Chile is revamping its so far successful private social security system to offer pension savers more equity choices -- and risk.
By Jonathan Kandell
March 2003
As her taxi squeezes through downtown Santiago’s narrow streets, Jacqueline Villanueva, account executive for BBVA Provida AFP, Chile’s largest private pension fund manager, concedes that she is a bit on edge -- “un poco nerviosa.” She’s headed for the Banco Central de Chile to sell its employees -- including some of the country’s most financially savvy executives -- new pension policies that offer a range of investment choices, from high-risk portfolios heavily weighted toward stocks to all-government-bond packages.
Stepping into the marble-floored beaux arts building, Villanueva braces herself for questions about the wisdom of gambling retirement funds on stocks at a time when global capital markets are taking a beating. She also expects to hear complaints about the low returns recently on Provida investments and the steep management fees charged by her company.
But the sales visit turns out to be as comfortable as a coffee klatch. A few executives want more details on the proportion of stocks and bonds in the various funds being offered. One asks if he can have the family housekeeper call Villanueva for advice.
In Europe falling equity markets have stalled the reforms meant to build up pension assets. In the U.S. advocates of a partial privatization of Social Security are running for cover. But to most Chileans the volatile markets that have wreaked havoc on savings and pensions globally are the rest of the world’s problem.
Chile was the first nation to privatize its social security system. That was under right-wing dictator Augusto Pinochet a generation ago. Now, under President Ricardo Lagos, a democratically elected socialist (Institutional Investor, March 2001), further capitalist reforms are ensuring that Chileans will depend on equities more than ever for their retirement income.
Last August the one-size-fits-all private pension portfolio was abandoned. Now Chileans are being offered a choice among five different pension fund models, with the riskiest and potentially most lucrative fund investing up to 80 percent of a future retiree’s savings in stocks and the most conservative fund devoting itself entirely to government bonds.
(Under an even more radical plan launched last October, a private consortium has been put in charge of the nation’s unemployment compensation system. Workers make monthly contributions to individual accounts that the consortium invests in bonds. Employees who lose their jobs will then draw money from these accounts. See box, next page.)
Despite modest recent returns, Chileans’ confidence in their privatized social security system owes much to the historical performance of the pension fund management companies, or Administradoras de Fondos de Pensiones (see chart). On average they have posted annual dollar returns of some 10.5 percent over their 21-year existence. That compares quite favorably with 9.6 percent for the Standard & Poor’s 500 index over the same period. Moreover, the $33.4 billion in assets under management by the AFPs provides Chile with a pool of low-interest, long-term investment capital unmatched elsewhere in Latin America.
So far eight Latin American nations have embraced versions of the AFP model, but none has come close to achieving Chile’s results. “To be successful, a privatized pension system needs the proper macroeconomic environment and investment and tax policies,” says Augusto Iglesias, a Santiago-based World Bank consultant on pensions. “In most of Latin America, you don’t see those conditions.”
Chile is the striking exception. Economic growth may have slowed to about 2 percent this year -- well below the 7 percent average of the 1990s -- and unemployment risen to nearly 10 percent, but the banking system remains solid, the government perennially runs budget surpluses, and the nearly 1-to-2 ratio of Chile’s $17.5 billion in exports last year and $40 billion in foreign debt is among the best in the developing world. Foreign and domestic investment are treated essentially alike, and by international standards Chile is a low-tax country, with a 15 percent levy on corporate earnings and a 35 percent charge on distributed earnings.
Private pension fund management has become one of Chile’s most profitable businesses. A Salomon Smith Barney report by José García-Cantera, who was recently picked to head his firm’s European research (see People), shows that the AFPs averaged a handsome 25 percent return on capital last year, thanks to aggressive cost-cutting and reduced competition, as well as stiff fees. Just five years ago there were 15 AFPs whose nearly 20,000 sales agents spent as much time stealing participants -- or affiliates, as they are called -- from rival pension funds as they did signing up new ones. Today, because of mergers, only seven AFPs remain, with a total sales force of about 2,600 agents.
