In August 2016, the Chilean government approved a law that reformed the way in which Chilean pension funds, or AFPs, could invest, both in the international and local markets. This legislative action is part of a larger strategy aimed at improving the competitiveness of the Chilean economy after years of mediocre growth.
This new set of reforms should have a significant impact on Chile’s economy, as the AFPs - a US$176bn business- are the largest investors in the local Chilean market, one of the most developed in the region.
“For years now the AFPs have been battling against declining returns as well as the lack of domestic investment options, while at the same time Chileans are protesting against low pension payments”, Marcos Morales, Economic Professor at the University Diego Portales explained.
In the 1980s the average return of the AFPs was 12%, 10.4% in the 1990s, 6.3% in the 2000s and just 4.3% since 2010.
Consequently, the new law authorizes investments in capital debt, real estate assets, infrastructure and investment fund bonds, while eliminating regulatory restrictions that up to now have hampered the ability of AFPs to make commitments of future participation in investment funds.
According to Alejandro Ferreiro, former Superintendent of Pension Funds (SAFP) and former Minister of Economy, these reforms will give preference to direct investments in infrastructure or real estate assets and indirect investments - through investment funds- in non-traditional assets, which could provide better returns, but at the same time present higher risk.
The success of these reforms is yet to be determined, the former Minister noted.
“It will depend on the secondary regulations to be implemented by SAFP, in particular, those dealing with the arduous task of assigning daily value to illiquid assets; and also on the disposition of AFPs to actually participate in assets, that, if true, provide better returns, but could also represent not only a financial, but a reputational hazard."
Ferreiro also mentioned that many AFPs - which manage billions of dollars - might not be too keen on explaining to the national press a possible “failure” of investments that are immaterial, compared to the rest of their global portfolio.
Further, the effectiveness of these reforms, which are set to be implemented in August 2017, will not become apparent right away. AFPs will need to build up teams of investment advisers and strategies before they can make use of the new law, which might take a considerable amount of time.
Both Ferreiro and Morales agree that the reforms will not represent a significant change in EMDs, given the fact that the AFPs already have the option to invest in these types of securities.
"The essence of the reforms is to incentivize the investments in assets that generate direct cash flows, rather than in new debt instruments,” Ferreiro stated.
AFP and the Chilean people: a broken relationship?
However, the new reforms will only address part of the issues facing the Chilean pension system. AFPs’ problems run much deeper that just poor returns. AFPs have become quite unpopular amongst the Chilean public, and politicians made them the centrepiece issue of the November 2017 elections.
For many years, institutions like the World Bank held up Chile’s defined-contributions pension system as an example to follow, and more than 30 countries have across Latin America, Southeast Asia, and Eastern Europe used it as inspiration, and with good reason.
The system worked very well upon its implementation during the 70’s by former dictator Augusto Pinochet and his “Chicago Boys”. In particular, Chile’s capital market roared to life, and pension funds now exceed $170bn, or around 70% of GDP. It also played a key role in turning Chile into the richest country in the region, lifting millions out of poverty.
However, today the reality is very different. Chileans receive the lowest average pension among the 35 nations of the Organization of Economic Cooperation and Development (OECD), barring Mexico.
Many also complain that lack of competition has allowed the privately owned AFPs to earn disproportionately high fees. Currently, investment returns have averaged more than 8%, and it has been that way since the system was founded. But in practice - after commissions - net returns are closer to 3%, according to a report published in 2015 by the Commission of Pensions reforms.
Other problems that contribute to the poor returns for workers included insufficient or irregular contributions by the many self-employed workers and those with unstable, seasonal or low-paying jobs, as well as the failure of some employers to pass on the money deducted from employees’ salaries.
The average monthly benefit is about US$300, less than earnings from a minimum wage job. The problem is made worse by inconsistent payments and a large shadow economy.
The low rates of contributions are another major issue in the pension system in Chile. Today, Chileans’ 10% contribution rate, just half the average in the OECD, is simply too small. As a result, the common benefit, including a supplement paid to poor people, is 45% of a pensioner’s final salary, well below the OECD average of 61%. Women are even worse off - they take home pensions worth 31% of their final salaries, compared with 60% for men.
As Chilean struggle in retirement, the anger has been directed toward AFPs. In July 2016 almost one million took the streets to demand change in the pension system.
The bubbling anger boiled over when it was discovered that the former wife of a Socialist Party leader was allegedly receiving a monthly pension of almost US $7,800 after retiring from the prison guard department. That figure dwarfs the average monthly pension, which is less than a monthly minimum-wage salary of US$384.
The AFPs and the government have failed to stress enough that the regular contribution level, when interrupted by spells of non-employment, would not provide pensions that could meet the 70% target; just 0.2% of workers top up their contributions.
Competition between the AFPs - mostly foreign-owned – has been largely desultory, allowing them to keep commissions high. Several AFPs reduced them after reforms in 2010, during which the AFPs offering the lowest commission were awarded all the new contributors.
This new wave of social rage could be dangerous, with some analyst believing that it could open the door to populist politicians that promise to use the system’s funds, which underpin local capital markets, to make higher payments now, or give way to more and more extreme proposals.
Chile´s current president, Michelle Bachelet is trying to force employers to pay 5% of workers’ wages, which would then be used to redistribute money to the poor, topping up reserves from people’s private savings accounts. Until now, the burden has fallen on the workers, who currently pay 10% of their salaries into their savings accounts.
“Chile is slowly moving to raise solidarity in the system: it will still be private, but with the new reforms, employers will have to contribute to the pension funds,” Morales explained.
However, the current proposals could add around US$1.5bn, or 0.5% of GDP, to the fiscal burden of a government that is already suffering from the unwinding of the commodity boom.
This is why, for Ferreiro, the debate of broader pension reforms in Chile is still very “unclear,” and while he does agree that the pension-wage is insufficient, he claims thhe low levels of contributions as the underlying cause.
“Even though pensions are low in many cases, it is mostly due to poor contribution levels, which are now around 10%. The low density of contributions, the increase in life expectancy, the recent decline in interest rates and the consequent low return of pension funds are forcing people to direct their anger at the AFPs, which were never popular to begin with. But this is a problem that will not be solved until the savings rates in Chilean society increase.”