Appendix III Brief Notes on the Pension Regimes of Selected Countries

Alfredo Cuevas, George Mackenzie, and Philip Gerson
Published Date:
September 1997
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Private Plans in Selected Industrial Countries


Private retirement plans in Japan are either lump-sum severance payment plans or pension plans that provide annuity benefits. Ninety percent of all firms offer one or both types of retirement plans, and virtually all firms with more than 300 employees offer some type of retirement plan for their regular workers. Even among firms with only 30–99 workers, more than 85 percent offer a retirement plan. Traditionally, most firms have offered lump-sum retirement payments, but annuities have become increasingly popular. Between 1975 and 1985, the percentage of firms offering only lump-sum severance payments fell from 67 percent to 52 percent. The trend toward annuities is even stronger in larger firms.

Lump-Sum Plans

Among firms offering lump-sum severance packages, payments are available regardless of the cause of a worker’s departure, although typically the value of the payment is sharply reduced when departure is voluntary, with the extent of the reduction depending on the worker’s length of service. Workers become eligible for some form of lump-sum severance payment after two to three years of service. The value of the lump-sum benefit at retirement is usually a function of years of service, typically one month of final salary for each year of service. In 1988, the average benefit paid to male college graduates retiring at age 60 was equal to about 3.5 years of annual salary.

Employers with lump-sum retirement benefits can establish a reserve fund in a public (external) financial institution from which to pay them. Alternatively, they may establish a book reserve within their own firm. These book reserves are an important source of capital for many firms and effectively make paying lump-sum severance benefits contingent on the firm’s financial performance. For funds invested within the firm, employers receive a tax deduction equal to the lesser of 40 percent of the amount that would be payable if all workers voluntarily separated from the firm, less the deduction that was available up to the end of the previous year; or 6 percent of total payroll costs. However, no tax deduction is allowed if funds are invested outside the firm, which explains why most firms create internal book reserves for lump-sum payments.

Because of the rising cost of lump-sum retirement programs (owing to rising wages, the aging of the population, and the limited deductibility of book reserves), many firms have opted to replace their lump-sum severance packages with pension schemes. More than 80 percent of firms with 1,000 or more employees have transformed their traditional retirement plans, partially or entirely, into funded pensions. (However, because many retirees opt to take their pension benefits in a lump-sum distribution, the effective magnitude of the shift may be overstated.)

Pension (Annuity) Schemes

Japanese pension (as opposed to lump-sum retirement) plans are either tax-qualified pension plans or employee pension funds. Tax-qualified plans are offered by smaller firms and are not coordinated with the social security system. The employee funds are coordinated with the social security system and can be offered only by larger firms.49 By offering an employee pension fund, a firm is able to opt out of the earnings-related portion of social security. Firms offering tax-qualified pensions may not do so.

Tax-Qualified Pension Plans

Employer contributions to tax-qualified pension plans are treated as a business expense and are there-fore fully deductible. Benefits are not taxable for retirees until they are paid. Retirees receive an income tax exemption for lump-sum payments based on years of service. In 1989, the exemption was ¥400,000 a year of service for the first 20 years and ¥700,000 for each year of service beyond that. One-half of the benefits beyond this amount are tax free, while the other half are taxable as regular income. Retirement income from annuities is also subject to preferential (though more complicated) tax treatment. Finally, the assets in a pension plan’s reserve fund are taxed at a rate of 1.173 percent a year.

By law, all employees of a firm, except company directors, must be eligible to participate in the retirement fund. Benefits must be based on years of service, using either a flat benefit or an earnings-related formula. Most plans offer fixed-term annuities of 5, 10, or 15 years, rather than life annuities, with no joint or survivor options. The interest rate used to convert fixed-term annuities to lump-sum values is specified by the Ministry of Finance. Because this rate, which has been set at 5.5 percent for some time, exceeds the rate of interest on government debt, it penalizes retirees electing the lump-sum option. This penalty notwithstanding, 90 percent of retirees opt for the lump-sum payment. Workers who leave the firm before normal retirement age typically must take a lump-sum benefit, because there is no vesting of annuities.

Employer contributions must be either a specific yen amount or a specific percentage of payroll; contributions depend on liabilities measured using service to date and a projection of future earnings based on the tenure-earnings relationship in place in that company at that time. Future inflation and productivity growth are ignored in calculating liabilities. Funding is limited to 100 percent of liabilities, and employee contributions are almost never required. Tax-qualified pension plans must be actuarially evaluated at least every five years, and any excess reserves must be returned to the firm at that time. As a result, pension plans are almost always under-funded because firms are not allowed to make excess contributions to take into account wage growth attributable to productivity enhancements or inflation.

Investment policies are dictated by law. At least 50 percent of funds must be in government bonds or bonds carrying a government guarantee. At most, 30 percent can be in stocks, 30 percent in foreign investments, and 20 percent in real estate. Finally, no more than 10 percent of the pension fund can be invested in the sponsoring company.

Employee Pension Funds

Employee pension funds can cover workers in a single company or in two or more companies. Because of minimum size regulations established by the government, these funds are much larger than tax-qualified pension funds. Both employer and employee contributions are tax exempt. Although the assets of funds are in theory taxable, the exemption level is set high enough that the assets of most funds are exempt.

Benefits are composed of two parts. The first, the “substitution” component, is linked to the earnings-related component of the social security system, the employees’ pension insurance payment. Its name reflects the fact that, in exchange for lower social security contributions, the employee pension funds take responsibility for providing the earnings-related component of social security. Contributions to fund these payments are shared equally by the firm and its employees.

The second benefit component is a supplemental payment, to be provided by the employee pension fund, that should equal at least 30 percent of the substitution benefit that employees accrue while working for the firm. Employer contributions to the supplementary payment must be at least as large as those required of employees. As with tax-qualified pension plans, an interest rate of 5.5 percent is used to calculate the lump-sum value of a retirement annuity. The government takes responsibility for cost of living increases to the substitution benefit. No cost of living increases are typically granted for the supplemental benefit.

