While the trends point to a reduced cumulative pension debt over the long run, governments have had to deal with higher pension deficits in the short run since shifting from a PAYG to a funded scheme requires the repayment of implicit pension debts. Most countries in the LAC region have resorted to borrowing and, in some cases, to the privatization of revenues in order to manage the transition cost (e.g., Argentina, Bolivia, and Mexico). The bulk of the new explicit debt has been acquired by pension funds. Chile has been an exception having prepared well for the 1981 pension reform by tightening its fiscal policies prior to the reform to make room for its envisaged fiscal requirements.<sup>16</sup> Authors such as Holzmann (1998) make the case for a mix of budgetary and debt financing with the split determined by the country’s circumstances to prevent a double burden on the transition generation. Therefore, debt financing needs to be used with caution to avoid a “privatization of the PAYG scheme.” Relying on debt financing can aggravate the domestic macroeconomic vulnerabilities as in the cases of Argentina and Bolivia.<sup>17</sup>

# **II.3. Coverage**

Expanding coverage has often been regarded as one important reason for shifting from the PAYG to the funded DC system. By establishing closer links between contributions and benefits as well as stronger property rights over future benefits through individual accounts, it was expected that participation in the pension system would expand. Increases in coverage rates, however, have remained elusive in most countries that implemented such structural reforms.

A positive relationship between GDP per capita and pension coverage is observed, which holds true globally and for other LAC countries that did not undertake structural pension reforms (Figure 2). When the evolution of pension coverage from the mid-1990s (around the time that many of these reforms were undertaken in LAC) to the early 2000s is considered, coverage rates increased in El Salvador and Peru, but stagnated or declined in the other reformed LAC countries (Figure 3). Besides the design of the pension system, other factors played a critical role in determining participation in the system.

Much of the literature argues that industry, the degree of unionization, and firm size are important determinants of the access of workers to pensions and the social security (Marquez and Pages 1998 and Mesa-Lago 2000). These factors can more than offset other positive effects resulting from changes in the pension design. Thus, the growing participation in the economy of self-employment, micro and small enterprises, and informality in most of these countries over the past decade have not favored coverage expansion (World Bank 2007).<sup>18</sup> Rofman and Luccetti (2006), who conducted a review of social security coverage in 15 LAC countries based on household surveys, confirm that there is a positive relationship between the coverage of wage earners and firm size – a

> 16 Debt financing in the peak years was less than 2 percent of GDP compared to a deficit of close to 5 percent of GDP (Holzmann 1998).

> 17 See Perry and Servén (2003) for details.

> 18 See World Bank (2007) for an analysis of rising informality trends in the LAC region, its plausible causes, and recommendations to address it.

- 9 -