Last week we described the main pillars of the Chilean pension system and how aspects of that model were ultimately copied around the world. Today we extend those lessons to pension reform in The Bahamas.
In 1981, influenced by the classical Chicago school of economics and the ideas of Milton Friedman, Chile became the first country in the world to fully privatize its national pension. In many ways, the Chilean pension-based development strategy can be viewed as an alternative to the East Asian model where national savings are generally captured by a government-controlled banking system, often at repressed interest rates and directed towards a massive export-oriented manufacturing sector. For countries with relatively sparse labor forces such as in Latin America and the Caribbean, such an export orientation is generally not feasible. Instead, long-term investment through private pension funds rather than state development banks can be a good option.
As its pension system matured, Chile gradually liberalized the AFP pension provider investment rules. When individual accounts were first introduced, investments were limited to government bonds, bank bonds and limited corporate bonds. Investments in equities and foreign investments were prohibited. By 1985, when the country's capital markets began to develop, the limit on government-issued instruments was lowered to 50 percent and AFPs could invest between 10 percent and 30 percent of assets in stocks. After 2002, AFPs were allowed to offer an aggressive Portfolio A with up to 80 percent in stocks. In the mid-1990s, foreign investment restrictions were eased, allowing up to six percent initially but increased to 30 percent in 2004 and 45 percent in 2008. These measures were made to allow AFPs to reduce the concentration in domestic instruments to lessen their impact as pension savings became a greater share of GDP. Increasing the foreign limit was also a way to potentially provide a higher rate of investment return.
As we mentioned last week, by the end of 2012, Chilean pension funds had approximately $164 billion in assets or the equivalent of 65 percent of GDP. The accumulation of these assets and their investment in financial markets has contributed massively to the development of Chilean capital markets. Pension funds optimized their allocation of resources to get the best combination of risk and return and have provided long-term development financing. This influence may have been most decisive in the housing market through the development of a private market for mortgage bonds. In 1996, almost 18 percent of pension fund assets were invested in mortgage instruments, equating to two out of every three houses purchased being financed by pension savings. AFPs must also purchase disability and life insurance in order to cover the risk of disability or death of the pensioner, leading to the development of a competitive insurance market and declining premium rates.
In the Caribbean, social security systems have been in place for close to 40 years in most countries, with our own National Insurance fund being established in 1974. Although most programs in the Caribbean are adequately funded for the short and medium term, almost all are financially unsustainable for the long term at current contribution rates and at the level of pensions promised.
While privatization of fund management in Chile was combined with individual choice of funds, this is not a necessary combination. A lower cost option could be to have a system where individual accounts are kept by the government, with shares earning their return from their portion of a single fund that was privately invested. In other words, a country can achieve privatization of fund management without having multiple fund choice options. In our context, such a structure would require the National Insurance Board to set an overall asset allocation for a single national fund and select private fund managers to actually manage those assets, free from political considerations.
In the Chilean example, they created a budget surplus to finance their transition to a privatized system. Would such a pension system be as successful if a country is instead running chronic deficits like in The Bahamas? With a large deficit there will be considerable political incentive to channel the privatized mandatory savings into government debt; National Insurance is already by far the largest investor in Bahamian Government Registered Stock (BGRS) with a holding of $660 million, according to the 2011 annual report. There will also be a strong desire to pay a lower interest rate on this debt in order to lower the deficit. The combination of primarily government debt and financially-repressed interest rates defeats much of the purpose of privatization, namely to broaden and deepen the capital markets and increase the investment return for the pension savers.
What should be the way forward?
In the wake of the 2008 crisis, some questioned whether leaving citizen's retirement at the mercy of the financial markets is the right thing for a government to do. In 2008, the value of Chilean pension assets crashed spectacularly along with global markets, experiencing average losses of one percent for the lowest risk funds to as much as 40 percent for the highest risk funds. These funds rebounded eight percent and 43 percent, respectively, in 2009. However, the fact remains that very few workers so far have been able to retire solely on their own AFP contribution, with 60 percent of all pension money still provided by the state under their various minimum guarantees.
In the Caribbean, a defined benefit and partial pay-as-you-go system combined with an individual account option seems to be an emerging solution. Rather than privatization, the focus has been to address the funding status directly through adjusting the contribution levels and/or gradually increasing the retirement age. After its 8th Actuarial Review, The Bahamas passed 22 amendments to the National Insurance Benefits and Contributions Regulations in 2010, which included raising total contributions (employee plus employer) to 9.8 percent, raising the level of the insurable wage ceiling from $400 to $500 a week and raising such ceiling bi-annually starting in July 2014 by an amount equal to inflation plus two percent. Pension benefits will also be increased to keep pace with inflation.
Thus far, there has been little regional appetite for a fully-privatized defined contribution system. Given their relative maturity, the unfunded liability that would be created at conversion to a privatized system would be huge. Moreover, if a switch to fully-funded defined contribution approach were made immediately, the amount of funds amassed would probably be too large for local financial markets to absorb, resulting in the money in all likelihood being used to finance government deficits or left sitting in the banking system. However, a move to adding an individual account component, outsourcing more of the portfolio management duties to home-grown Bahamian financial entrepreneurs, along with increased coverage of private pensions, will go a long way in improving the availability of risk capital and raising the level of investment talent in our country.
o CFAL is a sister company of The Nassau Guardian under the AF Holdings Ltd. umbrella. CFAL provides investment management, research, brokerage and pension services. For comments, please contact CFAL at: column@cfal.com.

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