Workers are fully vested for the substitution benefit after one month of employment. Vesting for the supplementary benefit typically occurs after 20 years of employment, although reduced lump-sum payments are available to those who separate from firms early. The Pension Fund Association (PFA), of which all employee pension funds are required to be members, takes responsibility for paying the substitution benefit to workers who leave their employers after fewer than ten years, with the assets sufficient to make these payments transferred from the firm’s pension fund to the PFA’s accounts. Thus, the PFA provides for portability of the contracted-out benefit. In addition, workers have the option of transferring their lump-sum supplemental severance payment to the PFA for a future life annuity that is actuarially equivalent to the lump sum.

Funding and administration are supervised by the Ministry of Health and Welfare. Funds are held and invested by either trust banks or insurance companies, although consideration has been given to allowing the use of investment advisors and in-house management. Investment policies are identical to those prescribed for tax-qualified pension plans. As with tax-qualified plans, liabilities are determined by projecting earnings out to retirement using the company’s current tenure-earnings profile. Funding is limited to 100 percent of liabilities, with actuarial reviews occurring at least once every five years. How-ever, excess reserves are not returned to the sponsoring firm. Instead, firms must either reduce future contributions or improve plan benefits, with either change requiring the approval of the Ministry of Health and Welfare.

Employee pension funds are organized as public corporations and are established by employers and employees. A majority of employees and unions must approve their establishment. They are managed by large governing bodies (14–68 members), with employers and employees each choosing the same number of members.

United Kingdom

A wide variety of occupational pension schemes are in place in the United Kingdom, to which about one-half of the workforce contributes, a level of coverage that has remained steady since the mid-1960s. By one estimate, private pension funds account for about one-third of all personal wealth in the United Kingdom and hold about 40 percent of all U.K. equities (Dilnot and Johnson, 1993).

Occupational Defined-Benefits Plans

The occupational schemes are required by law to offer a specific guaranteed minimum pension. Most offer more generous pensions, ranging from one-half to two-thirds of final-year earnings. Part of this benefit, up to one and a half times final-year earnings, may be taken as a tax-free lump sum.50 Except for the onetime lump-sum payment, annual pension benefits cannot exceed two-thirds of final-year salary without endangering the preferred tax treatment for pension contributions. In 1989, the government imposed a limit of £60,000 on pensionable earnings for new plans or new entrants to existing plans. This ceiling is indexed to the retail price index and thus increases annually. Occupational schemes are required to index the guaranteed minimum pension for price increases up to 3 percent a year, with the state assuming responsibility for the costs of any inflation exceeding this rate.

There are few restrictions on the investment practices of pension funds, other than an implicit requirement (through the trustees’ duty of prudence) to diversify assets. Not more than 5 percent of a pension fund’s assets can be invested in the stock of its sponsoring company. Pension funds must have a sufficient level of funding to cover a guaranteed minimum pension, payment of which is guaranteed by the government in the event that the private scheme fails. How-ever, there is no requirement that plans be funded above this level. In addition, assets are valued not at their current market prices, but rather on the basis of the discounted value of expected future cash flows.

Recently, provisions have been put in place to limit overfunding to 5 percent of projected obligations, require indexation of benefits for early retirees, outlaw compulsory membership, limit tax-free contributions and benefits, and increase portability. These changes are expected to lead to a decline in company-based pension plans because they reduce the attractiveness of the plans to both employees and employers. Nonetheless, no clear trend away from company plans is as yet observable.

Opting Out of the State System and Defined-Contributions Plans

Since 1988, workers and employers have also been allowed to choose individual personal defined-contributions plans, offered through insurance companies, banks, and other financial institutions. Under these schemes, the worker and the employer continue to make full contributions to the State Earnings-Related Pension Plan (the earnings-related component of the public scheme), which are then subsequently transferred to the chosen plan. This opting-out feature reduces contributions to the public system and, in this respect, is similar to the Chilean system, with the important difference that in the United Kingdom participation in defined-contributions plans is not compulsory.

Workers and employers can also make additional, tax-free contributions (within limits) to the scheme, whose value at retirement will depend not only on the value of contributions, but also on the performance of the investments made by the fund. Benefits under these schemes must be indexed for up to 3 percent annual inflation—again, with the state paying the costs resulting from higher inflation. It was expected that these defined-contributions plans would be more popular with employers and thus encourage the spread of private pension schemes. By 1990, about 4 million individuals had opted for personal pension plans (2.7 million of them men), and the take-up rate among men aged 22–26 approached 50 percent.

United States

The private pension system in the United States is massive, with more than 800,000 plans in operation in 1985. According to a 1995 survey, 91 percent of firms with more than 200 employees offer some sort of retirement plan. In 1987, nearly 42 million workers—representing 46 percent of private wage and salary earners—were covered by a private pension plan. However, the participation rate for full-time employees has declined over time and, between 1985 and 1988, fell from 91 percent to 86 percent.

At the same time, employer-provided plans (which constitute about four-fifths of all private pension plans) have been shifting from defined-benefits to defined-contributions coverage. In 1975, 87 percent of active participants in private pension plans received their primary coverage through a defined-benefits plan, but by 1985, the percentage had dropped to 71 percent. In 1995, more than half of all firms offered their employees both types of plans. Generally, the larger a firm and the more unionized its employees, the more likely it is to offer a pension program.

To some extent, these changes in the level and type of pension coverage reflect shifts in employment patterns, with the gaining sectors not being as heavily “pensionized” as the losers. However, they also reflect changes in the tax treatment of defined-contributions plans, and possibly also some loss of confidence in the financial integrity of defined-benefits plans.

Few private pension plans index their benefits for inflation. During the 1970s, many beneficiaries of private pensions received ad hoc inflation adjustments, although typically these were not sufficient to maintain the real value of benefits. During the 1980s, only about one-fourth of all participants in medium-size and large firms were in plans that granted post-retirement benefit increases to retirees. This aspect of the private pension system means that it does not really provide a full annuity to retired persons.

Vesting periods vary from program to program. After the passage of the ERISA in 1974, workers were generally vested after ten years of service. The Tax Reform Act of 1986 shortened the allowable vesting period for most workers to a maximum of five years. Typically, defined-contributions plans will have shorter vesting periods than defined-benefits plans. The ERISA also established IRAs, which allowed workers not covered by private pension plans to make tax-deferred contributions of up to $1,500 a year (later raised to $2,000) to a retirement account. In 1981, IRA eligibility was extended to almost all workers, although the Tax Reform Act of 1986 eliminated the ability of higher-income taxpayers to invest pretax dollars—that is, to make tax-deductible investments—in IRAs. In 1985, about 16 percent of all taxpayers contributed to an IRA, but by 1987, after the tax law change, the percentage of participants fell to about 7 percent.

