Chile’s socialist president Michelle Bachelet has named a commission to revise the country’s successful 35-year-old pension reform based on mandatory individual retirement accounts (IRAs). Bachelet declared: “Today, after more than 30 years, it is our duty to determine if the system has kept the promise made when the public system ended.”
During her presidential campaign, Bachelet demonstrated her bias against private individual retirement accounts by promising to change the system and the constitution. During her first term in office (2006-2010), she altered the program by introducing the World Bank-endorsed three “pillar” system (PDF), planting the seeds for a future tragedy of the commons à la Argentina, Bolivia, Hungary, and Poland.
To put the Chilean system in a nutshell: the taxes citizens pay to social security go into their own private accounts, which grow at compound interest over their working lives. This is forced savings because contributions are mandatory, but the government doesn’t collect a penny; instead the money goes to a Pension Fund Administrator (PFA) freely chosen by each citizen, though regulated by the government. What helps make the system succeed is that individuals decide—every month and with the click of a mouse—where their savings go. This allows competition among the PFAs, which therefore have an incentive to maximize the rate of return. Over more than three decades, the Chilean system has offered workers an average rate of return of 9 percent above inflation.
Nevertheless, Bachelet wants to determine whether the PFAs provide a “fair” level of benefits compared to the promises of a PAYGO scheme, in which government pays pensioners out of tax revenues collected from people who are currently working. In other words, unlike the present system, benefits would not represent a return on investment.
Bachelet’s objective is disingenuous since most government promises are “backed” by unfunded liabilities; future actions to pay what has been promised lead to the growth of the welfare state. In contrast, no private arrangement can grow beyond its means without eventually hurting its own customers.
In other words, you cannot compare the fairness of a sound system based on private trust funds to a coercive system based on a Ponzi scheme.
The real issue is which system poses a greater risk of default. Simply put, how are the promises going to be kept? As I have previously reported here and here, the Ponzi structure of a PAYGO system—that is, the increasing burden on younger generations that will not accept a social contract they never signed—strongly suggests that the money they are promised today won’t be there tomorrow.
Among the commission’s “expert” consultants, Nicholas Barr, a professor at the London School of Economics, is well known for his “wide range of choice,” which would authorize unconstrained political intervention. Another member is Leokadia Oreziak, professor at the Warsaw School of Economics, one of the biggest opponents of Poland’s private pension funds and a supporter of the nationalization of 50 percent of those assets. According to economist Marek Tatała, Oreziak now advocates nationalization of 100 percent of the assets by destroying the pension funds and favors a return to the unfunded PAYGO system.
I do not wish to question the intentions of the policy recommendations the commission will likely craft. But a first glimpse suggests that this academic elite subscribes to the romantic view that government officials are more virtuous than people in the private sector (more here). This behavioral asymmetry assumes that markets fail because people act in their self-interest and that this can be corrected by altruist individuals in the government sector. No possibility of government failure is ever acknowledged.
However, the ongoing tragedy of the pension commons is unquestionable evidence of government failure and a clear example of how politicians, by and large, act in their own self-interest under perverse incentives. Thus the questions we should be asking are: 1) which kind of failure will do the greater harm -- market or government -- and 2) what kinds of regulations will do a better job in bringing the desired results --those planned by the few or those planned by consumers and entrepreneurs who would profit by pleasing them?
Under this comparative analysis, government pensions will always fall short, simply because they are not constrained by the profit-and-loss system and so are bound to be more inefficient. The depletion of pension funds in a growing number of Club SEP countries is a huge government failure now happening in Chile’s backyard. The Bolivian and Argentine tragedies should have already helped people understand pensions without romance. But clearly this is not the case.
The ongoing depletion of pension programs’ second pillar is a robust signal that governments cannot offer a risk-free solution. If Bachelet wishes to give a normative task to the commission, she could ask which risk is Chile willing to take: one that individuals can assess for themselves and freely act on, or one that leaves no room for free individual action?
A system of IRAs rests on market performance and individual choice and responsibility. That entails a risk which society can afford. The centralized Bismarckian pay-as-you-go scheme, however, depends on coercion and political performance.
We should be asking how the current system could be improved so that it would provide better mechanisms for the freer movement of assets, not only between a handful of PFAs, but among a wider range of financial institutions. For example, lowering the current legal barriers to entry for PFAs would eliminate the oligopoly and allow greater competition, reducing administrative costs, widening individual choice, and most important, avoiding the “too big to fail” moral hazard.
No further reform is needed, Mrs. President.
However, the commission will most likely pull out statistics demonstrating the sustainability of a coercive PAYGO system via productivity gains. But that works only on paper, because younger workers will not accept the increasing tax burden that would be imposed on them, regardless of their productivity. Nevertheless, the commission is likely to give the government the “expert” green light to replace the funded system.
But make no mistake, even if the numbers are theoretically correct and even if the rate of return from a PAYGO’s sovereign wealth fund could match or outstrip the rate of return of all PFAs combined, the tragedy of the second pillar initiated by the Club SEP countries—and now spreading across Europe—cancels out the supposed theoretical supremacy of a government-controlled scheme. Practice tells us that eventually the political class will consume these tax revenues. Therefore, any statistical attempt to prove the sustainability of a pension system in which individuals lack property rights in their own funds is futile.
In assessing the risk of the two systems, one must note the following: if a PFA decided to deplete the funds, consumers would “vote” them out of the market. But if governments decided to do so—which is actually happening—there would be no room for free individuals to respond, and therefore no savings for the future.
Further economic analysis and statistical maneuvers proving the long-term sustainability of a Pay-As-You-Go system are hardly worth your while.
Headline photo credit: Acto en Centro Cívico de El Bosque 18 by