India Considers the Chilean Model

By M.K. Venu
[The Economic Times, India]

The finance ministry is looking closely at the 'Chilean model' to reform the system of collection and investment of the employees provident fund, which has a corpus of about Rs 35,000 crore. Chile's experience in this regard has interesting lessons for India. Chile, which began its economic liberalization programme 20 years ago, has managed to maintain a sustained and impressive growth in its national savings, largely by creating a safe and innovative institutional framework for attracting and investing the savings of its huge middle class.

Chile's success lay mainly in its ability to link the massive corpus of employees pension fund to the capital market, thus creating a market driven as much by domestic funds as by the foreign institutional investors (FIIs). An official at its embassy in Delhi says Chile was perhaps the only country which could withstand the shock sent out by the Mexican crisis in that region.

This aspect of the 'Chilean model' has particular relevance for India since there has been some debate, of late, on whether the domestic investment institutions like UTI and others can rival the financial muscle of the FIIs.

Chile realised long ago that the management of pension funds by the government, as is the case now in India, was inefficient and gave a low rate or return to the investor. In India, till a few Years ago, the PF money could be invested only in government securities or special deposits of the RBI. The average interest rate earned on these investments were thus less than ten per cent. Of late this yield on investment by PFs has improved with the progressive increase in the yield on government paper. The government has also allowed part of the PF corpus to be invested in PSU bonds which give a higher interest income.

The Chilean model advocates talking away the PFs completely from government control so that they could be managed by smaller fund managers run privately but strictly supervised by the government with proper guidelines.

Thus the PFs will act as quasi-mutual funds giving the investor the maximum return. According to data provided by the government of Chile, the privatised pension funds there give an average rate of return of 14 per cent with a host of options to a retiree. On retirement the private pension funds in Chile give a lump sum to the employees, as is done by our provident funds, but offers added incentive for retention of part of the funds to be distributed as pension in the later years.

The employee has the option to choose from the scores of pension funds which are run privately, but strictly monitored by a 'Superintendency of Pension Fund Administrators'. There is one administrator, who acts as a regulatory authority, for each pension fund. The employees go for the fund which charges the lowest fee with an indicative return.

The portfolio composition of funds is highly regulated and investments are made on the basis of a very conservative risk evaluation system. Most importantly, the government stands as a guarantor of the last resort just in case some fraud occurred in any of the funds. There are also specific measures which limit the losses of the pension saver.

Over the last ten years or so the people of Chile have accepted the new system in an overwhelming way. The newly created private pension funds have accumulated over $23 billion, about 40 per cent of the GDP, and projected estimates are that this amount will reach 60 per cent of the GDP.

The pension fund administration companies (AFPs) invest in stocks, bonds and government debt. They also invest in safe instruments in the international market. This acts as a cushion when there is a sudden dollar outflow when foreign institutional investors operating in Chile book their profits by selling stocks.

Each worker gets a passbook from his AFP informing him as to the amount accumulated in his account. The worker has to deposit a minimum of 10 per cent of his gross salary each month on an annual income of up to $20,000. On retirement when the amount is withdrawn the worker has to pay a lower tax. The AFP also includes widows and orphan benefits, insurance against premature death, permanent disability and so on. The AFP also organises insurance coverage for their clients. Thus the coverage is comprehensive and services prompt.