In general, pension contributions are tax deductible when made, and benefits are taxed only when they are received. However, there are upper limits on the size of contributions individuals can deduct from their taxable income, and there is a maximum benefit that defined-benefits plans can pay. In 1982, this limit was $90,000 a year (with cost of living adjustments to this ceiling beginning not in that year but in 1986), and contributions to defined-contributions plans were capped at $30,000 a year, with no inflation adjustment until the maximum defined-benefits pension reached $120,000 a year. The Tax Reform Act of 1986 linked the retirement age for defined-benefits plans to the retirement age for social security pensions, with actuarial reductions in benefits being mandated for early retirement. The 1986 law also capped the annual salary that could be used for calculating either benefits or contributions at $200,000 (to be adjusted for inflation annually) and limited the amount that employees could invest in tax-deferred 401(k) accounts. In 1993, the annual salary cap for pension calculations was rolled back to $150,000 a year. Employee income that is contributed to a retirement program on an after-tax basis is tax exempt when withdrawn, although any income earned on the contribution is taxable when with-drawn. Under the Tax Reform Act of 1986, employees pay a 10 percent excise tax on early distributions. The employer may also pay a penalty tax (in addition to corporate income tax) on any assets that revert to it following the voluntary termination of its retirement program and the distribution of benefits to its employees (e.g., as would be the case if the firm deliberately overfunded its retirement plan to reduce its current tax liability). Perhaps in part as a result of increasing legal restrictions on pension funding, firm contributions to pension plans in the United States fell sharply in the 1980s.

Private pension plans are subject to considerable federal regulation. Federal law requires that firms that offer pension programs do so in a way that does not discriminate among classes of employees. The Tax Reform Act of 1986 establishes a simple test: at least 70 percent of a firm’s rank-and-file employees should be eligible to participate in the pension plan, and at least 70 percent of those eligible to participate should do so. Average benefit tests, and a requirement that at least 40 percent of all employees should benefit from the program, also exist. Employees covered by plans must be eligible to participate after one year of employment. In June 1995, the U.S. administration announced plans to weaken some of the criteria used to determine if a plan is discriminatory. Specifically, under the administration’s proposal (which must be approved by the Congress), companies with fewer than 100 employees would be exempted from nondiscrimination requirements.

Financial aspects of private pension plans are also subject to federal regulation. The ERISA prohibited unfunded defined-benefits plans and set minimum funding standards that require defined-benefits plans to amortize past service liabilities over 40 years. Experience gains and losses had to be amortized over 15 years, and benefit increases over 30 years. In 1987, the amortization period for existing liabilities was shortened to 18 years, and the payment of funding contributions was changed from an annual to a quarterly basis. Since 1988, experience gains and losses for single-employer plans must be amortized over a five-year period. Defined-benefits plans are insured by the Pension Benefit Guarantee Board, with the plans paying insurance premiums. Benefits from defined-contributions plans are entirely at risk.

Pension Plans in Selected Countries Introducing a Chilean-Style System


Public Scheme

Prior to the 1994 Reform

Pension benefits have historically been generous in Argentina: prior to the reforms that were introduced in 1994, individuals who had worked for at least 30 years and contributed to the system for at least 20 years qualified for a pension at the statutory retirement age of 60 for males and 55 for females (65 and 60 if self-employed). The retirement age as well as contribution and employment requirements were lowered or relaxed by up to ten years for hazardous or unhealthy occupations. Pensioners could continue to work after retirement with full benefits, except that pensions were not recalculated to include post-retirement income. Special programs (e.g., for the legislative branch and the judiciary) and provincial pension systems allowed retirement on extremely generous terms and are now in financial distress as a result. Disability pensions were readily granted. Workers who had contributed for at least five years and who had a work history of ten years were eligible for an old-age pension.

Before 1994, pensions were set at 70–82 percent of the base wage, depending on the age of retirement. The pensionable base was calculated as the average of the worker’s three highest annual wages during the ten years prior to retirement. Pensions were in principle fully indexed. In practice, indexation was ad hoc, and over time the real value of pensions suffered a substantial decline. Thus, the real value of pensions declined by 25 percent between 1981 and 1988 and by another 30 percent from 1988 to 1991. Pensions could not exceed 15 times the minimum pension set by the government. The minimum pension was not automatically indexed to inflation, despite the country’s bouts with hyperinflation, but was adjusted on an ad hoc basis. The deterioration in the financial position of the system is essentially explained by the erosion in the contribution base—to which high payroll tax rates contributed—generous pension benefits, and demography. The economic crisis of the 1980s aggravated the financial position of the public scheme, and, by 1990, the pension fund had accumulated a substantial amount of arrears to pensioners.51

Reform of 1994

The social security reform adopted in October 1993 (which became operational in July 1994 and was modified in January 1995) kept the old system in place, albeit with reduced benefits, and gave participants a onetime option of participating in the new mixed public-private pension system (described below). The Argentine public scheme now consists of three parts:

  • the “universal benefit”: a basic pension with a flat component and a component that varies in proportion to the years of contributions in excess of 30;
  • a “compensatory benefit”: an earnings-related pension amounting to 1.5 percent of the individual’s average indexed monthly salary of the last ten years of contributions times the number of years of contributions made before July 1994, up to a maximum of 35 years or 52.5 percent of average indexed salary; and
  • an optional “staying benefit”: those who choose to stay in the public scheme receive 0.85 percent of their final ten-year average monthly salary for every year of contributions made after July 1994.

Those individuals who switch to the new capitalization regime forgo the staying benefit. As explained below, these workers make payments into a personal account held at a specialized financial institution. Upon retirement, they gain access to the amounts accumulated in those accounts.

