LSE pensions expert Nicholas Barr talks Chile, Peru

Chile's government is due in August to submit its pension reform bill, which overhauls the country's private pension fund system. The system has come under fire for the small pensions it provides to many retirees.

In neighboring Peru, a pension freedom law enacted last year has led to US$2bn being withdrawn from pension savings funds.

Against this backdrop, BNamericas spoke with pensions expert Nicholas Barr, a professor of public economics at the London School of Economics. Barr was part of a commission established by the current administration in Chile to come up with pension reform proposals.

BNamericas asked Barr about the two countries' different challenges, and more.

Barr has also advised governments in post-communist countries as well as in the UK, Australia, China, New Zealand and South Africa.

BNamericas: More than 100,000 members of Peru's private pension fund system have withdrawn 95.5% - the maximum allowed by law - from their savings pots, the country's association of private pension fund managers said this month. This works out to about US$2bn. What are the implications of this and did you foresee this happening?

Barr: Behavioral economics gives two reasons why people behave in the short-run in ways that do not benefit them in the long-run. Bounded rationality arises where a problem is too complicated for people to work out what they should do. The problem arises with medical care, and can do so also for complex financial products. With bounded will-power, people know what they should do but do not do it: they know they should save more, but delay doing so. Allowing people early and easy access to their pension savings faces both sets of problems. Relatively few people understand the relationship between a pension pot and the resulting flow of benefits - a sum of money that sounds large - say US$5,000 - provides only a small annual pension. The policy makes sense for very small pension pots, but as a general policy creates a major risk of future pensioner poverty.

BNamericas: In Chile, the government, as part of its pension reform bill that is due to be submitted in August, is proposing a 5% increase in contributions which employers would shoulder.  How far would this go in helping to address Chile's pension problems?

Barr: The [current] contribution rate of 10% in Chile is low by international standards. Thus the likelihood that a worker will have a good pension rests on a best-case scenario of a more-or-less full contribution record and a high long-run return on pension saving. For that reason, the Bravo Commission were right to recommend an increase in contributions.

BNamericas: Continuing with Chile, in your opinion, should all of the 5% increase go to private pension fund (AFP) members' individual accounts or should part of the increase go to the government's solidarity pension scheme?

Barr: Declining fertility in Chile means that the workforce in future will be smaller. A rational policy response is to make each individual worker more productive by investing in the physical capital (computers, etc.) he or she uses, and in more education and training. The need to finance such investment is a powerful argument for protecting the savings element in the pension system in Chile. However, there is no economic theory that says how the 5% increase in contributions should be divided between saving (the AFP accounts) and current solidarity benefits. Thus the division should be decided mainly on the political grounds of how best to protect the current level of saving.

BNamericas: The longevity issue appears to be everywhere. Are there any particular measures you have seen in other countries which Latin American governments could adopt?

Barr: Population ageing has two sources: declining fertility and longer lives. As noted in the previous answer, the policy response to the first is higher saving. The policy response to the second is over time gradually to raise earliest pension age. Alongside later retirement, a further useful policy is to give people more options for flexible retirement.

BNamericas: Chile's association of insurers has proposed a type of plan under which an affiliate's pension contributions would be paid for a period if he or she is laid off from formal employment. Could this help address the problem of contribution gaps?

Barr: Incomplete contribution records are arguably the main reason why pensions in Chile are low. Thus making sure that a formal-sector worker who is unemployed retains a continuous contribution record would make an important contribution to pension adequacy.