Analysis of the Brazilian pension system:
Should Brazil reform its pension system according to the Chilean pension model?
ERASMUS UNIVERSITY ROTTERDAM
Department of Economics
August 2009
Supervisor: S.G. van der Lecq
Name: Johanna van Tol
Exam number: 302692
E-mail address:
Abstract:
During the last couple of decades various countries have reformed their pension system. Particularly Latin America has been the platform of many pension reforms during the 1980s and 1990s. Chile pioneered in making a radical change from a publicly managed Pay-As-You-Go (PAYG) system to a privatized fully funded system and it was then followed by numerous neighboring countries. However, Brazil took a different approach as it kept its PAYG system. Currently Brazil faces several threats and challenges for the sustainability of the pension system. Examples are the ageing of the society, too generous benefits that are paid to the public workers and the increasing income inequalities. These threats and challenges lead to the question how Brazil can change its pension system in such a way that allows them to cope with problems and enhance the sustainability of the system. This paper analyses the several options a country can choose to design its pension system and lists of each the advantages and disadvantages. Subsequently it takes a closer look at the current system in Chile and the negative and positive effects of that reform. The paper continues with an examination of the problems in the Brazilian pension system. Combining the (dis)advantages of the pension design options and the characteristics of Brazil the paper finds that it would be in Brazil’s best interest to reform its system into a fully funded system like Chile. Additionally, the paper gives several recommendations on how the reform should be implemented in Brazil. The paper finishes with suggestions for further research that relate to the winners and losers of the reform and the transition and administration costs.
Keywords: pension reform, Brazil, Chile, pension system, ageing
Table of contents
1. Introduction 4
2. Why do pension systems exist? 5
2.1 What is a pension? 5
2.2 Functions of a pension system 6
2.3 Subsidiary objectives for pensions 7
3. Overview of different types of pension systems 8
3.1 Three pillar design 8
3.1.1 First pillar 9
3.1.2 Second pillar 10
3.1.3 Third pillar 11
3.2 Pay-As-You-Go system 11
3.3 Fully funded 12
3.3.1 Defined contribution (DC) plans 12
3.3.2 Defined benefit (DB) plans 13
3.3.3 Hybrid schemes 13
4. Advantages and disadvantages of different pension plan designs 14
4.1 Options to structure pension systems 14
4.1.1 Voluntary or mandatory contributions? 14
4.1.2 Publicly or privately managed pension system? 16
4.1.3 Fully funded or PAYG? 18
4.1.4 Defined benefit (DB) or defined contribution (DC) plan? 20
4.2 Remarks on designing pension plans 21
5. The pension system in Chile 22
5.1 Historical overview 22
5.2 Overview of current pension system in Chile 23
5.2.1 First pillar 24
5.2.2 Second pillar 24
5.2.3 Third pillar 25
5.3 Other features of the reform 25
5.3.1 Gradual transition 25
5.3.2 The role of the government 26
5.3.3 AFPs 26
5.4 Results of the pension reform 27
5.4.1 Positive effects of the reform 27
5.4.2 Negative effects of the reform and future challenges 29
6. The pension system in Brazil 32
6.1 Historical overview 32
6.1.1 The origin of the Brazilian pension system 32
6.1.2 1988 Constitution 33
6.2 Overview of the current pension system in Brazil 35
6.2.1 Zero pillar 36
6.2.2 First pillar 37
6.2.3 Second pillar 38
6.2.4 Third pillar 38
6.3 Challenges ahead 38
6.3.1 Ageing of the society 39
6.3.2 Too generous benefits for public workers compared to benefits for private workers 42
6.3.3 Disparities in the retirement age and contribution time between men and women 43
6.3.4 Income inequalities and poverty 44
6.3.5 Informality 44
7. Comparing the Brazilian and Chilean pension models 46
7.1 Comparable pension system problems 46
7.1.1 Demographic situation 46
7.1.2 Economic situation 47
7.1.3 Political situation 48
7.1.4 Government budget situation 48
7.1.5 Problems in pension systems 48
7.2 Analysis of the options to structure the pension system 48
7.2.1 Structure choices made in Chile and Brazil 49
7.2.2 How should Brazil structure its pension system? 49
7.3 Policy recommendations 51
7.4 Winners and losers 52
8. Conclusion 53
9. Reference list 55
1. Introduction
During the last couple of decades various countries, both developed and developing, have reformed their pension system. Possible motives for these reforms have been demographic developments (e.g. rising life expectancies and falling fertility rates), transitions in the labor market (e.g. increasing informality) or (increasing) deficits on the pension balance. Particularly Latin America has been the platform of many pension reforms during the 1980s and 1990s. Chile pioneered in making a radical change from a publicly managed Pay-As-You-Go (PAYG) system to a privatized fully funded system and was then followed by numerous neighboring countries. In total 11 Latin American countries took the Chilean model as an example for reforming their own pension system, but Brazil took a different approach. Brazil found the political and economic implications of the reform insurmountable because of fiscal constraints. Therefore, Brazilian government decided to focus on strengthening their public PAYG system.
