


10. (U) Larrain noted that Chile,s population was quickly
aging, while pension-eligibility ages remained relatively
young. While there is no mandatory retirement age, Chilean
men become eligible for AFP pensions at 65 and Chilean women
at 60. With increasing life expectancies, especially for
women, these eligibility ages were leading to longer and
longer retirements, in which retirees no longer contributed
to pensions but received benefits. At the same time, some
Chileans choose to start withdrawing their pensions while
still working at the same or a different job, since there is
no mandatory retirement age. Chilean labor law expressly
forbids termination of employment simply because the employee
chooses to start receiving his AFP pension. This put
financial strain on the pension system, which AFP was seeking
to alleviate through reform proposals that made it less
attractive to retire. While raising the minimum
pension-eligibility age was a possible solution, Larrain
said, a more effective mechanism might be to create a point
system that offered incentives for later retirement.

Second Pillar: Voluntary Additions
--------------


11. (SBU) Larrain said that while the basic pension system
relied on mandatory contributions, employees were free to
make additional contributions. As pension payments at
retirement are directly linked to contributions during an
employee's working years, additional voluntary contributions
were in employees, interests, he said. Another incentive
for contributions above the mandatory level was the
possibility of a one-time cash-out at retirement. If an
employee's accumulated retirement savings is high enough
(normally at least 150 percent of average lifetime pension

contributions),the retiree could collect the excess as a
lump-sum and use it without restriction.


12. (SBU) While the amount of mandatory pension contributions
is fixed, Larrain continued, fees and returns on plans could
vary significantly as a percentage of a worker's income.
Encouraging more voluntary contributions could thus be
confusing. Moreover, while competition among funds should
lead to lower administrative costs associated with pension
management, in reality entrance into this market was
difficult and thus competition weak. Larrain said that just
as relatively simple options among 401(k) plans in the U.S.
were confusing to workers, Chilean workers were often
confused by differing price structures and benefit plans
offered by private managers for these voluntary, additional
retirement contributions.

Third Pillar: Minimum Guaranteed Pension
--------------


13. (SBU) Larrain bluntly noted that the minimum guaranteed
retirement benefit was underfunded and did not meet some
seniors, basic income requirements. While Chilean retirees
who contributed pension savings throughout their working
years usually received at least 50 percent of their former
income, efforts to pay out a minimum guaranteed retirement to
everyone had been unsuccessful. The minimum guarantee (only
available at the legal pension-eligibility age of 65 for men
and 60 for women, even if the individual had left the work
force before reaching that age) was not sufficient to meet a
retiree,s basic living expenses. Even this limited amount
had not been paid in full because of inadequate government
budgeting to fund the minimum guarantee. Improving the
minimum guarantee and payouts to the poorest seniors, he
said, was a challenge that the Chilean government and the AFP
must overcome.


14. (SBU) Given the challenges of currently providing a
minimum basic income to Chile,s seniors, Larrain complained
of how the variety of private management plans and price
schemes confused Chileans, discouraging additional, voluntary
contributions. Larrain said that while the AFP was
supportive of more investment options, it opposed allowing
investment companies to increase the pension funds,
liquidity before retirement. Larrain did not support
allowing programmed withdrawal of funds by retirees after
retirement. While a programmed withdrawal would allow for
the flexibility to pass on monies to retirees, heirs,
something not possible in an annuity-type system, it also
passed the longevity risk on to the retiree as well.

Others Look to Chile's Model
--------------


15. (U) In discussing the Chilean pension system,s strengths
and weaknesses, Larrain noted other nations, experiences
with retirement systems similar to Chile,s. He said Mexico,
Hungary and Poland had adopted systems influenced by the
Chilean model, with varying success. A key difficulty many
of these systems faced, especially in Europe, was workers,
ability to maneuver between pension systems, making it
difficult to ensure relatively constant returns. Also,
Larrain noted that lowering pensions was highly unpopular,
even if mandated by legitimate economic factors. This
further argued for a more stable pension system where workers
would not increase the risk of not being able to fund fully
their own retirement by transferring between pension plans.

Sweden's Pension Reform Seen From Chile
--------------


16. (U) The most interesting example, and the best case study
for other governments, Larrain offered, was Sweden,s pension
reform. Unlike Chile,s pension overhaul, which was
introduced under the Pinochet dictatorship and involved a
mandatory migration of most of Chile,s workers over to a new
system, Sweden,s more gradual reform plan was adopted
democratically. The first step in Sweden,s incremental
reform from the current &pay-as-you-go8 model was the
introduction of capitalization in private accounts, with
points rather than monetary amounts as the basis of future
pensions. Unlike Chile,s drastic ending of its
&pay-as-you-go8 system, Sweden allowed a gradual transition
to government-regulated but privately-managed accounts.

Additionally, Sweden,s new system included the critical
element of linking amounts contributed to amount received at
retirement, which Larrain felt was a critical correlation.


17. (U) For Larrain, a possible flaw in Sweden,s new system
was that employees had too many (nearly 600) different
portfolios from which to choose. As most employees had
neither the capacity nor the patience to weigh the benefits
of 600 portfolios, the variety of choices introduced
confusion. Larrain also mentioned that Sweden,s social
welfare system and pension benefits, among the most generous
in the world, combined with its rapidly aging population,
created different challenges than would be faced in
retirement savings reform elsewhere.

Chile's Pension Reform &Best Practices8
--------------


18. (SBU) Regardless of which model a country followed,
Larrain said that successful pension systems shared several
key attributes:

-- They were simple systems with a clear correlation
between the amount of worker contributions and the amount of
benefits paid during retirement;
-- There was a limited number of portfolio options, with
low management fees, all presented in a user-friendly format
(Larrain said that President Bush,s portfolio proposal,
similar to the USG,s own Thrift Savings Plan for its federal
employees, was very good in this regard);
-- The systems had default options, perhaps with a
risk-return profile that tracked employee age and reduced
risk over time; and,
-- There existed easy entrance and conversion procedures
for both new workers and those seeking to convert their
existing social security accounts/pension plans into a
capitalized, universal system.


19. Codel McConnell did not have an opportunity to clear on
this message prior to departure.
KELLY