By Dr. Arturo Cifuentes

Original ideas seldom get a second chance to be implemented successfully. The Chilean pension system is one of the few exceptions. To grasp how much is at stake in the coming months—a third opportunity might never happen—we need to go back to its origins and identify the key events that shaped its evolution.

The Chilean pension system was the brainchild of José Piñera, who, as minister of labor and social security, conceived its basic architecture in 1981. The idea was simple: Workers would contribute 10 percent of their earnings to individual accounts managed by private-asset managers known as AFPs (their Spanish acronym). Upon retirement, they could use these funds to either buy an annuity or choose a scheduled-withdrawal alternative. Initially, each AFP offered a single investment fund, subject to guidelines set by the pension regulator. A 2002 reform introduced broader investment options, known as multifondos. In short, five funds—A, B, C, D and E—were designed to offer different risk-return profiles, ranging from Fund A, the most aggressive, to Fund E, the most conservative.

The Chilean model was received with enthusiasm and curiosity by policymakers and academics alike, and it served as a blueprint for pension reforms enacted in countries as dissimilar as Bolivia and Mexico, Kazakhstan and Bulgaria. Not surprisingly, in Latin America, the reception was far warmer among liberals and free-market enthusiasts—who saw it as a mechanism to give individuals greater agency over their own financial futures, free from the state’s reach—than among left-leaning ideologues, who resented placing these funds beyond the government’s control.

By the early 2000s, however, it had become clear that the system was delivering pensions that most Chileans found disappointing—a sentiment that only grew stronger over time and that was, unfortunately, grounded in reality. In recent years, the median replacement rate for self-financed pensions (i.e., excluding any state benefit) has been below 20 percent, compared with the OECD (Organisation for Economic Co-operation and Development) average, which hovers between 50 percent and 63 percent.

What happened? Where did things go wrong? Was it the concept or the execution?

Let us start with the mandatory contribution rate. Notwithstanding the power of compound interest, empirical evidence on asset returns indicates that 10 percent is insufficient to achieve an acceptable replacement rate. The consensus points to a figure closer to 15 percent. This is not a recent financial insight; it is straightforward arithmetic, something every government knew, or should have known, from the outset. Yet no government, regardless of its political orientation, has ever attempted to raise the rate. The reason is obvious: Increasing the mandatory contribution meant reducing the take-home paycheck—a politically dangerous decision with clear implications for the next election.

A second factor concerns the labor market’s formality. Roughly one in four Chilean workers is informally employed, and many move in and out of the formal sector throughout their working lives. Since informal workers typically make no pension contributions, this pattern generates gaps in their savings history—known euphemistically as lagunas previsionales. The unhappy result has been that the average Chilean worker contributes to his or her pension account for only about half of his or her working life, with women showing far more severe gaps than men.

Then there is the Régimen de Inversión de los Fondos de Pensiones: a 76-page document issued by the pension regulator that dictates how AFPs must structure their portfolios. Unfortunately, this document rests on some deeply flawed assumptions: that investing outside Chile is inherently risky; that currency diversification is inadvisable; that real-estate exposure should be minimal; and that alternative assets should be severely restricted. Needless to say, AFPs have repeatedly attempted to challenge this framework’s most damaging provisions, with little success. Its defining feature is that it reduces portfolio construction to a rigid set of asset-class limits, without referencing any investment objectives or portfolio-level risk metrics—a design that investment professionals have widely criticized for depressing multifondos’ returns and, by extension, the pensions that depend on them.

An aside: It is worth noting that during the COVID pandemic, the Chilean Congress (National Congress of Chile) passed legislation allowing workers on three separate occasions to withdraw funds from their retirement accounts. This decision, widely condemned by serious policymakers but embraced with gusto by populist politicians, will inevitably take a toll on future pensions. In total, the three withdrawals amounted to roughly US$50 billion, reducing AFP assets under management from 83 percent of Chilean GDP just before the first withdrawal to 62 percent by 2024.

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