Social Security, and the Chilean AFP System

There’s been a lot of talk, lately, from the American political classes, about “reforming” Social Security. About the need for “tough choices”.

This isn’t surprising. Social Security is a demographic and financial time-bomb. With something like 60 million Baby Boomers about to begin retiring, the so-called “Social Security lock-box” is going to take quite the beating—especially considering that that famed “lock-box” is stuffed not with money but with IOU’s, placed there by the Treasury as it used the Social Security money to finance deficit spending.

People aren’t blind or stupid, even though they do seem to act that way most of the time. They know that Social Security can’t possibly afford to pay off what it owes the Baby Boom generation. Politicians of both parties are making rumbling noises, essentially in two directions: Cutting benefits, and finding an “alternative system”.

One of those alternative systems some American pundits and politicians have been looking at is the Chilean system of AFP’s—Administradoras de Fondos de Pensiones, literally “Managers of Pension Funds”. 
 
This system is a workable free market solution to the problem of funding worker pensions. Unfortunately for this good idea, the system was imposed by decree by the dictator Augusto Pinochet back in 1980—so right there, you have some major political hurdles to overcome. Already one American politician fried herself irredeemably by merely mentioning the “P”-word: I’m not sure if it was “Pinochet” or “privatization” of Social Security that did her in—but one or the other was to blame. 


The Chilean AFP system is quite simple: All workers—salaried and independent, state and private—are required to have a Cuenta AFP (individual AFP retirement account). Salaried workers are obliged to pay 10% of their earnings to their Cuenta—their account—up to a ceiling of about $250 per month; a worker can contribute more to their Cuenta beyond that $250 ceiling, but that’s voluntary. 

The AFP’s—that is, the companies that actually manage these funds—are all private: Privately run, and privately held. But they are severely regulated by the State, by way of the Superintendencia de Pensiones. They are regulated specifically (and obviously) as to which assets and investment vehicles the AFP’s can allocate the workers’ monies. The regulatory relationship is rather aggressively adversarial—deliberately so, as told to me privately by a former head of the AFP’s watchdog agency, the aformentioned Superintendencia. This official told me that the bureaucracy assumes that the AFP’s are all trying to actively cheat the workers—a very healthy regulatory attitude, as it insures that the actual rate of corruption remains minimal. What’s more—and crucially—a supervisory bureaucrat can never go work for one of the AFP’s. So the bureaucrat has no incentive to cut the AFP’s any slack.

The AFP’s manage the money in the workers’ accounts. Once a worker retires—at the age that the worker chooses—the AFP turns the worker’s account into a pension. The younger the worker retires, obviously the smaller the pension. Workers have insurance policies, in case of a catastrophic injury or permanent disability, which obliges the AFP to pay the worker the full pension if they are permanently disabled.

Workers cannot take any money out of their accounts before they retire—but they are free to move their account from one AFP to another. Hence AFP’s have the incentive to compete for clients. They therefore compete on two fronts: Higher returns, and lower administrative costs.

Each AFP pursues its own investment strategy with its clients’ money, though all of these investment strategies are carefully vetted by the Superintendencia. The AFP’s offer workers different risk levels for their accounts. State-imposed age limits make older workers ineligible for riskier fondos (investment portfolios), while younger workers can allocate higher percentages of their Cuenta to higher risk strategies.

Annual returns adjusted for inflation run from about 3.5% to as high as 20%, during good years and depending on the risk of the fondo—but there can also be bad years: At the end of 2008, most of the AFP’s experienced losses—in October of ‘08, the high-risk Fondo A were down about 45%, though the moderate risk Fondo B had dropped 14.25%, and the Fondo D (for those who will retire in 5 years) and Fondo E (for those about to retire) dropped by 4% and 0.35% respectively. And note that this was immediately after the Global Financial Crisis. On average, the AFP’s deliver about 5% to 8% annual returns, above and beyond inflation.

