PRODUCT CHOICE UNDER GOVERNMENT REGULATION: THE CASE OF CHILE'S PRIVATIZED PENSION SYSTEM

• DOI: http://doi.org/10.1111/iere.12319
• Author: Petra E. Todd,Elena Krasnokutskaya,Yiyang Li
• Date: 01 November 2018
• Published date: 01 November 2018

INTERNATIONAL ECONOMIC REVIEW

Vol. 59, No. 4, November 2018 DOI: 10.1111/iere.12319

PRODUCT CHOICE UNDER GOVERNMENT REGULATION: THE CASE

OF CHILE’S PRIVATIZED PENSION SYSTEM∗

BYELENA KRASNOKUTSKAYA,YIYANG LI,AND PETRA E. TODD1

Johns Hopkins University, U.S.A.; Competition Economics LLC,U.S.A.; University

of Pennsylvania, U.S.A.

Chile’s individual retirement pension accounts system has been a model for many countries. To limit the

riskiness of pension investments, Chile required pension fund managers to deliver returns that are not more

than 2% below the industry average. We develop and estimate a model of the pension investment market

that allows us to study the impact of minimum return regulation. We find that the regulation leads to higher

demand for risky investments, creates incentives to offer riskier portfolios, and leads to higher management

fees. However, the regulation also stimulates balance accumulation that ultimately reduces the reliance on

government support.

1. INTRODUCTION

The United States and many European countries are considering how best to reform their pay-

as-you-go social security systems. Demographic trends indicate rising numbers of pensioners

per worker and pending insolvency of many social security systems. The kinds of reforms being

considered include increasing the required social security contribution per worker, raising

the standard retirement age, or overhauling the system by transiting to a private retirement

accounts system. Chile has been at the forefront of pension reforms, having switched to a

private retirement accounts system 25 years ago. Numerous other Latin American and South

American countries followed suit, building on the Chilean model. These include (with years

of adoption in parentheses): Peru (1993), Colombia (1994), Argentina (1994), Uruguay (1996),

Bolivia (1997), Mexico (1997), El Salvador (1998), Costa Rica (2001), the Dominican Republic

(2003), Nicaragua (2004), and Ecuador (2004).2

The proposed plans for pension reform in the United States and in Europe have many

features in common with Chile’s pension system. They outline a system under which workers are

mandated to contribute a percentage of their income to their pension account, which is managed

by money manager(s) (either a government owned company or a competitive industry of money

managers). The government serves as a last resort guarantor, supplementing pension income

∗Manuscript received October 2016; revised May 2017.

1We thank Ludwig Ressner, formerly of Munich University, for his contribution to an early draft of the article.

In addition, we thank David Bravo, Jere Behrman, Olivia Mitchell, Sven Rady, and Markus Reisinger for helpful

discussions. We are grateful to Jose Ruiz and Viviana Velez-Grajales for help in collecting the pension fund cost and

return data series and in understanding pension fund fees and regulations. Solange Bernstein of the AFP regulatory

agency provided helpful assistance in understanding the structure and coding of the administrative data set, and Javiera

Vasquez Nunez was very helpful in the preparation of the data sets. We also thank Chao Fu, Clement Joubert, Edith Liu,

and Naoki Wakamori for able research assistance at various points over the course of this project. Elena Krasnokutskaya

and Petra Todd gratefully acknowledge financial support from a Michigan Retirement Research Center grant (#UM-

0917) and National Science Foundation grant (#0922405). The collection of the EPS data set used in this project

was funded in part by NIH R01-543250 (P.E. Todd, PI). Please address correspondence to: Elena Krasnokutskaya,

Department of Economics, Johns Hopkins, 554E Wyman Park Building, 3100 Wyman Park, Baltimore, MD 21218.

E-mail: ekrasnok@jhu.edu.

2Cogan and Mitchell (2003) discuss prospects for funded individual defined contributions account pensions in the

United States.

1747

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(2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

1748 KRASNOKUTSKAYA,LI,AND TODD

if pension accumulations are insufficient upon retirement (below prespecified minimal level)

either because of low income or unfavorable investment returns. All these features are present

in the Chilean pension fund system, called the Administradoras de Fondosde Pensiones (AFPs).

Specifically, workers are mandated to contribute 10% of their earnings to a retirement account.

Contributing workers receive a minimum pension benefit guarantee from the government.

Several important concerns have been raised about this type of individual retirement ac-

counts system. The first is that government obligations can be large, particularly in years with

unfavorable market returns. Second, the government guarantee of minimal support may induce

moral hazard problems by providing incentives for consumers with low income to choose risky

investment options. If the system is run by a competitive industry, then money managers may

offer products to meet this riskier demand.

To insulate consumers from excessive risk, individual retirement accounts pension systems

usually incorporate features designed to limit the riskiness of the portfolios offered. In some

cases, there may be restrictions on the investment options that pension fund managers are

allowed to offer. In other cases, the burden of guaranteed pension support may be shifted

in part from the government toward the industry by requiring that the pension managers

guarantee a certain level of return. For example, the Chilean government required pension

fund management firms to guarantee a return on their enrollees’ investments that is within 2

percentage points of the industry average.

This article investigates how this type of minimum return regulation affects the pension fund

industry’s operation. To this end, we estimate an equilibrium model of demand and supply

in the pension investment market and use the model to study the effects of regulation under

alternative scenarios. The question of whether and to what extent such regulations protect a

privatized retirement accounts system from excessive risk taking is pertinent not only for Chile

but also for the many other countries (listed above) that operate similar retirement account

systems and for any country considering a move to a privatized account system. Our analysis also

provides general insights into the consequences of minimum return guarantees in the context

of a competitive money management industry.