Switching between pension funds by the 6.5 million affiliates happens far less often because of new rules requiring more paperwork. In many cases, affiliates wishing to transfer their accounts to another AFP must now visit a branch office rather than merely sign an application with a visiting sales agent. Agents are rewarded -- through deferred commissions -- for ensuring that the affiliates they enroll stay with the fund for at least a year.
In fact, AFP executives make it clear they aren’t interested in affiliates who are likely to jump ship. “We monitor new members to ensure they don’t have a history of frequent switching from one pension fund to another,” says Martín Costabal, chief executive officer of AFP Habitat, Chile’s second-largest pension fund.
Critics point out, however, that the newly consolidated AFPs’ greater efficiency has benefited them far more than it has the Chilean public. Besides turning over 10 percent of their monthly income to the AFPs, affiliates pay hefty management fees. Though AFP commissions have dropped from an average of 3 percent of an affiliate’s gross salary a few years ago to about 2.3 percent today, “they are still indefensibly high,” says Salvador Valdés, an economics professor and pension expert at the Pontificia Universidad Católica de Chile. “Massive layoffs in the AFP sales forces have resulted in huge cuts in costs that haven’t been passed on to affiliates.”
One way to bring down commissions might be to permit other financial institutions -- banks and insurance companies -- to get into the pension management business directly. “If AFPs aren’t interested in launching an aggressive strategy to reduce fees, then clearly it makes sense for government regulators to allow more options in the distribution of pension fund products,” says Salomon’s García-Cantera.
The AFPs have bitterly resisted that, saying it would create dangerous conflicts of interest. “I can easily imagine a bank offering loans at more advantageous rates to companies that encourage their employees to enroll in that bank’s pension fund,” says Gustavo Alcalde, Provida’s CEO.
The criticism is complicated by the fact that banks already hold big stakes in the leading AFPs: Citigroup has a 40 percent share in AFP Habitat, Banco Santander Central Hispano owns AFP Summa Bansander, and Banco Bilbao Vizcaya Argentaria bought Provida in 1999. Viewed in this light, the AFPs seem to be advocating an oligopoly: They object to banks other than those that already own or have major shares in AFPs entering the pension management business.
The ease with which AFPs have been able to ward off unwanted competition is a testament to their political clout. Although Mexico recently passed legislation to foster more competition among private pension fund managers to reduce commissions, no such move is afoot in Chile. Nor is there much pressure on AFPs to reduce commissions. “AFPs have discovered that they won’t increase their market share by reducing commissions, because most affiliates simply don’t pay attention,” says World Bank consultant Iglesias.
That holds true even among many sophisticated pension participants, like the central bank employees courted by Provida’s Villanueva. “No more than 5 percent of our affiliates understand how the AFP system works,” says her boss, CEO Alcalde.
Chileans would probably pay a good deal more attention to their pension system if AFPs failed to make healthy returns. Despite the fall in global capital markets in 2002, AFPs still averaged a 3.7 percent return, thanks to a conservative strategy that relied heavily on fixed-income securities. “We’ve done a lot better than U.S. mutual funds and 401(k)s -- that’s for sure,” says Joaquín Cortez, Provida’s chief investment officer.
Critics point out, though, that this same conservatism caused AFPs to miss out on much of the 1990s’ bull market and could leave them unprepared to capitalize on a future upturn in stocks. “I’m not at all impressed by their research or risk-taking capacity,” says Henry Rudnick, president of Chilean financial consulting firm Ojos del Salado. “If I want to know where the markets will be a year from now, the last person I’d ask is an investment officer at an AFP.”
The management companies maintain that they’ve become savvier investors in recent years. For much of their existence, AFPs were required to keep the bulk of their assets in domestic financial instruments, mostly government bonds. Today government regulations allow them to invest up to 20 percent of their assets in foreign stocks. “Buying and selling foreign shares is much easier to hide from other AFPs [than trading domestic securities], so there’s less of a pack mentality,” says Cristian Rodríguez, Habitat’s chief investment officer. “We’re seeing real differences in investment performances between the pension funds.” For example, in the 12 months ended August 31, Habitat was the industry leader, with a 4.51 percent return, while AFP Cuprum scored lowest, with 2.63 percent.