Currently Brazil faces several threats and challenges for the sustainability of the pension system. Examples are the ageing of the society due to rising life expectancies and falling fertility rates (United Nations 2008), too generous benefits that are paid to the public workers leading to large budget deficits (Ferreira Savoia 2007) and the increasing income inequalities (Besley and Burgess 2003). These threats and challenges lead to raising the question how Brazil can change its pension system that allows them to cope with problems and enhance the sustainability of the system. Is it advisable that Brazil also follows the other 19 countries worldwide that have transformed their pension system in accordance with the Chilean model? Or should the current PAYG system be adjusted in such a way that it can handle the problems? These questions lead to the main research question of this paper: ‘Should Brazil reform its pension system to the Chilean pension model?’
Previous literature has concentrated on analyzing the Chilean reform and describing the current Brazilian pension situation and the main challenges it faces. For example, Schmidt-Hebbel (1995) and Mesa-Lago (2003) assessed the Chilean reform benefits from a macroeconomic and growth perspective and outlined the accomplishments and weaknesses. Pinheiro (2004) and Medici (2004) described the historical overview of the Brazilian pensions system, explained why the Brazilian government did not reform the pension system like the other Latin American countries and how the current system operates. In addition, Bonturi (2002) and Ferreira Savoia (2007) identified five critical matters of concern for the sustainability of the current Brazil pension system. However, none of the literature gave clear suggestions on how the current problems in Brazil can be solved. No research assessed whether in particular the Chilean model would be a suitable alternative, as it has proved to be a success in other Latin American countries (Roncada 2000).
This paper first takes a look at the different options to design a pension system in general. Pension designers have the choices of having a mandatory or voluntary system, a publicly or privately managed system, a PAYG or fully funded system and finally Defined Benefit (DB) or Defined Contribution (DC) schemes. For each of the choices the advantages and disadvantages of the options are explained. Additionally, the current pension situation of Brazil and the Chilean reform is described. By combining the analyses of the pro’s and cons of the various options for structuring a pension system in general and the Brazilian characteristics in specific, the most suitable pension design for Brazil can be identified. The paper finds that this most optimal design for Brazil resembles the features of the Chilean pension system. However, before examining whether the Chilean pension model should actually be implemented in Brazil, it is important to ensure that the two countries face the same pension problem. After concluding that Brazil and Chile are quite similar in terms of their demographic, economic and fiscal situation, the paper gives several policy recommendations on how the Chilean model should be implemented in Brazil. Furthermore, it highlights the lessons Brazil can learn for Chile and eventually how the sustainability of the Brazilian pension system can be improved.
In section 2 the existence of pension systems in general is explained, followed by an overview of the different types of pension systems in section 3. Section 4 continues with the advantages and disadvantages of the different types that were described in the previous section. Sections 5 and 6 outline the pension situation in Chile and Brazil, respectively. Subsequently, section 7 makes a comparison between the two countries and answers the research question, whereas section 8 concludes.
2. Why do pension systems exist?
This section starts by giving a definition of pension, continued by the three main functions of a pension system. Furthermore, secondary functions of pensions are presented, which should be given the appropriate priority as they can undermine the original functioning of pensions.
2.1 What is a pension?
The concept of pensions is used to indicate different types of benefit payments. To define a pension, this paper uses the definition given by the World Bank. The World Bank (1994) defines a pension as: ‘Old age, retirement, survivors’, death, and invalidity-disability payments based on past contribution records plus noncontributory, flat universal, or means-tested programs specifically targeting the old.’