Pensions are no longer indexed but are revised every year during the budget discussions. Individuals who have reached retirement age but are not covered by the system are entitled to a public assistance pension (subject to a means test) that is financed from general revenue. The retirement ages in both schemes will increase gradually to 65 for men and 60 for women.52

Contribution rates are now set at 11 percent for employees and 16 percent for employers;53 the self-employed pay 27 percent. There is no ceiling on the earnings on which contributions are calculated. In agricultural activities, the insured’s contribution is replaced by a sales tax on agricultural produce. The government also contributes to social security through general revenues and certain earmarked taxes.

Pension income does not enjoy especially generous tax treatment in Argentina, and pension income in excess of the minimum pension is subject to income tax. In Argentina, less than 2 percent of social security expenditures are spent on administration of the old-age, survivors’, and disability pensions. This is the lowest level of all Latin American countries. Other countries with relatively broad systems, like Chile (4.8 percent) and Costa Rica (4.6 percent), have incurred much higher administrative costs.54

Private Sector Participation Under the Recent Reform

The major innovation introduced by the 1994 reform was a second tier, a feature inspired by the Chilean reform. The above-described reformed public pension system remained in place, but the worker’s 11 percent mandatory social security contribution finances the second tier should he choose to participate.55 The first tier is a PAYG scheme, while the second is a fully funded defined-contributions plan, privately administered and publicly regulated by the superintendency for pension funds. Individuals may choose to remain entirely within the public system (on the terms already described) or to opt for what amounts to a mixed system by contributing their share of the payroll tax to an individual capitalization account managed by a private pension fund. The employer’s contribution continues to go to the public scheme.

The reform does not entail the gradual elimination of the public scheme, inasmuch as the private scheme supplements but does not replace the public scheme. In contrast to the Chilean system, contributions are uniform for the whole system. The compensatory benefit serves the same function as Chile’s recognition bond, but rather than being deposited by the state as a lump sum in an individual deposit account, it is paid by the public scheme to the contributor once retired.

Between September 1994 and June 1995, the number of people covered under the social security scheme rose from 5.7 million to 7 million (about half the labor force), of which 55 percent were enrolled in the mixed system. Compliance in both systems has been weak: only 54 percent of those insured under the mixed scheme were active contributors, in contrast to 71 percent under the public scheme.

In addition to the complementary nature of the Argentine scheme, it differs from the Chilean system in other ways:

  • Contributions are collected by the social security system, instead of one of the pension companies.
  • Private pension funds are granted greater latitude in their investment decisions than in Chile.
  • The superintendency for pension funds is financed by the pension funds (not by the state, as in Chile).
  • The state is responsible for paying the life annuity to the pensioner if an insurance company goes bankrupt (not available in Chile).


Public Scheme

Colombia’s pension system is one of the most fragmented in Latin America; it includes a large number of pension plans (about 1,000) with a wide variety of benefits and low contribution levels. At one time, public sector agencies, including state-owned enterprises, were allowed to offer their own pension plans, which tended to be much more generous than the plan of the social security institute (ISS). In 1993, the total number of contributors in all plans (4.2 million) reached 30 percent of Colombia’s labor force, or 32 percent of total employment. About 70 percent of those covered were under the ISS, 5 percent were under the civil servants’ social security institute (CAJANAL), and the rest were covered by specialized public sector employee plans. The systern’s coverage is comparatively low for a country of Colombia’s per capita income level.56

Benefits for civil service workers are very generous, and entitlement conditions quite liberal. The retirement age is 10 years lower than in the ISS, which is in turn quite low: 60 for males and 55 for females. In some public plans, retirement is possible with only 10–20 years of service, regardless of age. Eligibility for an old-age pension under the ISS system requires at least 1,000 weeks of contributions.

The basic pension under the ISS system is set at 65 percent of base earnings plus an increment of 2 percent for each 50 weeks over 1,000 weeks of contributions up to 1,200 weeks.57 The increment is increased to 3 percent for each 50 weeks over 1,200 and up to 1,400 weeks. Pensions cannot exceed the lesser of 85 percent of the basic monthly wage or 20 times the minimum monthly wage. The minimum pension is set equal to the minimum wage. Pensions in Colombia are indexed to wages and adjusted annually.

Old-age pensions were financed by a payroll tax that averaged about 11.5 percent of the monthly salary in 1994 (12.5 percent in 1995 and 13.5 percent in 1996); the employer paid 75 percent of these contributions and the employee paid 25 percent. Before 1994, contribution rates averaged only about 6.5 percent. Employees who earn the equivalent of at least four monthly minimum wages a month must contribute an additional 1 percent of their salaries. A ceiling of 20 minimum salaries applies to the contribution base. Statutory contribution rates to CAJANAL and to other public sector employee pension plans are substantially lower (often zero). Moreover, actual contributions paid by government employees to CAJANAL and public sector employee plans have been insignificant, contributing to the system’s financial imbalance.

The ISS did not conduct any formal actuarial reviews in the 1980s. Recent actuarial valuations have revealed substantial actuarial deficits in both the ISS and CAJANAL. During the 1980s, the ISS pension reserves were invested in government bonds at a fixed nominal interest rate, which resulted in negative real rates of return. Moreover, the ISS was forced to finance the health component of the social security system. By 1991, reserves in both institutions were almost depleted. In 1992, accrued outstanding obligations of the ISS (the present value of anticipated payments net of contributions) were equivalent to 29 percent of GDP, while the stock of reserves amounted to only 1.6 percent of GDP. The contribution rate required to put the system back on even a partially funded basis was 18 percent for 1992–95, rising to 21 percent for 1996–2000. Pension administration is grossly inefficient.58

Contributions to pension plans paid by employers are tax deductible for the employer and not taxable for the employee, while contributions paid by employees are deductible from taxable income.

Recent Reforms and Private Pension Funds

The April 1994 pension reform (passed in December 1993) aimed to forestall the increase in the actuarial deficit of the ISS, CAJANAL, and the remaining funds and to increase their coverage. The reform of the pension system closely follows the Chilean model.59 Workers may choose to shift from the public to an individual capitalization account system, which, as in Chile, is publicly regulated and privately administered by pension fund administrators. Alternatively, they may remain in the ISS, which will become a partially funded, defined-benefits plan.60 Finally, government workers covered by solvent public sector funds may remain with them.

