Year end changes to El Salvador's national pension system

El Salvador’s government delivered a Christmas gift to participants in its national pension system in the days before the holiday.  A pension reform law was passed on December 22 which increased benefits for persons receiving retirement pensions and made other changes to the financing of those benefits.     

El Salvador's government run pension system is an individual account plan which functions by accumulating the contributions made on behalf of the employee, plus the credited interest on the account from the pension fund’s investment earnings.  At retirement age, a retiree’s monthly pension is the accumulated total divided by 260 (20 years at 13 payments per year).  If that calculation is less than the minimum pension ($400 under the new law), the minimum pension is paid.

The retirement age for women is 55 and the retirement age for men is 60 years old.  Someone can start receiving a pension once they have reached retirement age and have 25 years of contributions into the system.

The headline number for the newly passed reform is an increase of 30% for all retirement pensions under the system.  (Pensions for survivor benefits and disability benefits did not receive this increase).  At the bottom end of the pension scale, this will raise monthly benefits by $96 from $304 to $400 per month. But because this increase is the same percentage for everyone, persons who already have a larger pension, will receive a larger increase in absolute dollar amounts, and those with the largest pensions will receive the largest increases in monthly benefits.  Someone currently receiving $2300 receives a $690 a month increase.  Pension benefits are capped under the new reform at a maximum of $3000 per month. 

 Before this reform, someone could withdraw up to 25% of their savings in advance.   For someone reaching retirement age, but still lacking several years of contributions, this could be the only way to start drawing a pension.   That option is eliminated under the pension reform.

Whether the pension law changes manage to fully fund the pension increases is an open question. The new law increases the contribution to the system on behalf of workers from 15 % to 16 % of pay.  Of this, 7.25 % is contributed by the employee and 8.75 % comes from the employer. 

Is the system financially self-sustaining with this level of contributions?  Supposedly there were 176 actuarial studies regarding the system’s design.  I find that highly unlikely, given the cost and complexity of a single quality actuarial study of a public pension system, but regardless, not a single actuarial study has been released to allow public review of the underlying assumptions and data for funding the system.  

The challenge for the government, if the system is not self-sustaining through contributions, is that pension must be funded out of the general budget of the government of El Salvador and the taxes on its citizens.  (Except for Bitcoiner citizens who are told they will not have to pay taxes).  This means that Salvadorans who do not qualify for pensions because they work in the informal economy will be supporting the pensions of others lucky enough to have worked in government or the formal economy.

The pension trust fund will now have no limits in investing in debt obligations of the Salvadoran government used to pay future obligations.  In other words, workers’ investment savings can be used to help finance more Salvadoran government debt.

On a macro level, the reform does nothing to increase the coverage of the pension system.  Currently only 1 out of 6 elderly adults receives a pension.  And of current workers, only 1 out of 4 holds a job in the formal economy where contributions are being made on their behalf into the government pension system.  A significant percentage don't manage to have 25 years of contributions during their work life to qualify for a pension from the system.   (An informal worker can opt into the system, but they must contribute both their share and the employer share of payments into the system, something which represents a steep challenge for informal vendors and others who often live day-to-day on what they might manage to sell).

Politicians are not known to be the best designers of public pension systems.  This is not a comment specific to El Salvador -- it pertains to state and local pension systems in the US, to public pension systems throughout Latin America, and throughout the world.   It is easy to make promises of pension benefits today that will not need to be fully paid for until well into the future when a different government will need to deal with the issue.  The billions of dollars accumulated in pension trust funds to pay future benefits are an enticing source of financing the current objectives of the government, and so the government borrows from pension funds and replaces them with IOUs.

Certainly a pension increase in these inflationary times, especially for elderly retirees at the low end of the scale in El Salvador, is a good thing.   But to finance these increased benefits and to ensure longer term viability of the system, El Salvador needs to work to significantly increase the number of workers in the formal economy who are paying into the system.   This reform does not address that issue.