AFPs are showing new assertiveness in the domestic market. Their reputation for never selling local stocks is belied by figures showing that Chilean company shares now make up less than 9 percent of AFP portfolios -- down from 28 percent in 1997. The remainder of their invested assets break down this way: government debt, 32.5 percent; term deposits, 20.4 percent; foreign stocks and bonds, 15.5 percent; mortgage bonds, 12 percent; corporate bonds, 6.6 percent; investment funds, 2.2 percent; and financial firm bonds, 1.9 percent.
Assuming the role of arbiters of corporate governance, AFPs are demanding better terms on their local investments. In recent years they’ve forced the Spanish parents of the largest local telecommunications company and energy producer -- Compañía de Telecomunicaciones de Chile and Enersis, respectively -- to keep their subsidiaries listed on the Santiago bourse to maintain liquidity in the struggling market. And in recent months AFPs have pressured several troubled Chilean companies -- most notably, copper tube manufacturer Madeco -- into reducing costs and injecting new capital.
For all their new sophistication, however, AFPs should not be mistaken for true global investment firms. Local government debt still accounts for the bulk of their assets, and AFPs’ purchases of variable-income instruments are confined to the uncomplicated local capital market. And for their investments abroad the AFPs depend entirely on foreign mutual funds. “We’re not trying to reinvent the wheel,” acknowledges Habitat CEO Costabal.
International transactions are carried out through some 120 foreign mutual funds, selected according to three main criteria: how well they perform against industry benchmarks, how helpful they are in building an AFP’s desired asset allocation and how low their fees are. For tax reasons almost $9 billion -- or about 40 percent of AFP investments abroad -- are placed in mutual fund branches in Luxembourg, which doesn’t tax foreign mutual fund assets. Chileans don’t pay any taxes on their pension investments until they retire; at that point, pension payments are taxed at income tax rates of 5 to 40 percent. Most Chileans, because of their low incomes, pay just 5 percent.
Sales campaigns by AFPs leading up to last November’s enrollment deadline for the multiple funds seemed to bear out pension expert Valdés’s thesis that “most Chileans will just allow themselves to be assigned a fund by their AFP.” At lunch one day last October, a dozen Habitat policyholders crammed into a small corner office at a Santiago branch of the fund to hear saleswoman Carolina Burgos pitch the new product. Burgos explained that the funds, listed alphabetically, are suited for different age groups. People under 35, she said, could take a risk on fund A, which places most of their contributions in stocks. Somebody nearing retirement should probably opt for E, an all-government-bond fund. The B fund places 25 to 60 percent in stocks; for C funds the gamut runs from a minimum of 15 percent to a maximum of 40 percent in shares; and D funds invest anywhere from 5 to 20 percent in stocks. “But remember, even if you pick a fund now, you can still switch later,” said Burgos.
Her audience seemed hesitant. “Can we decide later?” asked a middle-aged beautician. Burgos told them they still had another month to voluntarily pick a fund, and that after the deadline the AFP would assign them to whichever fund it felt best suited them.
Only a few affiliates signed up, in each case selecting a fund according to the age profile suggested by Habitat. Javier Hernández, 25, a construction worker with Walkman earphones hanging around his neck, left the room without making a choice. In the lobby he explained his reasoning: “I don’t know anything about stocks and bonds, so I’ll just stick with whatever fund they put me in -- until they screw up.”
Chile’s social securities system
The country’s private pension firms look after retirement savings for 6.5 million Chileans by investing in stocks and bonds.