The system has been in place since 1980, imposed by the dictator Augusto Pinochet, and implemented by José Piñera, one of the original Chicago Boys, and the brother of the current president, Sebastián Piñera (who had nothing to do with the policy; the brothers famously despise one another, BTW, though publicly they act civil—most of the time). Pinochet left power in 1990, replaced by a Leftist coalition—La Concertación de Partidos por la Democracia—but in twenty years of power and four different Left and Center-Left presidents, the Concertación tinkered with the system a bit, but they never really touched it.

They wouldn’t have dared. There would have been hell to pay if they had—‘cause the AFP system works.

The AFP system not only changed the way people retire—it changed the Chilean people’s views on capitalism. Simply put, I would argue that with the AFP system, every Chilean worker became an instant and fervent capitalist, regardless of their supposed political beliefs.

Historically, Chile was an agricultural country. So the workers on the fundos—farms and ranches—received cradle-to-grave care in an informal system that was similar to a serf system. With industrialization, this sistema patronal was translated from the fields to the factory floor.

However, the pensions promised to the industrial factory workers were not always paid. Small companies might simply go bankrupt, medium-sized companies might cheat the workers, and large companies might simply ignore the workers.

The State was able to create cajas previsionales—effectively retirement savings accounts—but these did not invest in financial assets: They were strictly savings accounts, and so naturally, inflation had its way with these monies in due time.

Throughout the XX century, efforts were made to ameliorate the effects of the transition from an agricultural to an industrial economy, to little avail. In reaction to this failure, Socialism and Communism arose to defend workers’ rights, one of which was the right to a fair pension.

Most people depended on a company pension for their retirement—with all the uncertainty that that entails. Company pensions also maintained the mentalidad patronal—the patronal or serf mentality. People—workers—felt bound to the company: They did not feel free to work for a company, then change jobs, since they would then lose their seniority, which of course would affect their pensions.

So in a real sense, the XX century Chilean industrial economy was no different from the XVIII century Chilean rural economy, with regards workers and their employers—the only real difference was, farm workers had land, and food, and shelter. Industrial workers had none of that basic security—just the promise of a pension.

When the Allende regime won the election of 1970, and began imposing its Maoist-Leninist repressive and terrorist regime—because that’s what it was, repressive and terrorist, regardless of what its defenders might pretend—the situation came to a head. The Allende regime deliberately fomented worker unrest, using the threat of violent worker revolt to goad the different sectors of Chilean society—not just the oligarchs, but the military, the landed aristocracy, the foreign and domestic miners, the civil service, students (college and high-schoolers), etc.

It must be understood as I have defined fascism and corporatism previously, Chile was a fascist-corporatist country long before Pinochet.

Chile—long before the 1973 coup—was a syndicalist-corporatist country of competing union, social and corporate interests, where the State was one more competing interest among many.

This situation was what led to the near-civil war in September, 1973. Allende—in his urge to have the State (and his person) be the ultimate patrón de fundo (“plantation owner”)—essentially set the different interests groups of the country on a collision course. He radicalized the workers, played on the middle-class’ sense of economic uncertainty and social stratification, and tried to bring a crack in Chilean society where he could implement his Maoist-Leninist Socialist State. (This isn’t controversial—Allende said so himself in all his speeches.)

In this fascist-corporatist state which was Chile before Pinochet, the individual citizen was merely a cog within one of the corporate entitites or another to which he or she belonged—so naturally, the individual citizen allied himself with one of the competing interests in Chilean society, be it company or Party or union or class, in opposition to some other, competing interest from one of the other sectors of society. In other words, Chilean society was delineated like a street-gang, with everyone hell-bent on protecting their turf, rather than growing the country.

Pinochet—I believe deliberately—changed that. The more I study his policies, the more convinced I am that that was his conscious goal: To end the corporatist-syndicalist, competing-interest-group mentality that stratified and isolated different social groups in Chile, and which made the country a collection of competing and self-defeating little cliques, to the detriment of the country as a whole.

Whether I’m right or not on this specific issue is beside the point. What I can here say unequivocably is that, so far as the AFP system he forcibly imposed is concerned, it changed Chilean society forever—without question.

