Effects of COVID‐19 early release of pension funds: The case of Chile

• Published date: 01 December 2021
• Author: Miguel Lorca
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/jori.12365

Received: 2 November 2020

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Revised: 29 August 2021

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Accepted: 14 September 2021

DOI: 10.1111/jori.12365

ORIGINAL ARTICLE

Effects of COVID‐19 early release of pension

funds: The case of Chile

Miguel Lorca

School of Economics and CAER, UNSW

Business School, Sydney,

New South Wales, Australia

Correspondence

Miguel Lorca, School of Economics and

CAER, UNSW Business School, Sydney,

NSW 2052, Australia.

Email: m.lorca@unsw.edu.au

Funding information

Australian Research Council, Centre of

Excellence in Population Ageing

Research (CEPAR),

Grant/Award Number: CE170100005

Abstract

Amid the extraordinary economic effects of COVID‐19,

some policymakers have turned to retirement accounts

to support individuals in financial hardship. Given the

haste, the long‐term impacts and their heterogeneity

have scarcely been analyzed. Using Monte Carlo si-

mulations on the Chilean Social Protection Survey

linked with administrative data, this study quantifies

the effects of a 10% early release of pension funds. Each

withdrawn dollar brings losses of 1.59 dollars in future

retirement savings, reducing monthly pension benefits

by 7.26%. This policy raises income inadequacy and

inequality in retirement, increasing government ex-

penditure by 4.33% to counteract these effects for

65‐year‐old retirees. We propose four policies to miti-

gate these effects and address the current challenges of

most defined contribution pension schemes. Increasing

contributions combined with an intragenerational so-

lidarity component shows the biggest impacts. Con-

tribution enforcement, reducing tax evasion, and

delaying retirement by at least 1 year via incentives

have lower but significant effects.

KEYWORDS

fiscal sustainability, pension adequacy, retirement savings

JEL CLASSIFICATION

G23, H55, J32

J Risk Insur. 2021;88:903–936. wileyonlinelibrary.com/journal/JORI

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903

© 2021 American Risk and Insurance Association

1|INTRODUCTION

The COVID‐19 pandemic has put unprecedented pressure on people's finances and brought

forward the urgency of accessing funds today as opposed to saving for later. Intertemporal

allocation of money and time has been deeply analyzed since the lifecycle model proposed by

Modigliani and Brumberg (1954). The modern view on intertemporal allocation relates to

“consumption smoothing”(Hall, 1978), where individuals attempt to keep the marginal utility

of consumption constant over time—an objective recognized as one of the main goals of

pension savings (Barr & Diamond, 2006; A. M. Schwarz, 2006). In a world plagued by un-

certainty and with sufficiently impatient individuals, however, savings behavior is better de-

scribed by the “buffer‐stock”version of the lifecycle theory (Gourinchas & Parker, 2002), in

which individuals save (dissave) if their wealth goes below (above) some target wealth‐to‐

permanent‐income ratio.

For most Latin American countries, Bosch et al. (2020) find that voluntary savings to insure

against economic uncertainty are not widespread and, if they exist, are insufficient to cover

severe income shocks for extended periods. It is thus unsurprising that given the extraordinary

economic effects of COVID‐19, several policymakers have turned to “unlocking”retirement

savings to “smooth consumption”and support those facing dire financial difficulties. Australia,

Brazil, Chile, Costa Rica, Iceland, Malaysia, Mexico, New Zealand, Peru, the United States,

among others, have eased conditions and/or penalties associated with accessing retirement

accounts.

1

At what cost, however? In other words, how much will early access to pension funds

affect the retirement savings adequacy and financial sustainability of the public pension sys-

tem? What are their distributional effects and how could they be mitigated?

This study considers the Chilean experience, where the COVID‐19 pandemic and the strong

social distancing measures designed to reduce its spread have severely affected the income

adequacy of the working population. The Central Bank of Chile's monetary policy reports for

the second quarter of 2020 have shown (1) a GDP (gross domestic product) drop of 14.1%, the

highest since the Chilean financial crisis of the early 1980s, (2) almost 50% of firms availing

themselves of the Employment Protection Law provisions,

2

and (3) the unemployment rate

reaching 13.1%, the highest level since 2010.

3

In response, the Chilean government im-

plemented three relief packages aimed at protecting employment and labor income and sup-

porting companies in financial hardship through credit schemes.

4

The Chilean parliament

subsequently went further by approving an additional support scheme financed via individual

1

http://www.iopsweb.org/iopsmembersmeasurestakentoaddressthecovid-19crisis.htm and https://openknowledge.

worldbank.org/handle/10986/33635. Australia, Costa Rica, Malaysia, Mexico, New Zealand, and the United States have

allowed access under specific circumstances. In Brazil, Chile, Iceland, and Peru no access requirements have been

established other than having savings in private accounts. In the United States, the CARES Act allows qualified

individuals impacted by the COVD‐19 pandemic to pay back funds withdrawn from a qualified retirement plan over a

3‐year period, waiving taxes and the 10% penalty for early withdrawals.

