Pension systems are fundamental pillars of both present and future well-being for populations in any society. But what exactly are they, and how do they work in Latin America and the Caribbean?
In this article, we break down the “ABCs”—the essential basics you need to understand pension systems in the region. We also provide a guide to their structure, how they function, and the challenges they face in the Latin American and Caribbean context. If you’re looking to understand what a pension is, how pension systems operate in Latin America and the Caribbean, and the crucial role they play in workers’ lives, read on.
How Do Pension Systems Work—and What Are They?
Pension systems aim to ensure economic and social protection for individuals as they transition from working life to retirement. This is done by collecting regular contributions during the working years, with the goal of providing income once individuals retire. This financial benefit, known as a pension (or retirement benefit), is typically paid monthly and is granted after meeting eligibility requirements that vary by country. The most common requirement is reaching a specific retirement age, although earlier access is possible in cases such as disability or widowhood.
Types of Pension Systems
- Contributory pension systems are based on building retirement benefits for individuals who made contributions to the social security system during their working life. The size and conditions of the pension usually depend on the accumulated contributions, how long the person remained in the system, and their age.
- Non-contributory pension systems are public programs that provide income to people who, for various reasons, were unable to contribute sufficiently to the social security system or save for retirement during their working years. These benefits target older adults who, due to their economic or health status, require public support to survive.
Key Features of Pension Systems in Latin America and the Caribbean
The region has a variety of pension system models, each with different rules for contribution, access, and benefits. Most are regulated by the social security laws of each country.
Here are some examples of how pensions are organized and characterized in the region:
Types of Pension Schemes in the Region
Among contributory systems, schemes differ based on how workers’ contributions are managed and how pensions are calculated.
The two main models are:
- Of distribution or defined benefit, where current workers contribute to fund pensioners’ benefits. This is the scheme used in countries such as Argentina, Brazil, and Paraguay;
- Individual account or defined contribution, in which workers contribute a fixed amount to form a capital for retirement. This scheme is used in El Salvador.
In other countries, pension systems have characteristics of these two schemes, combining them, complementing or establishing competition between them.
There are mixed schemes in which defined benefit and defined contribution are complemented, as in Costa Rica, Panama, and Uruguay. There are also countries in which the public distribution scheme competes with that of individual accounts managed by pension funds, as is the case in Colombia and Peru. Finally, there is the integrated scheme, such as that in Chile, where non-contributory pensions are partly financed by contributory pensions.
In addition, there are voluntary schemes where people save additional amounts to the statutory schemes mentioned above. This capital is saved in individual accounts managed by private entities (Afores in Mexico or AFPs and pension funds in other countries).
Some countries offer semi-contributory options, aimed at older adults who were not covered by formal social security systems. For example, in Colombia, the Periodic Economic Benefits (BEPS) program allows individuals to save in personal accounts, with the government matching a portion of their savings.
Types of Pensions Based on Benefit Type
Pensions can be classified into:
- Widows’ pensions, granted to widowed couples of a beneficiary;
- Old-age pensions for taxpayers who reach the minimum retirement age;
- Disability and early retirement pensions granted to those suffering from an accident at work, or their working capacity is limited after having contributed to the system and before reaching the minimum retirement age.
These economic benefits usually come from worker contributions, although countries with distribution schemes are also financed by subsidies from the pension system.
For countries with a defined contribution scheme, the pension benefit is often paid through a lifetime income that functions as a policy that is generally contracted with private sector providers and is acquired from accumulated or saved capital.
“Ageing of the population threatens the stability of pension systems in the region, as the number of elderly people to attend and fewer contributors will be increasing.”
Other Key Concepts in the ABCs of Pensions in Latin America and the Caribbean
Contribution Rates
These are the mechanism by which pensions are financed at the retirement stage and represent a percentage of the income accumulated throughout working life. They are usually defined by the social insurance law in each country and is one of the key parameters for understanding the financial sustainability challenges of pension systems. For the region, the average is 14% of a worker’s income, about four percentage points lower than the OECD average of 18%. In most countries, contributions are shared between employers and employees, and in some cases the government contributes as well.
Replacement Rates for Financial Benefit
It is understood as the percentage that pensioners receive at the retirement stage compared to their income at the productive stage and varies depending on whether compared with the last income or with an average income. On average, for countries with defined benefit schemes, the replacement rate in the region is 65%, while in defined contribution schemes, pensions are not as generous, reaching an average of 40%. In contrast to the OECD countries, where the average rate is 48%, it can be said that the defined benefit schemes are quite generous, and the defined contribution schemes are not so generous. There is no consensus on what should be the standard amount of a pension with respect to the worker’s last salary, but there is consensus that defined contribution schemes provide pensions that are not sufficient to maintain quality of life when you reach retirement age. For their part, defined benefit schemes can threaten the sustainability of the pension system by the mismatch between contributions and benefits that involve.