Contribution rates for the private system are the same as in the ISS. Since 1996, the contribution rate has been 13.5 percent of the wage base, 10 percent of which goes to the individual’s retirement account and 3.5 percent to administrative expenses and insurance premiums (for privately administered funds). An additional 1 percent of pensionable wages is still paid by all employees with wages greater than four times the minimum wage. This additional contribution is deposited in the Pension Solidarity Fund to help cover pension contributions for those who are unable to pay even the contribution required of a minimum wage earner. A recognition bond will be issued for those who switch to the new system to account for their years of contributions to the old system; this bond will be indexed to the consumer price index (CPI) and will earn interest at a rate of 3–4 percent a year. The present value of these bonds is estimated at about 18 percent of GDP. There is a minimum pension guarantee by the government for participants in the new system.

The reform also includes increases in the retirement age to 62 for men and 57 for women by 2014 as well as measures to tighten eligibility requirements and benefits of the ISS system. Insolvent public employee plans—which constitute a large majority of funds for public employees—are being closed, and their contributors are being offered a choice of affiliating with the ISS or the private system. The law makes no other changes to CAJANAL or other public sector employee pension plans. New labor market entrants have mandatory coverage under their choice of the ISS or the private system, implying that the old systems for public sector employees will be phased out over the next 40 years. As of about end-1994, about 20 percent of the state plans’ participants had opted to move to the new system, in which eight pension fund administrators were functioning.

Contributions made by an employer to individual capitalization accounts not exceeding 13.5 percent of the salary paid to the employee are excluded from the taxable income of the beneficiary. The excess over 10 percent is, however, included in employment income subject to the income withholding tax. Pensions less than 20 times the minimum wage are exempt. Consequently, pension saving receives highly favorable tax treatment.


Mexico is about to enter the crucial stage of the reform of its social security system. The largest element of the present pension system, a publicly managed PAYG-financed plan for private sector workers, has been replaced, as of July 1, 1997, with a privately managed defined-contributions plan. The design of the Mexican reform calls for all participants in the old plan to begin contributing to the new plan as if they were new entrants to the labor market. In this respect, it differs from the Chilean model. However, current participants will have the option of retiring under the provisions of the old plan. This option will not be open to young workers. As explained below, the Mexican reform has some other special features that distinguish it from the reforms introduced in other countries.

Current System

The existing system has three pillars. The first pillar consists of a set of publicly managed, mandatory PAYG plans that provide benefits for old age, disability, unemployment in old age (before retirement age is reached), and death (called IVCM plans—invalidez, vejez, cesantia en edad avanzada, y muerte). The most important plans in this category are the plan for private sector workers (managed by the Mexican Social Security Institute, IMSS) and the plan for government employees (administered by the Institute for Social Security and Services for State Workers, ISSSTE). Other plans cover specialized groups of public sector employees, such as the oil company workers and the military. The IMSS and ISSSTE are each supplemented by a mandatory housing-saving fund (INFONAVIT and FOVISSSTE, respectively), which have offered a minimum return guarantee since 1992.61

The second pillar, which is also mandatory, consists of individual retirement accounts (SARs) for workers in both the public and the private sectors that are financed by an employee payroll tax, managed by commercial banks, and supported by a minimum-return government guarantee. About 8,000 occupational pension plans constitute the third pillar of the system.62

The public PAYG plans are the largest element of the current arrangement. These plans cover about 45 percent of the workforce: the IMSS has 10 million contributors; the ISSSTE, 1.5 million; the PEMEX plan, 0.5 million; and the plan for the military, 0.3 million. The institutions managing these IVCM plans also administer health care, maternity benefits, work-accident insurance, and other benefits for contributors and their families.

The IVCM plan for private sector workers is financed with contributions adding up to 8.5 percent of the gross wage (5.95 percent is paid by the employer, 2.125 by the employee, and 0.425 by the government), with a ceiling of ten minimum wages on the portion of the wage used for computing the contribution. The public sector workers’ IVCM is financed by a contribution of 7 percent of their gross wage, subject to the same ceiling. Additional contributions of 5 percent and 6 percent of the wage are made to the corresponding housing funds, INFONAVIT and FOVISSSTE.63 The SAR is financed with a 2 percent payroll tax paid by employers.

Workers become eligible to retire with a full pension under the IVCM plans upon reaching age 65 and after having made contributions for at least 500 weeks.64 Monthly benefits are computed with a formula that takes into account the length of the contribution period and earnings during an individual’s final five years of work,65 but a minimum pension equal to 95 percent of one minimum wage is guaranteed (about 80 percent of the pensions paid by the IMSS are given at the minimum level). IVCM pensions are adjusted in proportion to the minimum wage and include Christmas bonuses.

Reform of 1997

The reform of July 1997 will initially affect only the IMSS-administered PAYG plan for private sector workers; the rest of the pension system will remain unchanged. That PAYG plan will be replaced by a privately managed defined-contributions plan. The reform will split the IVCM plan in two parts: the disability and life insurance parts will remain with the IMSS, while the old-age, old-age unemployment, and retirement parts (known now as RCV—retiro, cesantia, y vejez) will be managed by private sector firms called AFOREs—Administradoras de Fondos de Ahorro para el Retiro. The AFOREs will administer individual capitalization accounts built up with participants’ contributions. (Accumulated balances in INFONAVIT and the SARs are expected to be transferred to the individual’s account held with an AFORE; however, INFONAVIT funds will be kept in a subaccount and will continue to be available to finance the purchase of a dwelling.)

Under the reform, current pensioners will continue to receive their pension from the IMSS on current terms. New workers—defined as those who have never contributed to the IMSS—will contribute to the new plan from the start and will retire under it. Workers who have contributed to the IMSS—called transition workers—will switch to the new plan and start contributing to it as soon as it is operational. Their individual accounts will be credited with their accumulated contributions to the SARs and the INFONAVIT, but there will be no explicit recognition of their past contributions to the IMSS scheme. Instead, transition workers will retain the option of retiring under the benefits of the old IMSS scheme, including their accumulated contributions to INFONAVIT and their SAR balances accumulated over 1993–96 (in this case, when they retire, they will turn the balance in their capitalization accounts over to the IMSS).

