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Positioning Paper
China’s Pension System
Professor Dr. Haico Ebbers
Drs. Rudolf Hagendijk
Harry Smorenberg
We would like to thank:
Renmin University
Fudan University
CEIBS University
NSSF
China Insurance Regulatory Commission
Ministry of Commerce – Department of European Affairs
China Life Pensions
With special thanks to:
Stuart Leckie (Sterling Finance Limited)
Wensheng Peng (BarclaysCapital)
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1. Introduction
China is currently undergoing many transformative processes: from a communist system to a socialist
market economy, from a rural to an urban society, from an industrial country to a service economy.
Finally, and that is the topic of this positioning paper, one can witness a demographic transformation
and consequently a social security transformation.
China is now in the process of developing a social security system that corresponds to its transformation into a socialist market economy. Central to this social security system is the pension scheme.
The “iron rice bowl,” China’s traditional social security system, was very simple: employees of State
Owned Enterprises (SOEs) and state related organizations enjoyed cradle-to-grave security for all basic
social security services, from employment to health care to pensions. In this environment, the state
owned enterprises were responsible for supporting their own pensioners.
Due to economic, social and demographic changes, the traditional socialist way of organizing pensions became no longer possible and step by step reforms were implemented to shape a new, more
modern pension system. The main economic factors relevant to the Chinese pension system are the
transformation of SOEs that resulted in higher unemployment, the emergence of a dynamic private
sector and strong income growth in the urban regions. Urbanization is the most important social
factor shaping the discussions of the pension system. Despite the flow of migrant workers to the cities
though, more than 50% of the Chinese population still lives in rural areas. The central theme in the
pension system debate is demographics. The Chinese population is ageing rapidly. Furthermore, the
one-child policy is especially problematic when taken together with the traditional system of children
caring for their parents and grandparents. Basically, one working child may need to be able to provide
for two parents and four grandparents, the so-called 4-2-1 problem.
Despite some reforms in the 1970s and 1980s, it became clear that demographic changes would
eventually collapse the traditional pension system in China. In a sense, China presents a special case.
Although it is a low-income emerging market, China has developed country problems with population ageing and sharply rising dependency ratios over the next few decades. At the same time, China
has a highly organized state employment and pension system as well as other social security. So,
China not only faces developed country demographics but also developed country social liabilities—
all at a per capita income level of only slightly more than US$1000. The demographic challenges will
strike China at a comparatively earlier point in time than in more developed countries. In short, China
becomes grey before it becomes rich. One of the experts stated that “China will be leader in many
[economic] aspects, but it is almost certain that China will be a world leader in another category: old
people”. We met our experts during our trip to China in May 2008. During this trip we interviewed
7 persons, all experts on pensions. Their opinions are implemented in this basic document.
The pension system obviously had to be changed. Starting in 1997, there was a shift of the burden
of pension provisions from only the state to be shared by state, employers and employees. There was
also a move from PAYGO financing to a combination of PAYGO and funded systems. Last but not
least, it was expanded to include all urban workers.
Most of the experts we interviewed indicated that reforms are moving in the right direction. However, many challenges still lie ahead. Moving to a partially-funded pension system resolves the issue
of implicit pension debt in the longer term, but it also puts an additional strain on fiscal resources
during the transition period. This combination of legacy costs and transformation costs is not solved
yet. There is also the coverage problem. Participation is still low, even in the cities. This partially is
an incentive problem, as the unattractive rate of return on the individual accounts means workers are
reluctant to participate. Here we come to an institutional challenge: due to restrictions of investment
opportunities, the nominal rate of return in China’s low-interest rate environment is low, much lower
than the annual increase in wages and inflation. Another challenge is the limited portability; workers
changing jobs between administrative units are in many cases not entitled to take their savings in their
individual accounts to another pension fund in the next province. A final challenge is resolving the
large differences in system parameters due to conflicting local and provincial regulations.
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As laid out in the summary above, there are many related factors influencing the pension discussion. Firstly, the institutional design in which provinces and local government established their own
regulations negatively affect the portability. Secondly, the lack of labor mobility that results from the
fragmentation of pension management may also hinder China’s economic development. Furthermore, enterprise downsizing and privatization negatively affect the contribution base that is already
beleaguered. And the same SOE restructuring needs labor mobility yet this labor mobility is handicapped by the limited pension portability. It is clear; we are dealing with a very complex, interconnected
system.
