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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former investment banker in New York, former head of the Chilean wealth fund investment committee and co-author of “The Worth of Art — Financial Tools for the Art Markets”
The Chilean pension system, a pioneering, privately managed defined-contribution scheme that started in 1980, was initially regarded as the gold standard among retirement schemes.
Consequently, it served as a blueprint to reform the pension systems of many Latin American, Asian, and eastern European countries. Numerous Chilean professionals involved in its implementation morphed into global pension consultants. However, today, the system is despised by a large number of Chileans and its survival in its current form is doubtful. So, what went wrong?
In short, it was a classic case of a sound idea poorly executed. At present the system consists of five investment options, known as funds A, B, C, D and E. Fund A is the riskiest, while Fund E is the most conservative. Workers are expected to transition gradually from Fund A to Fund E as they age, depending on their risk tolerance. The regulation attempted to control the risk in these funds through time-independent limits — minimum and maximum percentages by asset class — rather than portfolio-level risk metrics.
The unfortunate result of this decision has been that in terms of risk-adjusted returns the funds are in severe disarray. A recent study published in the Journal of Retirement shows, for example, that in more than half of the cases Fund E outperformed Fund A. In short, participants in riskier funds were not adequately compensated for the risk they took.
The regulation also discourages investments in alternative assets, which is ill-conceived considering the long-term horizon of pension funds’ portfolios. Another problematic regulation dictates that any investment not denominated in pesos must be at least partially hedged, which is tantamount to negating the benefits of currency diversification. The additional requirement that the hedge must be done on an asset-by-asset basis rather than at a portfolio level has only exacerbated this inefficiency.
Together, I estimate these policies have effectively pushed returns down by more than 2 percentage points in most cases as suboptimal asset allocation choices with significant practical implications. Note that a mere 1.5 per cent difference in annual returns over a 35-year period can lead to a 30 to 40 per cent reduction in pension payouts.
Additionally, there are three more critical issues to consider. First, the initial design mandated an insufficient 10 per cent contribution from a worker’s salary. Studies suggest that a 15 per cent to 17 per cent contribution is necessary to obtain an acceptable pension. But there has been political reluctance to increase this figure, which would require workers to sacrifice their current take-home pay for future benefits.
Second, about 30 per cent of Chile’s labour market operates informally, and many workers frequently shift between formal and informal employment. Unfortunately, during informal periods, they seldom contribute to their pension accounts.
Third, surveys and anecdotal evidence indicate that most workers do not understand how the pension system operates. For example, they do not know in which of the five funds they have their savings (most workers are assigned to a default option based on their age). Moreover, they are not aware that their funds are in segregated accounts, and do not belong to the private asset managers, or AFPs. This combination of poorly designed investment policies and inadequate contributions has resulted in disappointing pensions. Regrettably, many Chileans blame the AFPs for their low pensions, although the managers have operated within the constraints of a regulatory straitjacket.
There is now a consensus that something must be done to address the “pension problem”. However, some initiatives proposed by the current left-leaning government seem aimed at scrapping the current system rather than correcting its shortcomings. These include creating a state-owned asset manager, or divesting part of the workers’ contributions to a common “solidarity” fund.
At the very least, a sensible reform now should be to eliminate the investment limits by asset class and introduce an investment policy based on risk metrics at the portfolio level. The government should also relax the restrictions on alternative investments and eliminate the ill-designed hedge requirements. Unless Chile pursues such reforms, a second wave of Chileans dissatisfied with their pensions might be just a generation away.