Contributions under the new RCV systems will be 6.5 percent of the worker’s wage, plus a government contribution of Mex$1.00 a day (the “social quota”). Additionally, the INFONAVIT subaccount continues to receive 5 percent of the wage, and the IMSS will still get 4 percent of the wage to finance disability and life insurance (the part of the old IVCM that it retains under the reform). Under the new arrangement, total contributions will exceed the level of contributions under the old arrangement (IVCM plus SAR and INFONAVIT) by the amount of the social quota. The cap on the salary used for calculating contributions will be increased to 25 times the minimum wage under the reform.

When individuals retire, benefits will consist of the accumulated AFORE balances, including the INFONAVIT subaccount (transition workers also get back their 1993–96 SAR balances). AFORE balances can be withdrawn gradually or used to purchase an annuity from an insurance company. The new system will be supported by a government guarantee of a minimum pension equal to one minimum wage as of January 1, 1997, indexed to the CPI. Under the new system, workers will become eligible to retire at age 65 (age 60 if unemployed), but to be eligible to benefit from the minimum pension guarantee, they must contribute for at least 1,250 weeks.

It is difficult to determine whether saving rates will increase as a result of the reform, largely because the reform’s impact on the budget constraints of system participants is hard to determine. The reform will increase the ceiling for calculating contributions to 25 times from 10 times the minimum wage, which should increase involuntary saving. However, total payroll taxes earmarked for the financing of pension schemes would drop by almost 1 percentage point, which would have the opposite effect.66 The freedom of choice given transitional workers to retire under the old or the new system has an important bearing on the reform’s impact on benefits. Because the terms of the old system do not change, the freedom to choose may make workers feel better off after the reform (i.e., they may experience a positive wealth effect), which could actually reduce their saving. Transitional workers may also believe that the reform will render their future pensions more secure.

To the extent that the new system is more attractive to the self-employed—who do not now contribute to the IMSS in significant numbers—and to the extent that their contributions are not simply offset by a decline in other forms of saving, their participation in the scheme should raise saving. As discussed in this paper, however, the fiscal consolidation undertaken with the reform is key to its impact on total saving. In particular, the reform’s separation of the old-age pension scheme from the social security system could be significant if the new financial structure improves the balance of the latter (the health scheme has a deficit that is partially covered by resources from the IVCM).


Public Scheme

Before July 1995, Peru’s public pension system comprised the general plan (the Peruvian Institute of Social Security (IPSS)), the civil servant pension plan (cédula viva), and several specialized public sector plans. In 1992, more than 80 percent of those covered were under the IPSS. Little is known about the benefits and financial position of the specialized public sector plans. The IPSS was providing pensions to workers who had reached the statutory retirement age (60 for men and 55 for women), provided they had contributed for a minimum of 20 years. The coverage of the Peruvian pension system is very narrow (the effective coverage of the labor force is about 30 percent).

In the past, the IPSS suffered dramatic decapitalization in real terms because of negative real investment yields, evasion, and payment delays. It also accumulated substantial arrears to pensioners. In addition, the IPSS has been remarkably costly to administer.

In July 1995, the IPSS was restructured: the responsibility for public pensions was assigned to the Oficina de Normalization Provisional (ONP); health care activities remained under the IPSS. At the same time, the retirement ages were increased to 65 for both men and women.

The basic pension is currently set at 50 percent of the reference salary, which is defined as the average salary a worker earns during the final three years of work. It is increased by 4 percent for each year of contributions over the minimum of 20 years. The maximum monthly benefit is equal to 100 percent of the reference salary, but not more than S/. 600 (about US$300). Pensions are usually adjusted at the time of central government wage increases.

In July 1995, the government increased the ONP’s contribution rate from 9 percent to 11 percent. The employer makes no contribution (previously, 6 percent); workers contribute 11 percent (previously 3 percent). Workers’ contributions are based on their total monthly remuneration including in-kind benefits—with certain exemptions, notably, participation in profits and extraordinary bonuses. Employees’ contributions are tax deductible, as were employers’ contributions prior to July 1995.

Benefits under the cédula viva are very generous, at least compared with salary levels; most pensioners are entitled to a pension equal to the highest earned pensionable salary. However, the system’s administration is inefficient and prone to abuse, as evidenced by the many cases of fraud detected through audits. Under the cédula viva, active workers contribute 8–15 percent of their pensionable salary. Only a small fraction of pension benefits are covered by these contributions, so that benefits are financed almost entirely from general revenues, implying a very high implicit rate of return on contributions.

Recent Reforms and Private Pension Funds

Since June 21, 1993, Peruvian workers have been allowed to join a Chilean-style individual capitalization account.67 The Peruvian private pension plan is a privately managed but publicly regulated defined-contributions plan. Upon reaching retirement age, workers may choose from a range of pension options. The value of the annuity or lump-sum combination they choose depends on the value of the contributions they made during their working life and the investment experience of the pension company (Administradoras de Fondos de Pensiones (AFP)) managing the funds. Affiliation with the private plan is voluntary for new entrants to the labor force, implying that the existing schemes are not automatically phased out, as they would be under the Chilean model. By the end of October 1995, about 40 percent of IPSS participants had opted to move to the new private plan.

In July 1995, the government passed legislation designed to increase the popularity of the private pension plan. First, contribution rates and retirementages in the IPSS and the private plan were set approximately equal to one another (the contribution rate for the latter was lowered from 15 percent to 11.6 percent). Second, to increase competition, workers were now allowed to move freely and without penalty between AFPs. Third, the new legislation contemplates the introduction of a minimum pension for those in the private plan whose pension would fall below a certain threshold.

Under the private plan, employees contribute 8 percent of their total pay to their individual capitalization account (plus additional commissions to cover invalidity, survivors’ pensions, and administrative costs that together amount to about 3.6 per-cent. Employers make no contribution, although they are obliged to increase the pay of existing employees who opt to join the private plan, which they can do without loss because contributions to the ONP are no longer required.

To encourage long-time IPSS contributors to move to the private pension plan, a recognition bond based on the work history of each individual is issued to them for credit to their account at retirement. Because of the lack of reliable records, a simple formula was defined to calculate the value of the bonds.68 The present value of these bonds is calculated at about US$4 billion.

