Why is it more efficient a capitalization pension system?

Why is it more efficient a capitalization pension system?
Why is it more efficient a capitalization pension system?
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Álvaro Martín

Álvaro Martín

Estudiante de economía internacional. Defensor del libre mercado desde que tengo uso de razón. Una sola frase para cambiar el mundo: "Laissez faire"
Álvaro Martín

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The Spanish pension system

Now we can say that there’s or will be son a government in Spain, but not an easy one, and not with easy chores.

During the last weeks, many goals have been set for the new government by the mean of the population, and many people have indicated the public pensions fund as one of the major problems of the Spanish society nowadays.

The Spanish pension system is based in share-out of funds by the population, and the quote each pensioner receives goes in relation of percentage with the last wages received during their working period.

Actually, this system is clearly unsustainable, as new workers, don’t provide enough money to the pension fund, as to be able to cover pensions costs in the future, we are finding ourselves in a pay-as-you-go situation, where pensioners are receiving money from the actual worker’s taxation, and not from their saved incomes from the past, which is really the main objective of a pension fund, no matter what type.

Chile and the capitalization pension

Otherwise, in Chile since the period of the 1980’s, a capital-based pension system has been installed, where instead of making people dependent on nowadays labor capital wages, invests the income into different assets and various markets, distributing between bonds of different states, stock market, derivate market or even in some cases private equity. But why is the capitalization system more efficient?

Firstly, through the capitalization system, each citizen has an individual account; and not a general fund, which measures its retirement income, where each month, the contributed quantity is deposited into that account, being later on invested by the Fund Administrators.

The profit yield earned from the investment is added to the personal fund afterwards and used at a later date to pay for the individual pensions of workers.

During their active working period, workers don’t receive money from this accounts, even in unemployment situations, and most important of all, the government is not allowed to use this funds for other purposes which differ from direct investment.

The State control

Even though the State controls the funds, its basic function in the pensions sector is just providing certain benefits to their contributors, and being able to reduce the effect of systemic risk on the system in situations as a downturn or recession.

In the capitalization pension system, workers are able to choose; at least in Chile, in what financial institution they want to invest their money, at what cost, and most important of all, what risk do they want to take with their investment, taking into account the arousing profitability market.

Fondo de reserva de la seguridad social

Citizens

Second, in order for the government to be able to guarantee a minimum number of pensions, and to obtain a respectable amount of benefit from the investment funds, the State requires citizens to provide a 10% of their income through income tax just for the pension system, while in Spain the percentage of income tax in relation to the pension system is 28.3%, showing the clear tax relief the Chileans enjoy.

This increase the efficiency in the system, as in difference of many public workers in other countries, there exists very high competition in the Chilean capitalization pensions system, as if they don’t reach the desired benefit, the main workers for the investment funds will be fired, which in the mean term increases productivity in the sector even though of being publicly financed.

It is true that maintaining a capitalization of pensions system is much more expensive than a share-out one in terms of payments for administration and services offered, but we have to remind that the fund managers in charge of this have a minimum fixed salary, and the rest of their wages in variable terms depending on the 10% of the whole monthly profitability of the funds, which acts as an incentive to increase productivity and efficiency in investment, and leads to take risks which can be profitable in the future, but never in excess.

 Chilean AFP System AUM

Conclusions

In conclusion, we have been able to see, how the capitalization pensions system is much more and lower income tax gives citizens a major disposable income, and overall freedom to decide what to do with their money, even if they want to invest it, save it in a fund or deposit, or spend it into goods and services, leading to an increase in consumption levels.

This system will maintain a constant economic growth, through annual increases in GDP, while the pension returns will keep on increasing, and many of the yield margins from the national investment funds have a tight relationship with internal economic growth or external investment, which will also be attracted by this system, and good growth conditions, over stable bases.

To end up, I would like to remind a phrase the philosopher Robert Nozick wrote in one of his books in clear reference to the income tax:

“Taxation of earnings from labor is on a par with forced labor.”

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