Pension Reform in Chile: Challenges and Opportunities

Positive and Negative Aspects of the Reform

Among the most notable aspects of the reform is that out of the additional 8.5% employer contributions, 6% would be allocated in part to pension funds that will be reorganized as target date funds managed by private sector AFPs and in part to a new government owned fund called Fondo Autónomo de Protección Previsional (FAPP). This measure could generate greater investment opportunities, benefiting not only pensioners but also boosting economic growth by channeling resources into productive and infrastructure projects. However, the FAPP will be used for the most part to make certain defined benefit payments to current pensioners.

Thus, the pension system will have revamped private sector and government pillars. Indeed, out of the 8.5% additional employer contributions, 4.5% will go to the individual accounts of each worker with the relevant AFP; 1.5% to the FAPP under a loan structure; and the remaining 2.5% to the FAPP to finance compensation for differences in life expectancy between men and women, as well as to ensure the financing of disability and survival insurance.

This reform also brings important positive elements. Firstly, the pension fund statute (known as DL 3500) is not repealed, which means that the defined contribution pillar is maintained and the AFPs continue to exist. This provides greater stability and predictability for the system. Secondly, a significant increase in assets under management (AuM) is expected both in the pension funds managed by the AFPs and in the FAPP. This translates into more resources available for investment and, potentially, better pensions for beneficiaries. Additionally, the participation of international players in tenders to manage FAPP assets could bring experience and best practices in investment management to this government run fund.

Initially, the Bill provided for a controversial legal limit of 0.25% on investment fund commissions, along with maintaining the concept of maximum TER. As originally drafted, the total commissions charged to pension funds could not exceed 0.25% of the total assets of the pension funds managed by each AFP. Additionally, there was an even more controversial prohibition that prevented the payment of any commission to pension funds that invest more than 10% of their assets in Chilean fixed income instruments and shares of listed Chilean companies.

What Congress finally approved was that (A) the total underlying commissions charged to the pension funds cannot exceed the limit to be established by the Investment Regime, expressed as a percentage of the pension fund assets. The Investment Regime is a regulation issued by the pension regulator subject to the approval of a standing independent technical committee (Consejo Técnico de Inversiones – CTI). If the aggregate limit mentioned above is exceeded, the excess will be borne by the AFP. The maximum limit established by the Investment Regime will come into effect from the first day of the seventh month following the issuance of the relevant resolution.

(B) Congress also approved an exception to the prohibition on paying commissions to investment vehicles that invest more than 10% in Chilean issuers. The exception relates to investment vehicles or separately managed accounts that preferably invest in instruments of Chilean small or medium cap issuers, as defined by the Investment Regime (however, the new text of the bill allows the Investment Regime to extend the prohibition to investment vehicles or separately managed accounts that invest in certain foreign instruments determined by the Investment Regime that could include regional or global funds that have an exposure to Chile over a certain threshold). These commissions will continue to be exempt from value-added tax.

The reform also introduces heightened cost reporting and transparency rules for AFPs in order to distinguish investment management from front office, administrative and account management functions. The aim is to generate cost transparency and improve the efficiency of the system. Additionally, the government agency in charge of certain social security payments (Instituto de Previsión Social -IPS) will now be authorized to provide account administration services, in order to facilitate new entrants to compete with the incumbent AFPs by only having to focus on portfolio management. This is seen by some as a procompetitive measure and by others as creating a risk of unfair competition. Furthermore, the formation of new AFPs is facilitated by, inter alia, allowing non-bank general fund managers (AGFs) and certain privately held employee benefits institutions called cajas de compensación to incorporate AFPs as subsidiaries, while at the same time new restrictions are established to avoid conflicts of interest and to ensure the independence of the AFPs.

Of note is the reorganization of pension funds whereby the multi-fund system is replaced by a target date fund scheme (the target date funds are given the name of fondos generacionales, in Spanish). Beneficiaries will be mandatorily selected for the target date fund of the age cohort that they belong to. Each target date fund will have its own glide path with a decreasing risk profile as retirement approaches. Reference portfolios are established for each fund, with rewards and penalties for AFPs based on their performance relative to these portfolios.

It is important to highlight that the Comisión Clasificadora de Riesgo (CCR) is maintained with its current formation of seven commissioners, three of whom are designated by the regulators and four by the AFPs. It will continue to perform is role in relation to determining the eligibility of securities, such as investment fund interests, for pension fund investment.

Further Challenges and Criticism

One of the most worrisome aspects of the reform is that in an attempt to increase competition, a call for tenders for the management of the accounts of a certain number of beneficiaries will be organized every two years by the government. It has been claimed that this measure generates uncertainty and volatility in the system, affecting the confidence of beneficiaries and making long-term planning difficult. The forced tender of 10% of beneficiaries allegedly not only compromises and limits the AFPs’ ability to design optimal long-term investment strategies, but also exposes beneficiaries to being transferred without their explicit consent if they do not act within a brief period of 30 days. Critics further point out that this reform prioritizes the reduction of commissions over the profitability of the funds, which could result in lower pensions for workers.

In relation to the above, the risk of expropriation for pension fund managers, although dismissed by the authorities, has also been brought up as an issue. This fear has been reflected in a letter sent to President Gabriel Boric by US insurers, who warn that the reform could constitute an expropriation of significant US investments in Chile. The letter, signed by the president and CEO of the American Council of Life Insurers (ACLI), David Chavern, states that the proposal to require a biennial tender of pension beneficiaries would violate the investment rights of US investors under the investment treaty protections contained in the relevant chapter of the US-Chile free trade agreement.

The implementation of the reform could also face operational and administrative challenges. The transition to a new system requires meticulous planning and efficient execution to avoid disruptions in pension payments. Additionally, there is a risk that the proposed changes will not achieve the expected results, which could generate frustration and discontent among beneficiaries.

Critics have also focused on the loan of 1.5% of the employer’s contribution to the state. According to some business associations, this measure could increase informal employment and generate additional costs for companies. Additionally, there are doubts about the financial viability and fiscal sustainability of these loans, which has raised concern among experts.

From the seventeenth month after the publication of this law, the employer will contribute 0.9% to the FAPP to increase the pensions of current pensioners, a figure that will rise to 1.5% a year later. This contribution will not be deposited in the worker’s individual account but will be a loan to the FAPP that will be repaid upon retirement with the corresponding interest (Treasury General of the Republic bond rate for an equivalent term). It is worth mentioning that this loan will probably have a lower rate of return than the worker’s individual account, which will affect the amount of pensions. After 20 years, the contribution in the form of a loan will begin to decrease by 0.15% annually, and that amount will be progressively transferred to the worker’s individual account so that after 30 years, the entire 1.5% will go to that account.

Additionally, another concern raised is that beneficiaries will not be able to change target date funds with their mandatory savings. That option will only be open for voluntary savings.

Despite these challenges, this pension reform represents a crucial opportunity to improve the current system and guarantee dignified retirement for all citizens. It is essential to address concerns and implement measures that ensure transparency and confidence in the process. Only in this way can a balance be achieved between the potential benefits and the associated risks.

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