A mixed pension system

Guillermo Larrain Academic, FEN University of Chile, former Superintendent of Pensions

William Larraine

An idea rarely contradicted in economics is that corner solutions are not optimal. It makes sense, because public policy usually has several objectives and the Tinbergen rule says that an equal number of instruments is required.

In pensions there are two main objectives: prevention of poverty in old age and smoothing of consumption between active and passive life. Since there are two objectives, there must be two instruments. One is savings and the other is insurance. This explains the convergence towards mixed systems, unlike what Cecilia Cifuentes raises in her column yesterday.

“The left must accept that many people value their individual savings, and the right that there are ways of conceiving solidarity that do not coincide with their vision. A good mixed pension system makes that stick”.

Savings can be individual, collective or both. There may be mandatory and voluntary savings, financial or notional accounts, you can invest in financial instruments (AFP) or directly in projects and companies (Canadian funds). There is variety. What is clear is that (a) savings are needed and (b) despite the fact that there may be an offer of state management, the bulk must be private management, because in order to value financial instruments, correct price formation requires conflicting views of the same asset (it is the “fair price” in finance).

For its part, insurance is a contributory mechanism (a premium is paid) that allows resources to be redistributed between those who suffer an accident and those who do not. Insurance is a pay-as-you-go system. Those of us who crashed the car received compensation financed by those of us who bought the insurance. In anticipation, disability and survival insurance follow this logic, but it is more complex.

Think of those who entered the job market in 1982, in the midst of a recession with mass youth unemployment until at least 1988. The advertising of an AFP said that a pension gap at the beginning of life has a gigantic effect on the final pension. It is true. The massive unemployment of the 1980s seriously affects the pensions of those who will be retiring in the next decade. Is it necessary to think of a form of insurance for that generation? It is a corporate option. Some think not, but it seems that in Chile the opposite idea prevails.

The insurance component can also be structured in various ways. In New Zealand it is a universal pension financed by the State, generous and of very high cost. The Chilean PBU is going in that direction. It can be a distribution system with prefunding or pay-as-you-go. There are several ways to create a pre-funded pay-as-you-go system. One was the Bachelet 2 collective savings system. Another was the longevity insurance system that I myself proposed.

Faced with shocks such as longevity, pension gaps and financial shocks, the adjustment variable in a fully funded system is the level of the pension. In an insurance system, fiscal variables. A mixed system recognizes this complexity and has various adjustment tools. There are many combinations, we must be pragmatic and flexible to choose.

Acemoglu and Robinson say that the key to success is inclusive institutions. But inclusiveness is not a theoretical attribute of a pension system. There must be trust and credibility, because taking complex measures (eg retirement age) requires legitimacy. The political acceptance of a reform is not politicking, but the condition for a system to persist and be perfected.

So how to choose? The left must accept that many people value their individual savings, and the right that there are ways of conceiving solidarity that do not coincide with their vision. A good mixed system makes that stick and is what you have to build now.

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