Workers may contribute up to 20 percent of their employment income (including the mandatory 11.6 percent) to their individual capitalization account. These supplementary contributions are not tax deductible; however, pension income is tax exempt.


Public Scheme

Before the 1995 social security reform, Uruguay’s mandatory PAYG social security system was one of the most extensive in Latin America. The system comprised the Social Security Bank (Banco de Prevision Social (BPS)), the special retirement plans for the police and the military, and three employee-run plans for bank employees, notaries, and professionals.69 Total outlays of the social security system—including retirement, disability, and old-age pensions; health care; unemployment insurance; and family allowances—were almost 18 percent of GDP in 1994. Of this, outlays for pensions by the BPS alone were about 10 percent of GDP, and by the other plans about 3.5 percent.

For a mature social security system, Uruguay’s dependency ratio of contributors to pensioners is one of the lowest in the world. As of 1995, about 70 percent of the labor force (of 1.4 million) contributed to the system, albeit not necessarily at the legally mandated levels, implying, in light of the number of pensioners noted above, a dependency ratio of 1.4. However, adjusting for the fact that some double-dipping took place and that the average old-age and disability pensions was less than half the average retirement pension, the ratio of contributors to effective pensioners was about 1.9.70

According to a 1989 constitutional amendment, all pension outlays are indexed to movements in the national wage index. Pensions are adjusted three times a year with a lag of four months.

Under the old BPS plan, average pensions were relatively low, although the number of pensions per capita was high, at about 20 percent. The statutory replacement rate ranged from 60 percent to 75 percent for men, and from 65 percent to 80 percent for women, depending upon years of contribution and age of retirement. There was a ceiling on monthly pensions equal to 7 minimum salaries (currently US$630) and 15 minimum salaries (US$1,225) for all BPS support payments. In 1995, the average retirement pension was only about US$280 a month; the average old-age pension, US$110; and the average disability pension, US$135. These pensions compared with a standard (not minimum) monthly cost of living estimate of over US$1,000 a month.

Since 1979, the minimum retirement age for the social security system (excluding the plans for the police and military) has been 60 for men and 55 for women. The expected life spans of men and women who reach retirement age are 76 and 81 years, respectively; hence, pensions are paid out, on average, for many years.

The combination of an aged population, early retirement ages, comparatively easy entitlement conditions, and an inefficient administration helps explain why the BPS plan generated deficits on the order of 7 percent of GDP (excluding earmarked value-added tax (VAT) revenues and transfers). Administrative shortcomings existed on both the collection and expenditure sides. Tax evasion was estimated at one-third of potential revenues (2.5 percent of GDP), and the requirement that individuals must have 30 years of contribution to the system for pension eligibility was widely evaded.

The pensions offered by the special retirement plans are more lucrative. The average retirement pension for professionals is about US$1,500 a month; for bank workers and notaries, US$700. Average monthly police and military retirement pay is low, US$200 and US$270, respectively; however, retirement can be taken after 20 years of service. Furthermore, the pension of retired commissioned military officers can be increased to that of a higher rank if it is determined that they would have achieved this rank had they remained on active duty. Under this regime, a significant number of military retirees collect more in pensions than they earned while serving.

The BPS and the police and military plans have been funded through a 37.5 percent tax on wages, of which 17 percentage points have been paid by employees and 20.5 percentage points by employers. Of these amounts, 13 and 14.5 percentage points, respectively, go for pensions.71 The remainder goes for health and unemployment insurance and family allowances. Actual collections amount to 8.5 percent of GDP: 7 percent from the private sector, the remainder from public sector employment. The BPS has also been funded through the earmarking of 7 of the 23 percentage points of the VAT (almost 3 percent of GDP) and transfers out of general revenues. The police and military plans run substantial deficits (in 1994 a combined US$250 million, or 1.6 percent of GDP), which are covered by general revenue transfers from the central administration. The employee-run plans are funded through—in addition to the plan-specific wage deductions—special taxes (e.g., a 3 percent tax on notarized contracts) and endowments set up under previous governments.

Employers’ contributions to public pension funds are deductible from the corporate income tax. There is no personal income tax in Uruguay.

Recent Reforms and Private Pension Funds

The government approved a reform of the BPS plan in September 1995.72 The new regime took effect January 1, 1996. The objectives of the BPS reform are to put BPS finances on a sustainable path, reduce labor costs through benefit reductions, improve tax administration, and, eventually, cut the employer contribution rate.

The new BPS plan has two tiers. The first is a reformed version of the present PAYG plan, which is designed to provide a basic pension; this would be supplemented by the second, a capitalized and funded scheme.

The first tier has a uniform retirement age for men and women of 60. For pensions, the pensionable base is the larger of the retiree’s average earnings of the final 20 years or the average of the final 10 years, but the latter can be no more than 5 percent larger than the former. The minimum contribution period has been raised to 35 years. The replacement ratio has been reduced significantly for those who retire before age 65—to 52.5 percent from 65 percent for men, and to 52.5 percent from 70 percent for women. For men retiring at age 65, the replacement rate is relatively unchanged at 65 percent; but for women the rate is reduced to 67.5 percent from 80 percent. Replacement rates rise by 3 percent for each year of retirement delayed beyond age 65 and by ½ of 1 percent for each year of contribution beyond 35 to a maximum of 40. The result is a maximum replacement rate for women of 85 percent, which would correspond to a person retiring at age 70 after having contributed for 40 years.

The minimum age for the old-age pension is a uniform 70 years for men and women (it was 65 for the latter), and this pension is available to those who, not qualifying for the benefits described in the previous paragraph, have nevertheless contributed for at least 15 years (compared with 10 years previously). The replacement rate is 55 percent of the pensionable base with a 1 percentage point hike for every year of contribution in excess of 15, up to a maximum of 14 years. Those who contributed for less than 15 years are eligible for a minimum pension when they reach the age of 70. Replacement rates for disability pensions have been reduced to 65 percent from 70 percent.

In addition to these structural changes, there are numerous administrative improvements, the most important of which is the implementation of a system of individual accounts that should allow for better cross-checking of contributions and payments.