2.2 Functions of a pension system
In designing a pension and social insurance system, particular emphasis is placed on balancing the functions of consumption smoothing, insurance and redistribution. Disparities in pension design are the result of differences in the level of solidarity and policy priorities between countries.
The first key function of a pension system is to facilitate individuals to smooth their consumption over their lifetime. Over an individual’s life course his or her income varies substantially. This particularly holds for individuals who are mainly dependant on wages as means of income. Consequently, it necessitates for shielding an individual’s consumption from part of these fluctuations in income. If an individual saves a part of his or her income during his or her working life, then after retirement these accumulated savings can be used to provide an adequate income. In Figure 2.1 and Figure 2.2, the consumption smoothing with two scenarios is graphically illustrated. Even in the event of uncertainty in terms of labor market, economic crises and cuts in social programs, consumption can still be partially shielded from fluctuations.
Figure 2.1 Consumption smoothing Figure 2.2 Consumption smoothing
without uncertainty with uncertainty
Source: Barrientos (2002) Source: Barrientos (2002)
Secondly, a pension plan operates as an insurance against several unforeseen events or risks which could have an adverse effect on household consumption. It mainly protects against the longevity risk which is defined as the possibility that people could outlive their accumulated savings. With rising life expectancies across the world (UN 2007), this possibility becomes more likely if the benefit formula is not adjusted accordingly. On the other hand, a pension plan insures against early deaths as well. In case of the (premature) death of the breadwinner, benefits will be paid to the dependent survivors. Moreover, factors influencing the length of the working life, for instance unemployment and disability, can be minimized. Lastly, via indexed pension benefits pension plans also limit the inflation risk.
Thirdly, pension plans can serve a redistributive function, if contributions paid by workers are used to pay the benefits of the elderly. Besides redistributing income across generations, by for instance passing on income from individuals who work to people who are old, pension plans can also redistribute income within generations. This can be accomplished by, for example, a redistribution that favors the benefits paid to women or poorer elderly. Another, perhaps more obvious, example are the benefits paid to the disabled.
These three functions together attribute to the main objective of a pension system, which is to assure an adequate standard of living for elderly to the highest level possible. Adequacy can be classified into three categories; relative, absolute and, partly relative and partly absolute. Relative adequacy means that the retirement benefit is adequate relative to the individual’s previous standard of living. Absolute adequacy, on the other hand, refers to a retirement benefit that results in a pension income high enough to afford a pre-specified absolute level of living. (e.g. to the nationwide poverty line) The last possibility focuses on providing a higher benefit per dollar contributed to people who have lower incomes. In designing a retirement system a country can choose which type of adequacy it wants to fulfill and adjust its plan accordingly.
2.3 Subsidiary objectives for pensions
It is often found that pension systems also carry other responsibilities in addition to the previously described objective. Examples in Latin America can be found where the pension reforms are also intended to deepen the capital market or to stimulate the country’s economic growth. However, caution is in order as subsidiary motives can cause problems that undercut the original functioning of pensions. Additionally, these secondary objectives should not become more important than the fundamental objective, as they could undermine rather than improve retirement income security.
3. Overview of different types of pension systems
This section will outline the general design of a pension plan, with the frequently used three pillars system. Each pillar serves a particular function and is managed differently. The main characteristics of each pillar are listed and elaboration is given on funding each particular pension pillar.
3.1 Three pillar design
Pension plan features vary considerable among countries in, for instance, who has to pay pension contributions. Another issue is who receives pension benefits. Lastly, the relationship between benefits and contributions shows variances in the degree of linkage across the world. However, a general picture of a pension system design can be drawn as in the majority of countries the system consists of three pillars or parts of it (World Bank 1994). This construction can simply be described as; ‘Do not keep all of your eggs in one basket’. Specifically for a pension system design, it refers to the three pillars that are exposed to various risks and the correlation among these risks is considerably lower than 100 per cent. Consequently, a pension system that is built upon multiple pillars will profit from security through diversification (Rutkowski 2002). The most effective size and combination of pillars varies over time and place. This combination is partially path dependant and influenced by the nation’s pension objective and current situation. Moreover, the extent to which the financial markets are developed, the sophistication of the regulatory system and the government’s taxing ability should also be taken into account in determining the right size and combination of pillars.