Despite these challenges and problems, there are reasons to be optimistic too. People are healthier
and can work longer, which will increase the years of accumulation of savings. In addition, globalization means expansion of investment opportunities with higher returns and lower risks with regional
diversification. Due to increased welfare, there is an enormous pool of savings available. Temporarily,
there is also a favorable age structure as the main pension crunch is still two decades way. China is not
facing an imminent fiscal problem, and there are certain measures that can be taken to prevent problems in the coming decades. One can look to the establishment of the National Social Security Fund
(NSSF) and the increase in the voluntary corporate system or the enterprise annuities (EA).
The fund management industry has high hopes for these voluntary enterprise annuities. Until now,
however, the NSSF had been the largest source of business for fund managers operating in China’s
pension sector. While the focus of fund managers is now on NSSF mandates, the expectation of our
experts is that EA will emerge as the largest source of new funds under management.
The paper is structured as follows: We start in chapter 2 with the early changes in the pension system
and explicit and implicit choices by the policy makers. We will discuss both the pre- and post-1997
reforms. 1997 was selected as the dividing year because the three pillar pension model was established in that year. In chapter 3 we will describe the current pension system and introduce data on the
main parameters. We will also bring in the objectives of the National Social Security Fund in 2000.
The challenges ahead is the subject of chapter 4. We will separate the short and longer term challenges
while focusing on the main discussion points such as coverage, portability and institutional design.
We will end in chapter 5 with some final thoughts on the reforms, necessary steps to take and the role
of foreign pension service suppliers.
Throughout the paper, the text is complemented by boxes with additional information regarding
pension systems and developments worldwide. This information makes it possible to compare
China’s choices with developments in both Asian and worldwide pension systems.
The aim of this position paper is to describe the Chinese system and to highlight the choices and steps
taken to develop a sustainable pension system. Consequently, the paper is descriptive in nature and is
the starting point for an in-depth discussion during the “exchange of minds meeting” which will be
organized by Mn Services.
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2. Earlier changes and choices
In the early 1950s, the first insurance measures for employees of SOEs and collectively owned enterprises were introduced. In addition, there was a separate and very generous pension system for a
broad group of civil servants. The social security system consisted of not only guaranteed employment but also pensions, medical care and other social benefits. The system was very simple: each state
owned enterprise was responsible for supporting its own retirees from current revenue and workers
were guaranteed a retirement income. The scheme was funded through employer contributions set at
3% of the total enterprise wage bill. Workers did not make any contributions. If the enterprise did not
have enough funds to cover pensions, the state budget would allocate additional resources. This money was paid to and pooled into a nationwide pension fund administrated by the All China Federation
of Trade Unions (ACFTA). Meanwhile, the rural population did not have any formal old-age insurance schemes and was left to rely on more traditional family or collective farm based arrangements.
Communes and villages continue to provide education and health services, but there are virtually no
formal pension liabilities. Because of a young workforce, demands were few and a substantial surplus
was built up in the 1950s and 1960s.
During the Cultural Revolution of the 1960s, trade unions were abolished and individual state owned
enterprises became responsible for administrating and paying pensions (and other benefits such as health and housing) out of current revenues. The advantages of national pooling were lost. In the 1970s
and early 1980s, the number of retirees increased sharply as high replacement rates in the system
incentivized workers to retire early. Other factors that increased the costs of maintaining the pension
system include: higher replacement rates, shorter careers and guaranteed job security for one child per
retiree. Restructuring of the state owned enterprises began in this period because a successful reform
of SOEs could maintain social stability if a social security net were available. As additional finance was
needed, employee contributions into the pension system were introduced. They paid 3% of their
basic wages, which was added to employer contributions of 15% of the enterprise pretax wages bill.
The money was paid to collective funds operated by newly established local Social Security Agencies
(SSA) to reduce the responsibilities of and costs to enterprises. Although changes were made to divide
responsibility among companies, employees and the government and to introduce administration of
pension payments at a local government level, most characteristics did not change: the system was
still an urban- and enterprise based generous PAYGO system which was almost solely financed by
enterprises current revenues and with only partial (local) pooling through the SSAs.