By imposing the AFP system in 1980, workers became free to move from job to job, and not be bound to any one company because of fear of losing their pension. Hence it gave the opportunity for real middle-class mobility. (Though Chile had always had a fairly large middle-class when compared to the rest of Latin America, it was stagnant, and bitterly divided by issues of social class: The inordinate social stratification of Chilean society makes the British class system look positively egalitarian in comparison. And much of this social-class bitterness expressed itself politically—with terrible consequences.)

By creating the AFP’s, and making them invest the money of the workers, the Chilean economy suddenly had a lot more home-grown capital chasing returns—so there was more local investment in small to medium-sized firms. Most of the wine and salmon industry in Chile was financed this way.

By freeing companies from the obligation of pensions—from the very idea of pensions—companies could behave like companies, and not like pension funds—or worse, like fundos. In other words, a company’s financial health of today and tomorrow is not affected by unwise but binding promises made twenty or thirty years ago. Look at GM, loaded with all those promises made to UAW workers—no Chilean company has such a burden. 


It also shuts out the State from managing money—which is something devoutly to be wished. A State with excess cash is a State which will spend that cash—the famed Social Security “lock-box” is a case in point: The money American citizens have contributed to the system is not parked there, carefully earning interest. It’s gone—spent on foolish wars and monstrous health care plans. By keeping this money away from the State, the AFP system reduces the State’s temptation to simply throw money at problems, and instead actually solve them.

Finally, a subtle but exceedingly important effect of the AFP system, which I mentioned before briefly, is that it makes everyone a capitalist. I actually think it’s the most important of all of the effects of the system. In Chile, everyone follows their Cuenta de AFP as closely as the soccer league. Closer, even: You get a statement in the mail every month, telling you how much you added this month, how much your nest-egg is now worth, and how much you would receive were you to retire right now, or continue to add to your Cuenta until 65. It’s a heady feeling, and it makes Chilean society very protective of private corporations and companies. Strikes happen, but far fewer—usually for genuine financial reasons, not for random political reasons, as used to be the case. And unlike before 1973, striking workers don’t destroy machinery or other assets. It has become politically unpopular—not to say anathema—to disrupt the economy for the sake of making a political statement. People measure work stoppages of any sort by how much the overall economy lost—because that is now the measure of how much an individual’s Cuenta has lost. People actually bitched about the February earthquake in terms of damage to the economy, and how lucky Chile was that it happened at the start of a weekend, instead of in the middle of a work-week—I’m not kidding.

In other words, with the AFP system, every citizen feels he or she has skin in the game, so far as the overall economy is concerned. This is an extremely significant effect of the system—I believe the most significant—as it points the way for other developing nations, and how they should organize their domestic economic life, in order to achieve stability and progress under a Capitalist regime.

Now, the AFP system isn’t without flaws. Critics in Chile tend to focus on two aspects: The dwindling of the AFP’s down to half a dozen companies, and the possible oligopolistic tendencies that that might entail; and the lack of “democratic representation” on the boards of directors of the AFP’s. 

Insofar as the first criticism is concerned, from an original 12 that began in 1980, the number of AFP’s grew to 22 by 1994. Through buy-outs and consolidations, there are now 6. The largest, Provida, has 43% of the market as measured by assets-under-management, the second, Habitat, 24%, the remaining four fractions thereof. But none of the six have acted oligopolistically, and all are tightly regulated. Indeed, all of their mergers occurred under Left-leaning regulators. And to top it off, market share does tend to swing wildly, as customers vote with their feet—after all, they can move their account to a better, higher yielding AFP whenever they want. So in my opinion, the first criticism is a possibility to be prevented, but not a near-term possibility that might cause concern. 

The second “criticism” is really a complaint by Union officials and the professional Left, who are marginalized from participation in this virulently Capitalist scheme because of their own views. The same people and parties who want more “democratic” representation on the boards of the AFP’s are the same people and parties who regularly call for the end of the AFP system altogether. Their “criticism” can’t be taken seriously.