The model we develop is a three-stage model of industry competition and consumer choices.

In the first stage, the firms participating in the market simultaneously decide which portfolios to

offer. In the second stage, the firms observe competitors’ portfolio choices and simultaneously

decide on the fees that they charge their consumers. In the third stage, consumers choose pension

management firms to manage their pension accumulations, portfolio returns realize, and profits

accrue. We argue that in the absence of other incentives, the minimal return regulation induces

pension managers to choose riskier portfolios relative to the choices they would make in the

absence of regulation. However, the specific features of the demand (consumer heterogeneity)

may work to enhance or mitigate these incentives in a competitive environment. Specifically,

the joint distribution of risk preferences, price sensitivity, accumulated balance, and income

in the population plays an important role in determining the overall regulation impact. Also,

changes in products offered to the market, in fee structures, and in consumer choices induced

by the regulation will affect pension accumulation and may therefore have important welfare

implications. For example, if the regulation leads to riskier investments, we would expect to

see an increase in the variability of consumers’ balances, perhaps accompanied by an increase

in accumulated average balances. Depending on the magnitude of these effects, the minimum

return regulation may work to facilitate balance accumulation and decrease reliance on govern-

ment pension support. Empirical analysis is needed to fully assess the effect of such regulation

on the market operation.

Our empirical analysis combines data from multiple sources. First, we have administrative

data on contributions and fund choices from 1981 to 2004 from the pension fund regulatory

agency. These data were merged with longitudinal household survey data gathered in 2002 and

2004. Thus, we analyze microlevel data on individual characteristics, wealth levels, and pension

fund choices. Additionally, we obtained data series on portfolios’ returns and fees charged by

funds as well as accounting cost data.

PRODUCT CHOICE UNDER REGULATION 1749

Descriptive analysis reveals that consumer heterogeneity plays an important role in this

market. For example, evidence that different firms attract different types of consumers can be

seen in the fact that the pension management firm that attracts the highest share of enrollees

does not have the highest share of balance under management; that is, this company tends

to attract individuals with relatively low average balances. Indeed, preferences for risk and

for residual income that drive consumer’s choices likely vary across demographic groups, and

AFP firms can exploit this heterogeneity to segment the market. We capture this feature of the

environment by rationalizing the observed demand for pension managing services through an

indirect utility function where the risk preferences and price sensitivity depend in a flexible way

on consumers’ demographics.

As in many other developing countries, the Chilean economy is characterized by a substantial

informal sector. Descriptive analysis reveals that many individuals participating in the pension

system spend almost half of their working time in the informal sector and, during these periods,

do not contribute to their pension account. For this reason, we also incorporate in our model

individuals’ decisions whether to work in the formal or in the informal sector.

We find that consumers’ risk preferences and price sensitivity vary with demographics. In-

terestingly, consumers in this market are quite risk averse, which suggests that concerns about

excessive demand for risky products may not be justified. The estimated level of risk aversion is

comparable to the levels that have been estimated for other markets, for example, the market

for car insurance.3

Our estimated model fits the data well. In particular, using a single set of firm fixed effects,

the model rationalizes market shares of various pension managers with respect to the number

of enrollees, balance under management, and contributions in the population of informal and

formal sector workers. A large part of the model fit is accounted for by the systematic part

of the model instead of the unobservable error terms. Unlike other studies of differentiated

products markets, we have access to detailed data on firms’ costs. We use these data to estimate

the pension managers’ cost function directly, instead of exploiting optimality of firms’ pricing

decisions as is more standard in the differentiated products literature. An advantage of this

approach is that it allows us to recover the model primitives without having to impose a

particular model of pricing and competition in the estimation.

We use the estimated parameters characterizing the demand and supply side of our mar-

ket to conduct counterfactual analysis of the impact of the minimal return regulation on the

industry and on consumers.4We find that given the market returns in our data, minimal re-

turn regulation incentivizes firms to move toward riskier portfolios relative to those that would

be chosen in the absence of regulation. Specifically, the risk of the safest portfolio offered

in the market increases substantially. We isolate the effects associated with the two channels

through which regulation impacts the market: (i) It directly affects consumer choices by of-

fering them protection from downside risk, and (ii) it imposes additional costs on the pension

management firms, which is tied to their performance relative to that of competitors. The first

component effectively shifts consumer demand toward moderately risky products. This induces

the industry to substantially increase the risk of the safest portfolio offered while reducing

the risk of the riskiest portfolio. The second component has dual effects. On the one hand,

it introduces complementarities in firms’ portfolio choices. On the other hand, the regulation

imposes additional costs on the industry that results in an increase in the fees charged for pen-

sion management services. The relative impact of these two effects appears to depend on the

degree of protection from downside risk offered to consumers by the regulation. Specifically,

3See Cohen and Einav (2007) for the review of the levels of consumer risk aversion documented in different settings.

4In this analysis, we study the impact of minimal return regulation holding constant other features of the market.

In reality, however, this regulation was implemented in combination with some other restrictions on the operation of

portfolio managers. In the analysis below, we investigate the combined impact of the minimal return regulation and

one such restriction, an upper bound on the riskiness of the assets that the money managers were allowed to include

in their portfolios. We find that the imposition of portfolio restrictions can reduce the impact of the minimal return

regulation.