Eligibility for the second tier depends upon age. For those under 40, all 13 percentage points of the employee wage tax on total earnings must be placed in the capitalized system. For those 40 or older, contributing to the capitalized system is optional. BPS plan contributors who shift to the capitalized plan are eligible for a reduced pension from the PAYG system of 75 percent of the pension to which they would have been entitled had they remained in the system—making a transfer quite attractive for regular contributors to the BPS.

In the absence of the reform, the BPS’s financial imbalances would have continued to widen, with outlays growing from almost 15 percent of GDP in 1995 to about 17 percent of GDP by 2035, and with a corresponding increase in transfers from the treasury (including earmarked VAT revenue) from 7 percent of GDP in 1995 to about 9 percent of GDP in 2035. The reform is projected to reduce the BPS plan’s outlays to 10 percent of GDP by 2035, while the capitalized element of the reform could reduce BPS revenue by about ¾ of 1 percent of GDP by 2035—to just over 7 percent of GDP. Under the conservative assumption that the new system will cut evasion by one-third, the burden on the treasury will be reduced to just under 2 percent of GDP by 2035, less than the level of earmarked VAT revenue. Thus, with earmarking continued at current legal levels, some of the saving could be used to reduce the heavy tax burden on labor.


Tax-qualified plans are overseen by the Ministry of Finance, while employee pension funds are overseen by the Ministry of Health and Welfare.


In general, firms limit the amount of final-year earnings that may be taken as a lump sum to three-eightieths for each year of service, so that an individual would need 40 years of tenure to qualify for the maximum lump-sum withdrawal of one and a half times final-year earnings.


In 1991, the government took some important steps to improve the system’s financial position: (1) the minimum contribution period required for a pension was raised to 20 years form 15 years and the contribution rate was increased to 26 percent from 21 percent; (2) the consolidation of pension arrears was begun by issuing “consolidation bonds” with a ten-year maturity. In 1991, improved collection efforts helped to stem the accumulation of pension arrears. In April 1993, the Federal Tax Administration was made responsible for social security collections, which further improved collections.


The retirement ages rose to 63 and 58 in 1996 and will rise to 64 and 59 in 1998 and 65 and 60 in 2001.


In 1994, employer contributions were reduced by between 30 percent and 80 percent of the statutory rate of 16 percent, depending on the location of employment.


The figure for Chile is for the old state-run and the new privately administered systems together.


About 70 percent of the employee’s contribution goes to his individual account, and the rest covers administrative fees and disability insurance premiums.


World Bank (1984) presents cross-country regressions linking pension coverage to per capita income. The results predict pension coverage in Colombia equal to 43 percent of the labor force, about one-third higher than actual.


Base earnings are defined as the inflation-adjusted average income over the preceding ten years.


See Schmidt-Hebbel (1995) for a detailed analysis of the reform.


The partial funding of the defined-benefits plan will be achieved through a combination of higher contribution rates, lower benefits, and later retirement ages for younger workers.


The housing funds can be said to play a complementary role in the sense that, upon retirement, workers are eligible to receive the unused portion of their accumulated contributions to the funds. They also receive the amounts accumulated in their individual accounts under the SARs.


The law does not require the existence of an occupational pension plan as part of the normal labor relationship. The plans may or may not be voluntary for the individual worker depending on the characteristics of the plan itself. The law allows employers to buy additional benefits for their workers by transferring additional contributions to the IMSS; the additional contributions for the desired additional benefits are determined by the IMSS using actuarial techniques, and are then incorporated into collective contracts on the one hand and into a contract between the employer and the IMSS on the other. Any change in the collective contract that affects the original terms of the additional insurance would prompt a review of the contract between the employer and the IMSS.


Health and other benefits provided by the IMSS and ISSSTE are funded with additional contributions of 12.5 percent and 9.5 percent of the gross wage, respectively.


A reduced pension is available for system participants who have contributed during the requisite period and become involuntarily unemployed between the ages of 60 and 64. If they choose to claim this benefit, they will not be able to claim a full pension later on.


The formula is such that benefits are the sum of a “basic amount,” which is approximately equal to 80 percent of one minimum wage, and an “increment for years.” The increment is computed by multiplying three factors: (1) a worker’s average wage over the final five years of contributions, (2) the number of years of contributions in excess of the minimum contribution period of ten years, and (3) a factor (between 0.56 and 2.4 percent) that varies positively with average income. For any given contribution period (longer than ten years), the increment for years grows faster than average income, and for any given average income, it grows in proportion to the excess contribution period.


Worker and employer contributions to the IVCM and the SARs under the current law add up to 10.075 percent of the wage, while their combined contributions to the disability and life scheme and to the old-age and old-age unemployment scheme (including the retirement account) under the new law add up to 9.125 percent of the wage (contributions to the housing-saving fund are unchanged). Because of the practice of consolidating the contributions to each component of the IVCM scheme, it is not possible to make an exact comparison of the rates for the old-age pension component under the old and new systems. Further obscuring this comparison, take-home pay is also affected by the change in the contributions to the health insurance and workers’ compensation schemes, where the nature of the formulas, and not just the rates, will change more radically.


Civil service workers belonging to the cédula viva system cannot switch to the private scheme.


The value of the bond is a function only of the age of the contributor and a reference value that is the same for all contributors.


The BPS plan, according to the latest data, covers about 594,000 people: 360,000 retirees, 62,000 old-age pensioners, and 172,000 other retirees—mainly disability pensioners. The retirement plans for the police and military cover about 30,000 (14,000 retirees and 16,000 pensioners) and 40,000 (23,500 retirees and 16,500 pensioners), respectively. The three employee-run plans together cover about 20,900 (11,400 retirees and 9,500 pensioners). To put these numbers into perspective, Uruguay’s total population in 1994 was 3.2 million. Consequently, about 21½ percent of the population receives a pension from one of the plans.


This ratio is not uniform across retirement plans; the dependency ratios are, for the military, 1.06; for the police, 1.24; for bank workers, 1.65; for the BPS, 1.97; for notaries, 5.57; and for professionals, 5.58.


In June 1995, the employer contribution for manufacturing enterprises was reduced by 6 percentage points, to 14.5 percent.


In early 1997, draft laws were submitted to the congress to reform the pension systems of the police and military and the three special regimes.

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