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Choice of product under government regulation: The case of Chile's privatized pension system

Many countries are considering adopting individual retirement investment accounts to replace traditional pay-as-you-go social security systems that are projected to become insolvent. Chile was one of the first countries to transit to a private accounts system 28 years ago. Since then it has served as a role model for pension reforms in several other Latin American countries. Under the Chilean pension system, workers are mandated to contribute 10% of earnings to a retirement investment account at a pension fund firm of their choice. Workers who contribute at least 20 years are guaranteed a minimum pension benefit, so government obligations depend on fund performance. The pension fund industry is privatized but subject to regulations aimed at reducing the riskiness of industry products. This paper uses data from Chile to study the operation of the privatized pension fund industry under alternative regulatory schemes related to pension fund returns and fees. It estimates an equilibrium demand and supply model using individual-level data on fund choices and firm-level data on costs, pricing, and market performance. The estimated model is used to investigate how alternative regulatory schemes affect firm pricing behavior, consumer choices, consumer balances and government obligations. We find that in the absence of any pension fund return regulation, the industry offers very risky products, which induces highly volatile consumer balances and government obligations. Another finding is that the government’s regulation that requires firms to deliver returns close to the industry average has the intended consequence of limiting product diversity but it is not very effective in reducing the riskiness of the industry’s products. This discourages individuals to participate in the pension system. An alternative form of regulation that is found to be more effective places explicit restrictions on pension fund firms’ portfolio riskiness.