In 1981, Chile was the first country to adopt the World Bank’s recommended Tier 2, compulsory pre-funded retirement savings scheme. In summary:
- Tier 1 is now a pension that is both means-tested and reduced by any pension that emerges from Tier 2.
- Tier 2 comprises member accounts that are managed by private providers and into which all employees contribute 10% of pay to build up a retirement saving account. An additional 1.5% of pay (approx.) pays for the costs of insurance and administration. At retirement, there are rules about how the retirement account is applied. There are two main choices – a ‘phased withdrawal’ (PW) that is calculated according to a regulated formula, or a life annuity.
The 2008 reforms that strengthened Tier 1 are described here. This 2009 report looks at how the system was working to distribute benefits at the retirement age.
The PW option leaves the investment and survivorship risks with the retiree. With an annuity both these risks are passed over to the annuity provider that gets a 2% commission from the retiree’s balance. Again, there are rules about the terms on which the annuity is calculated. The government underwrites the possibility of provider-failure.
“One of the most interesting features of the Chilean pension system is that approximately two-thirds of all retirees purchase annuities, a very different result from other countries.”
The report puts this down to a number of factors:
“1. High value of annuity payments. Money’s worth ratios for the Chilean pension system are high in comparison with international experience and appear to be rising over time.
“2. Information transparency in the annuity bidding process. The transparency and ease of the online mechanism makes it easier for retirees to find good information on annuity premiums. In addition AFPs are now required to issue a list of people nearing retirement age to all the pension providers, as a means to boost competition.
“3. Access to early retirement. Chilean law permits people to retire early if their pension accrual meets certain payout thresholds. Since one need not leave the labor force in order to receive the pension, people with sufficient accruals in their AFP accounts will value access to the funds. Most of these retirees with substantial balances are unlikely to have their benefits fall to the MPG threshold, so they are more likely to annuitize.
“4. Small incentives for the AFPs to promote PW. The AFP managers are mainly paid based on affiliates’ contributions and are prohibited from paying commissions to insurance brokers. Furthermore, AFP’s are not permitted to charge a front-end fee to retirees who leave their money with the AFP, so agents have little incentive to encourage phased withdrawals. All AFPs charge a fee of 1.25% on the pension balance in order to provide pension payouts.”
However, the report notes some issues that need to be addressed. Sex-specific annuity rates are used and women can access their accounts from as early as age 60. Partly because of this but also, mainly, because of low lifetime earnings, “…women’s benefits are relatively low compared to men’s.”
Also, the low, income-tested Tier 1 has apparently encouraged savers to buy “…annuities to help smooth old-age consumption as long as there was some chance of not getting welfare support.” The previous minimum contribution period of 20 years for Tier 1 entitlements (eliminated in 2008) also apparently reinforced that.
PensionReforms suggests that some of these influences will probably reduce following the improvements to Tier 1 in 2008. The report suggests that the global financial crisis may reduce Chileans’ confidence in annuities.
Given the importance of commissions in the Chilean system, PensionReforms thinks the front-end fee is likely to be the most significant influence. The AFP gets nothing extra from the PW option while it is in the direct economic interest of sales staff and brokers to encourage annuitisation. The underpinning government guarantee for the annuity option is likely to feature prominently in the sales pitch.
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