2

Under this law, companies affected by COVID‐19 can suspend employment contracts and reduce work schedules,

retaining only obligations to pay health and social security contributions. Affected workers receive unemployment

benefits, with the first payment corresponding to 70% of worker's remuneration over the preceding 3 months, and

gradually reducing to 30% in the seventh month. For more details, see http://www.protecciondelempleo.cl/

3

In particular, data from the Chilean Bureau of Statistics (INE in Spanish) shows that the largest and most persistent

drops in employment are concentrated in sales and service workers, farmers and fishermen, and unskilled jobs. https://

www.ine.cl/informeempleo/

4

https://www.gob.cl/coronavirus/plandeaccion/

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retirement funds, which are managed by private entities called “Administradora de Fondos de

Pensiones”(AFPs) and are equivalent to 77% of national GDP.

5

This new scheme became law

on July 30, 2020;

6

it allows people to access up to 10% of their pension savings in 12 months,

with a maximum of USD 5664 and a minimum of USD 1322. Those with pension balances

below USD 1322 can access all their funds.

Using nationally representative survey data linked with administrative pension informa-

tion, this study conducts Monte Carlo simulations to forecast labor outcomes and compute

future retirement savings balances; the idea is to quantify the effect of this policy on self‐funded

pension benefits and government supplements. We find that this policy results in an average

withdrawal of 22.92% from individual accounts, representing a drop of 8% in the aggregate

savings balance of the system and equivalent to USD 2623 per person.

7

Regarding life annuities

in the first year of legal retirement age, this scheme reduces their benefits by 7.26% on average,

although the greatest effects are recorded for young people, women, and workers with low

private pensions.

The consequences of this policy reinforce the need to strategically address the current

challenges of most defined contribution (DC) schemes, some of them particularly imperative in

the Chilean pension system,

8

as are income inadequacy and inequality in retirement, integrity,

risk‐sharing, legitimacy, and fiscal sustainability. With the aim to propose a functional and

efficient design, rather than only supplementing outcomes at the end of the working life, four

different mitigation policies are analyzed: (1) contribution enforcement via fiscalization, in-

centives to formalize low‐income jobs, and paying wages directly into a bank account, (2)

reducing tax evasion and enforcing administrative taxable wages to be the same as self‐reported

taxable wages via fiscalization and reconciliation of bank statements, (3) delaying retirement

through incentives related to making it optional to contribute beyond the statutory retirement

age or via better employability opportunities for mature workers, and (4) increasing con-

tribution rates by 4 pp and using 50% of that increase for intragenerational redistribution. We

find that higher contributions with an intragenerational solidarity component show the biggest

impacts. Contribution enforcement, reducing tax evasion, and providing incentives to delay

retirement by at least 1 year have lower but significant effects. These measures would be

effective policies and entail a lower political cost than a simple change on parameters such as

an increase in the legal minimum retirement age, tightening eligibility rules, or reducing the

size of pensions by adjusting benefit formulas.

We make a small but critical contribution to the literature. For instance, Butrica et al. (2010)

and Argento et al. (2015) show that early access to 401(k) and IRA funds is strongly correlated

with income shocks and is more common among vulnerable individuals, explaining their

reliance on social security in retirement. Other papers, such as Copeland (2009), Engelhardt

(2002), Engelhardt (2003), Hurd and Panis (2006) analyze preretirement lump‐sum

5

https://www.spensiones.cl/portal/institucional/594/w3-article-13686.html

6

https://www.diariooficial.interior.gob.cl/publicaciones/2020/07/30/42718/01/1791258.pdf

7

The average withdrawal (22.92%) is calculated using the Carli index formula, while the aggregate drop in the re-

tirement savings balance (8%) considers the Dutot index formula.

8

Defining the net replacement rate as the individual net pension entitlement divided by net preretirement earnings,

OECD Data shows that the Chilean net replacement rate is 37.3% and the OECD average is 58.6%. https://data.oecd.

org/pension/net‐pension‐replacement-rates.htm. Mercer CFA Institute Global Pension Index 2020 evaluates 37 pension

systems and reports: (1) a relevant fall in the adequacy index for Chile from 59.4 in 2019 to 56.5 in 2020, (2) a fall in the

average adequacy index from 60.6 in 2019 to 60.2 in 2020, and (3) the Chilean adequacy index is consistently below the

average. https://www.mercer.com.au/our-thinking/global-pension-index.html

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