Pension fund mgmt cos. (AFPs) Assets as of 9/1/02 ($ millions) No. of affiliates covered One-year return 8/31/02
Provida $10,528 2,691,044 3.56%
Habitat 7,780 1,517,644 4.51
Cuprum 5,192 438,750 2.63
Santa Maria 4,294 961,532 3.67
Summa Bansander 3,721 503,080 3.89
Planvital 934 313,507 4.01
Magister 931 111,470 3.68
Total 33,379 6,537,027 3.70
Sources: “Private Pension Funds in Latin America,” Salomon Smith Barney; Superintendencia de AFP.
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Capitalist twist on jobless benefits
Traditionally, Chilean leftists have viewed government as the bulwark to protect workers from the unemployment caused by the inevitable crises of capitalism. But now, under a program launched in October by President Ricardo Lagos, a socialist, and managed by a private consortium, workers will depend on investments in the capital markets to see them through the dislocations of capitalism.
“Workers are to an important extent assuming personal responsibility to finance themselves when they are unemployed,” says Ricardo Solari, minister of Labor and Social Security.
For Alvaro Donoso, president of the Administradora de Fondos de Cesantía, or AFC, the consortium that will be administering the unemployment insurance scheme, it makes perfect sense that the government should relinquish control over yet another social safety net. “In this country we already accept that the private sector does a better job than the state at managing retirement pensions and life and disability insurance,” says Donoso. “So why not unemployment benefits as well?”
Under the new system a worker will deposit 0.6 percent of his gross monthly income into an account managed by AFC, while an employer contributes the equivalent of 2.4 percent of the worker’s wages. AFC will invest the money in government and blue-chip corporate bonds. When a worker loses his job, he will be able to draw an amount equal to 40 percent of his last monthly paycheck for up to five months out of the general fund.
The government will have only a marginal role, contributing $12 million a year to a separate fund for the lowest-paid workers, whose contributions to their individual unemployment insurance accounts won’t be enough to guarantee them minimum benefits.
“This is a completely new approach to unemployment insurance,” says Jürgen Weller, a Santiago-based labor economist at the United Nations Economic Commission for Latin America and the Caribbean. “The Chilean left has tried to create a system that ensures more security for workers without having a negative impact on free-market forces.”
One way it accomplishes this is by tackling a key obstacle to a freer labor market: the cost to both employer and employee when a worker is dismissed or quits his job. Until now a worker was better off getting fired than resigning because he could collect a severance package. The new unemployment insurance system enables a worker to quit and still receive benefits -- from his individual account rather than from his former company’s coffers -- while he searches for another job.
“We don’t want workers to feel bound to an employer out of fear that if they took a better job, they would lose unemployment benefits based on seniority,” says Labor minister Solari.
Besides eventually freeing the government from most obligations to pay unemployment benefits, the new system will achieve further public savings by ending temporary make-work programs for the jobless that now cost the state up to $200 million annually. And the government estimates that within five years the privatized unemployment benefits plan will bring several billion dollars in new long-term investment capital into the Chilean economy.
The new program is largely modeled on Chile’s 21-year-old private pension system (story). In fact, AFC, the managing entity, is a consortium of the seven private pension management companies, or AFPs. It was awarded a ten-year renewable contract by the government to create and administer the jobless benefit program after making a bid substantially lower than that of two other rival consortia of banks and insurance firms. With a permanent staff of only 32 employees, AFC intends to subcontract most of its tasks to the AFPs and use their hundreds of branch offices throughout Chile to attend to jobless workers.
“We even advertise our link with the AFPs in our publicity campaigns,” says AFC’s Donoso. “That’s because every opinion poll shows that the AFPs are considered among the most trustworthy and solid institutions in the country.”
People already in the workforce can choose to remain in the old state-run unemployment benefits program, but first-time hires must join the new plan. The government predicts that up to 3 million people, out of the 5 mil- lion-strong workforce, will sign up for the new program within three years. “By then enough people will have collected unemployment benefits under the privatized plan to make everybody realize it’s a lot better than the old state system,” contends Solari. -- J.K.
©Copyright 2003 Institutional Investor, Inc.
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