My own criticism goes in another direction: As a Chilean, I object to the fact that workers’ Cuentas diminish during bad years, such as 2008, whereas in good years, the AFP’s enormous profits—albeit well-deserved—remain in their coffers. In other words, I think there ought to be a High-Tide Mark: If the individual Cuentas diminish during a bad year, then the AFP ought to go into its back profits and “top-off” the workers’ accounts. Call it socialism, call it what-you-will: It doesn’t seem fair to me that the AFP—earning good money off of managing its customers’ monies, which they are legally bound to deposit with the AFP’s—should not share the pain when times are tough. The AFP’s have the privilege of receiving citizens’ monies by order of the State—they ought to share the pain when things go south. (This is a similar objection that many people have to hedge funds—and which is why I'd never buy into one.)

These criticisms aside, since Pinochet left in 1990, there haven’t been any serious, structural changes to the basic system. Independent workers and the poor have been encouraged to join, and a few cosmetic changes have been implemented—but basically, it’s worked like a charm.

How does this Chilean pension fund system help the U.S.? Well, in a word, it doesn’t.

Chile is a historically poor country—hence Chileans are aware that the State cannot provide everything. Manipulating the private sector into a course of action which creates a public good—such as the AFP system, such as the ISAPRE (health care) system—yet at the same time creates a profit (and therefore an incentive) for the private sector, is something that Chileans have gotten into only recently; really since Pinochet starting in ’73. But boy has it caught on!

The average American citizen, on the other hand, has gone in the opposite direction. American citizens fully believe that the U.S. Government can do it all—fight all the wars, pay all the bills, in short, “do what’s right”, etc. In other words, Americans believe in a Mommy State—the Great American Teat. It should come as no surprise, then, how willingly Americans allow their basic civil rights and liberties to be trampled by the Government—attitudes such as those exhibited by American politicians and leaders would be cause for outrage in Chile. But American citizens are as docile as sheep—except when it comes to what they believe is coming to them.

Every American believes they are owed Social Security. What was once a stop-gap, temporary measure adopted by Roosevelt at the height of the Depression, which could be easily financed with 30 workers to every retiree, is now a monster-spending program—it has gone off the rails. According to George W. Bush’s State of the Union speech of 2005, in 1950, the ratio of workers to retirees was 16 to 1. At the time of his speech, it was 3.3 to 1. And by the time the Baby Boomers retire, he said it would be 2 to 1. He said it—George-fucking-dubya-fucking-Bush in a State of the Union speech. Not exactly Noam Chomsky at a Bennington College coffee klatsch.

The Social Security shortfall is inevitable—but American citizens are unwilling to sensibly change their pension system. They lack the political will to do it for themselves, and there is no dictator—such as Pinochet—to force the country to do it.

Therefore, the outlook is inevitable: Social Security will either be cut, or taxes will rise to pay for it.

I believe shrewd policy makers are hoping that inflation helps the cause and gives Social Security beneficiaries a de facto haircut. These policy makers—Bernanke, Geitner, Summers—seem to believe that inflation is the only way to stave off The Deficit, which of course includes Social Security. But as I have argued, I do not believe you can have “controlled” inflation—and as I have further argued, once the Fed’s “asset purchases” (id est, money printing) reaches a certain tipping point, nearly-flat Treasury yields will reverse and skyrocket, as people lose faith in U.S. sovereign debt, and this will trigger hyperinflation.

If there is hyperinflation—as I believe there will be—then Social Security recipients would be the first to clamor for an “adjustment”. Call it the Mother of all COLA’s. Therefore, cuts in benefits are unlikely.

Karl Marx said it best: A democracy will fail when the people realize that they control the purse strings. In America, in short order, there will be more retirees—who will be politically better organized—than the rest of the population. Therefore, taxes will skyrocket, to pay for these people who didn’t plan for their own retirement. What would be the effects of way higher taxes in a stagnant economy? You fill in the blanks.  

Social Security should have been privatized back in 1985—now, it’s far too late.