What we can learn from Chile’s pension system

In pensions, unfunded state pensions and unfunded public sector schemes were replaced overnight by a universal system of individual defined contribution accounts, featuring mandatory employer contributions and free-market competition for the accounts between commercial providers. This approach – not coincidentally ­– also created new resources to seed Chilean capital markets.

The sustainability of the pension systems from the state’s perspective was therefore improved apparently, via the simple expedient of making individual Chileans carry their own pension risk as individuals. By the mid-2000s, however, the fatal flaws in the privatised model were crystal clear. 

Countries can use DC as a pension and not simply as tax-incentivised savings. The UK is caught between seeing DC as savings and seeing it as a pension providing an income

First, it excluded the informal economy, which has been traditionally sizeable in Chile. Many citizens are never eligible for the mandatory employer contribution, or only irregularly over a working life.

Second, heavy costs and charges were extracted by the pension providers, made possible by the enormous information disadvantages of ordinary Chileans vis-à-vis the handful of providers, all of whom are for-profit entities. Robust regulation of the commercial pension system, to ensure value for money, was lacking.

Very modest retirement savings was the result for many, with women most likely to be in pensioner poverty.

Policy turns a corner

A non-contributory, means-tested state pension was therefore introduced in 2008 to help fill the savings gap. Meanwhile, the government had already begun intervening in the private pension system to ameliorate the poor value for money delivered by the market.

Nowhere was this interventionist spirit more successful than in decumulation policy. In 2002, Chile required its pensions and insurance sector to establish a new independent whole of market annuity broker, known as Scomp.

Both pension funds and insurance companies are required to participate directly, while around half of those going through Scomp use an adviser. This government’s mandated annuity and income drawdown exchange is very efficient.

There are different ways for customers and their advisers to use the Scomp system. Each of these, though, weights the sales process in the direction of the customer.

At the outset of the annuity sales process, for example, the system effectively invites sealed bids from participating insurers. Customers can either choose to accept one of the bids, invite another round of bidding, seek an offer from an insurer that did not participate in the initial bidding round and initiating a private bidding round after setting a minimum price.

Analysis for the Financial Conduct Authority by Oxera shows that the Scomp system has increased the level of competition between annuity providers. A review for our new book shows that Chilean retirees tend to achieve better annuity rates than retirees in other countries, when controlled for relevant differences.

It also, partly by legislation and partly through system design, prevents leakage through intermediary fees. A system of programmed withdrawals (a form of income drawdown) is also available, attractive chiefly to those whose pots are small, or who have a shortened life expectancy. 

What the UK can learn

The Chilean experience shows two things: first, that it is possible for a mature DC accumulation system to convert capital into income in a sustainable manner. Countries can use DC as a pension and not, simply as tax incentivised savings. The UK is caught between seeing DC as savings and seeing it as a pension providing an income. It is not yet clear which path policymakers will choose.

The second learning from Chile is that it shows the importance of what behavioural economists call “choice architecture”. That unlovely phrase refers to the deliberate structuring of choices, perhaps in pursuit of a particular outcome or to make certain choices easier or more difficult for people.

The UK has tended to rely on information remedies – giving people more information and hoping that they understand it and know how to act on it.

If effective competition is an objective, policymakers should not be afraid of learning from Chile’s government-led retirement income exchange.

Tim Gosling is the head of policy at The People’s Pension and is the co-editor of a new book, Towards a New Pensions Settlement – The International Experience, Volume III, which examines pension systems in nine different countries, including Chile. On June 25 at 9.30am a webinar will be held to discuss findings of the book and will include speakers such as Stephen Timms MP, chair of the work and pensions select committee, Jo Cumbo, the pensions correspondent from the FT and Pensions Expert columnist, and Gregg McClymont, director of policy at The People’s Pension and a co-editor of the book.