Choice of Product under Government Regulation: The Case of Chile’s Privatized Pension System

Chile was one of the first countries to implement pension reform by transiting from a pay-as-you-go system to a fully funded individual accounts system in 1980. When designing the pension system, the Chilean government sought to restrict the downside market risk of pension investment by regulating the investment activities of pension fund management companies, called AFPs. In particular, the AFP firms were required to guarantee a return within 2% of the industry average. We study the effect of this government regulation on the performance of pension funds, on the fees, and on pension accumulations. We develop and estimate a model of balance accumulation where the consumer chooses an AFP firm to manage his pension investments and invests 10% of monthly earnings, as mandated under Chilean law. The supply side is modeled as an oligopolistic environment in which AFPs sequentially choose product location (mean and variance of the return), and the fees they charge for service, taking into account consumers’ preferences for risk. The model is used to assess the consequences of the current regulations and analyze alternative regulations that the government could use to achieve the same goal of protecting pension investors from market risk.