How to Integrate Disability Benefits into a System with Individual Accounts: The Chilean Model.

Abstract

Chile offers an innovative approach to disability insurance within a multi-pillar social security system. The individual’s retirement savings account is used as part of his disability insurance, but if he becomes disabled the account is topped up enough to finance a defined benefit annuity that pays 70% of the reference wage. This is accomplished primarily through the private insurance market, but with government providing regulations and back-up guarantees. The private pension funds and insurance companies that participate in the assessment process have a pecuniary interest in keeping costs low, unlike most public systems that are run by agencies without a personal incentive to contain costs. The individual accounts, used for old age retirement savings, help to finance the disability and survivors’ insurance as a joint product. This further keeps costs down and makes the system less sensitive to demographic shocks than a public pay-as-you-go system would be. However, pre-funding a defined benefit makes system costs much more sensitive to interest rate shifts. The defined benefit reduces risk to the worker but non-differentiated pricing creates cross-subsidies and, in a competitive market, incentives for creaming. Some of the cost reductions to the private insurance may imply a larger future public obligation, due to the minimum pension guarantee. This study examines the potential successes and pitfalls of this mixed public-private funded system of disability insurance and evaluates whether it provides a useful model for the US and other countries.