Skip to main content

A pension reform begins to bear fruit

By Daniel Drosdoff

LIMA, PERU – Roberto Francisco Cardenas, 42, works as a chauffeur for the regional government in the Andean city of Cusco. Angel Cruz, 59, is a retired driver in Lima who takes on occasional assignments. Maria Antonieta Garibotto 63, is a widow living in Lima.

What all three have in common is that they are affiliated with Peru’s private pension system. And all three are convinced they got a good deal.

Peru’s private pension system was established as an alternative in 1992 during a time of financial crisis and virtual collapse of the state-run pension system. The system consists of funds controlled by five competing pension fund management firms known as Administradoras de Fondos de Pensiones, or AFPs.

Mrs. Garibotto receives 700 soles (about $200) a month as a widow entitled to payments from the account of her late husband. “Thank God for my AFP,” she says. “If my husband had been affiliated with the state system I would be receiving 80 soles a month.”

The AFPs got off to a shaky start when first launched, partly because people were skeptical about the viability of the new system. But over the years, as the funds have accumulated assets and have begun to pay out benefits, word of their attractions has spread and a growing number of people have signed up.

Cruz elected a U.S. dollar-denominated option in his pension plan, and receives US$350 a month from his AFP. Colleagues in his same profession who elected to continue with the public system are receiving 350 soles a month, slightly more than US$100. When he joined an AFP in 1992, Cruz, like other Peruvians, was given a choice: stay in the public system with a return guaranteed by the state, or sign up for the new, riskier, untested private system with the potential of more income at retirement.

Cruz said he was sold on the private plan. “It was easier to sign up," he said. "There was less red tape.”

In Cusco, Cardenas was persuaded to join the private system partly because of persuasive pitches made by AFP salespeople, and also because friends and associates told him the benefits would be higher than those offered by the state system. Eight percent of his salary is deducted for the pension fund, while his employer, the regional government of Cusco, provides him with a health plan as a fringe benefit. Under the public pension plan, 13 percent of his salary would have been deducted for both a pension and a package of fringe benefits including a health plan.

A new source of capital. After more than a dozen years in operation, Peru’s AFPs now cover 3.5 million employees and have cumulative assets of US$8.7 billion. That amount already accounts for about 60 percent of the country’s investment capital and is growing at the rate of $60 million a month, says Fernando Muñoz-Najar Perea, an advisor to the AFP Association.

“The funds have achieved their major objective of improving the pensions of millions of affiliated workers,” says Muñoz-Najar.

The private system was launched in response to a fiscal crisis. “The country was broke,” he recalls. “The national accounts needed to be overhauled.” Peru based the design of its private pension system in large measure on the successful model developed by Chile. The system's development received financial support and technical assistance from the IDB and the World Bank. However, unlike Chile, which required all employees in the formal economy to enter the obligatory private plans, Peru chose to maintain a parallel national state pension system that was gradually downsized as the private plan took hold. The state plan continues to compete with the private pension system and covers around 800,000 workers.

Muñoz-Najar estimates that those receiving retirement benefits from the private plan typically get twice the income compared with those receiving a pension from the state-run system.

There are some exceptions, however. Schoolteachers by law receive parity from either the state or private pension plan. Former public officials until recently received a pension known as the Cédula Viva, which allowed them to retire at full pay. The Cédula Viva was discontinued in 2002 as part of the ongoing pension reform process, but those who were receiving benefits before the law changed continue to do so, costing the treasury an estimated $1.5 billion a year.

Low rate of coverage. Despite its successes, Peru’s private system receives criticism on two counts: it covers only about 27 percent of Peru’s economically active workforce of 13 million, and its transaction costs are considered high by some analysts.

Independent international consultant Oscar Blanco Sanchez says the “Achilles heel” of the private pension is the fact that a majority of Peruvian workers don’t receive any pension at all because they are either self-employed or belong to the 50 percent of the work force in the informal sector.

Muñoz-Najar agrees. “The main problem of the private pensions is the low number of people covered. Peru lacks of a pension culture,” he says. “People expect their children or grandchildren to take care of them in old age.”

The three million self-employed taxpaying workers in the formal economy could be enticed to join the private system if their pension contributions were exempt from taxes, as is the case in most countries, says Muñoz-Najar.

He says the AFP Association is urging the government to introduce a tax exemption for contributions and make enrollment in the private pension system obligatory for self-employed workers in the formal economy.

Workers in the informal economy will be even harder to reach with a pension plan, he says, and may need a state-financed system of allowances based on the amount a worker pays in consumption taxes, such as the value-added tax or the gasoline tax.

“An independent cab driver doesn’t get fringe benefits, but, if you ask him, he’ll tell you he doesn’t pay taxes,” says Muñoz-Najar. “In fact he pays a lot of taxes—every time he fills up his gas tank he pays a high tax on the gasoline. The state may have to take consumption taxes into consideration in devising pension systems for those not yet enrolled in any plan.”

High administrative fees. A recent study by Carmen Li of the University of Essex, United Kingdom, and Javier Olivera of the Department of Economics of the Potifical Catholic University of Peru say the average administrative fee of the Peruvian AFPs is the highest in Latin America. Muñoz-Najar notes the study was published before a significant drop in the commission rates charged by the Peruvian AFPs. He says the administrative fees vary among the five AFPs, which compete and charge different fees. Many fees dropped about three quarters of percentage point during 2005 when a new provider, AFP Horizonte, opened for business with an administrative fee of 1.45 percent of contributions to the fund, 82 basis points below the industry average.

“During the first five years of operations, all eight original AFPs lost money,” he recalls. “There was a lot of criticism in the press. People were calling the system a failure because the AFPs didn’t make a profit. Then four of the AFPs closed their operations, and the others began to make a profit. Then they were criticized for having high fees.”

Strict national laws created firewalls between the assets of the AFPs and funds held in the name of depositors, who can transfer their accounts intact to a different AFP if their original administrator goes out of business. Risk is reduced by a cap on stocks, which can account for a maximum of 30 percent of a portfolio. A single company cannot account for more than 4 percent of the stock holdings. Though conservative, the AFPs return around 6 to 7 percent, “a very good yield,” says Muñoz-Najar.

Consultant Blanco agrees that overall the AFPs have made a positive contribution to Peruvian society and the economy. “Basically, the system works,” he says. “A pension is being provided to an important segment of the population. Domestic savings are rising. The state is solvent, and it would not have remained solvent if the old system had not been changed.”

The IDB’s role. The IDB contributed to the design and establishment of the private pension system in Peru with a $200 million policy-based loan to reform the financial sector in 1992, and that same year with a parallel loan of $22 million for technical assistance.

In 2002 the Bank approved a $300 million policy-based loan to Peru to deepen public pension reform and for other measures to strengthen public finances and improve the targeting of social spending to the poorest sectors of the population.

IDB financial sector specialist Hunt Howell says Peru not only successfully carried out the programmed pension reforms but also did so in a manner that was more thorough and extensive than originally foreseen. For example, the reform effort included passage by Congress of a constitutional amendment that enabled the government to begin phasing out the Cédula Viva pensions. Howell notes that the policy-based loan also led to the reform of the police and military pension program set up in the 1970s as a nominally private, “AFP-like” plan, which had become increasingly undercapitalized due to poor governance and management. Reform was essential because the program represented a significant contingent liability for the government treasury.

Jump back to top