Chile’s Social Security Lesson For The U.S.

Pay-as-you-go social security systems destroy the link between contributions and benefits, between effort and reward. Everyone tries to minimize what he puts into the system while trying to maximize through political pressure what he can get out of it. That’s why pay-as-you-go plans are going bankrupt all over the world.

Chile faced that problem in the late ’70s. As secretary of labor and social security, I could have postponed the crisis by playing at the edges, increasing payroll taxes a little and slashing benefits a little. But instead of making some cosmetic adjustments, I decided to undertake a structural reform that would solve the problem once and for all.

We decided to save the idea of a retirement plan by basing it on a completely different concept — one that links benefits and contributions.

Chile allowed every worker to choose whether to stay in the state-run, pay-as-you-go social security system or to put the whole payroll tax into an individual retirement account. For the first time in history we have allowed the common worker to benefit from one of the most powerful forces on earth: compound interest.

Some 93% of Chilean workers chose the new system. They trust the private sector and prefer market risk to political risk. If you invest money in the market, it could go up or down. Over a 40-year period, though, a diversified portfolio will have very low risk and provide a positive rate of real return. But when the government runs the pension system, it can slash benefits at any time.

The Chilean system is run completely by private companies. We now have 15 mutual funds competing for workers’ savings.

We guaranteed benefits for the elderly — we told those people who had already retired that they had nothing to fear from this reform. We also told people entering the labor force for the first time that they had to go to the new system.

Today, all workers in Chile are capitalists, because their money is invested in the stock market. And they also understand that if government tomorrow were to create the conditions for inflation, they would be damaged because some of the money is also invested in bonds — around 60%. So the whole working population of Chile has a vested interest in sound economic policies and a pro-market, pro-private-enterprise environment.

There have been enormous external benefits: the savings rate of Chile was 10% of gross national product traditionally. It has gone up to 27% of GNP. The payroll tax in Chile is zero. Of course we have an estate tax and an income tax, but not a payroll tax. With full employment and a 27% savings rate, the rate of growth of the Chilean economy has doubled.

That does not mean that we do not have any problems in Chile, but I believe that a society based on individual freedoms — economic, social and political — is a much more prosperous and lively society.

Could something like this be done in the U.S.? People have said it’s utopian and that nobody in the establishment would support privatization, but I believe the situation is changing.

Recently, I was invited by Sen. Phil Gramm, R‑Texas, to testify before the Senate Subcommittee on Securities. Basically, everyone agreed that a system like this is much more consistent with American values than a system created by a Prussian chancellor in the 19th century.

Of course, that does not mean that the reform will be done in the next month or the next year. I believe there’s still a lot of education yet to go. But there’s also a great opportunity here, and I think it’s a very responsible thing to give your children and grandchildren.