Minimum Retirement Age
In most countries in the region, women are allowed to retire 3 to 5 years earlier than men. Generally, retirement is permitted around age 60. For example, in Argentina, the retirement age is 65 for men and 60 for women. In Brazil, it is 65 for men and 62 for women.
Pension Challenges in Latin America and the Caribbean
We are aging rapidly. Today, about 10% of the population are older adults. By 2050, this will increase to 20%. By 2085, Latin America and the Caribbean will be the first region in which one in every three people is over age 65. The region’s future is marked by rising life expectancy and falling birth rates.
The ageing trend threatens the stability of pension systems in the region, as the number of elderly people to attend and fewer contributors will be increasing. In Latin America and the Caribbean, moreover, there are few formal workers who contribute proportions of their income that would allow them to retire earlier. This implies challenges to the sustainability of pension systems.
The decisions made by governments on issues of social security financing and reforms are fundamental to the future of pensions and a system of healthy pensions, social security and social protection.
Key Pension System Challenges in the Region Include:
- Limited coverage in beneficiaries: Only 4 in 10 people cannot access a pension, and this is exacerbated in the lower income population.
- Few people contribute to pension systems due to the high degree of labor informality in the region: 6 in10 workers consider themselves informal, meaning they do not contribute regularly to the pension system and likely cannot save for retirement. Many lack access to any formal retirement savings mechanism, despite emerging innovations aimed at facilitating saving.
- Sustainability: As aging accelerates, the number of beneficiaries will outpace contributors. By 2050, the region’s dependent elderly population will approach OECD levels (28%), yet pension spending as a share of GDP will be at least 3% higher than today.
- Sufficiency of the amounts: In several countries, pensions for older adults are not sufficient to guarantee a decent standard of living, exposing them to situations of economic vulnerability. This is more pronounced in countries with defined contribution schemes.
- Gender gaps: Pension systems reflect labor market inequalities. According to the IDB’s Labor Observatory, only 55% of women in the region are in the labor market, compared to almost 75% of men—a 20-point gap. Women also earn 18% less per hour, which leads to lower contributions and savings.
Laura Ripani, head of the IDB’s Division of Labor Markets, explains in a few minutes the impact of gender gaps in labor markets on the pensions of men and women in the region, How does the gender gap in pensions reflect?
Current Trends that Could Positively Impact the Future of Pensions
We have the opportunity to transform ageing into opportunity in Latin America and the Caribbean, but we need to act now. Adjustments cannot wait: the longer reforms are delayed, the greater the bill that future generations in the region will have to pay. We need public policy actions and coordinated and consensual reforms with citizens that, far from being abrupt, must be gradual, dynamic, and innovative.
Over the past few years, some trends have emerged that could provide tools to address the future of pensions in longer-lived societies, strengthen retirement savings systems, improve access to social protection, and achieve solutions with long-term benefits to prevent poverty for future generations of older people.
Technological and Digital Transformation
Technological changes and the digital economy could facilitate, automate and massify access to savings systems for the retirement of many independent workers and in non-traditional forms of employment such as those that generate income from the gig economy, simplifying voluntary contributions and savings with innovative digital applications and financial products.
Changes Beyond the Design of Pension Systems
We need reforms that go beyond designing pension systems. For example, redefining the concept of retirement, extending periods of active work and rethinking the retirement stages. Following the experience of countries in the world with more advanced aging processes, we can think of alternatives to extend the working life of older adults with incentives for different economic sectors (private, public, or mixed companies) incorporate and train workers aged 65 or older, or allow workers close to retirement to remain productive longer.
Pension reforms in Latin America and the Caribbean are necessary How to make them a reality? Find out how it was achieved in Uruguay in this note👉 What is the future of pensions in older societies?
Innovating Pension Financing and Investment
To build a sustainable pension system we also need to:
- Modernise investment schemes
- Encourage the offer of annuities for life by private sector providers such as AFPs or AFORES.
- Consider other factors besides longevity, which also affect pensions. Climate change, for example, requires us to rethink investment strategies and incorporate GSA (Environmental, Social and Government).
The IDB is committed to supporting Latin American and Caribbean countries in the transformation of their pension systems to ensure that pensions are equitable, and cover most of the population without affecting public investment in other key areas such as infrastructure, education or health.
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