The environment changed dramatically during the late 1980s and early 1990s. First, the economy
started to shift from one dominated by SOEs to one where the private sector is generating an increasingly larger share. Second, labor migration to the cities accelerated, and most of these migrants were
not included in a pension scheme. Third, the one-child policy in combination with improvements in
life expectancy and more and more retirees created a heavy burden on pension payments. The system
was unsustainable given these fundamental shifts in economics and demographics. The central government and state council proclaimed again and again that a modern pension system, which would
combine social pooling with individual accounts and transfer the burden of pension provisions toward individuals, was needed. A partially funded system was also necessary to counteract existing and
future demographic changes. Emphasis was put on increasing coverage to all urban workers and, at a
later stage, to the rural population. An important side effect would be the encouragement of private
sector development and increased labor mobility. The first official indication of this new pension system was the 1991 guideline that aimed to bring all workers in SOEs into a uniform pension scheme
with three tiers:
• Basis pension for all retirees jointly financed by state, enterprise and workers
• Supplementary scheme funded by the enterprise
• An account funded by individual worker on a voluntary basis and payable at retirement as a lump
sum
The choices above are in line with what can be seen over the world. Most countries have a mixed
system with a PAYGO component and a funding element that sits in the middle of a fully fledged
PAYGO system, as is the case in Sweden, and a fully funded individual defined contribution scheme,
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as is the case in Chile. The most significant drawback of any PAYGO system is that it can create large
liabilities for the state as measured by the implicit pension debt. Moving to a fully funded pension
system resolves the issue of implicit pension debt in the longer term, but it also puts an additional
strain on fiscal resources during the transition because setting aside money for the individual accounts
means that these funds are no longer available to pay current pensions. Large transition costs are the
result.
Box 1: Public pension designs in Asia
Public pension design
Mature public systems
with broad coverage
Public systems in the
process of increasing
coverage
Social welfare /
No public pension pillar
Australia
China
Hong Kong
Japan
Taiwan
India
South Korea
Thailand
Singapore
All the above countries introduced defined contribution schemes. Singapore took this step as early as 1955. China introduced the
(State) DC scheme in the 1990s and EAs in 2004. Thailand was the latest country that shifted towards DC plan (2008). In
general, mandatory schemes dominate.
Type of DC scheme
Mandatory occupational
Voluntary occupational
Mandatory for civil servants
Australia
China
India
(volutary for all citizens)
Hong Kong
Japan
Thailand
Singapore
South Korea
Taiwan
Thailand
(from 2008 onwards)
Source: Allianz Global Investors, OECD seminar, November 14, 2007
The first years of the 1990s were not successful. The private sector did not participate in the first tier.
Because they had only a few retirees on their payrolls, pooling was seen as a way of subsidizing SOE
retirees. The rural area was and still is absent in the pension system. Instead, the old-age provision was
organized through extended family networks and institutionalized through the Family Support Law of
1981, which obliges younger generations to support their parents if needed. Family support was the
primary source of income for nearly half of those aged 60 and above in rural areas. Also problematic
was inconsistency across the system due to different pilot projects and the discretionary power given
to local governments by the 1991 resolution. The creation of a unified national basic pension system
insurance system received highest priority after 1993, and in 1997, this aim was officially published
in the State Council Document Number 26. The architectural basis of this modern, national old-age
insurance system was formed with the advice given by the World Bank. The three pillar system formed the central theme of Document 26.
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3. Describing the system
3.1
The multi-pillar pension model
The discussion on the design of the pension system in China was influenced by the following macroeconomic factors.
• Impressive economic growth that resulted in a dramatic reduction of poverty but also increased
income inequality
• Transformation of SOEs that led to a large number of laid-off employees and increasing unemployment
• Increasing migration to urban areas in search of job opportunities. However more than 50% of the
Chinese population still lives in rural areas
• Rapid aging of the Chinese population
Within this rapidly changing environment, reforms of the social security and pension systems were
particularly important. The choice was to transform the PAYGO system into a multi-pillar system
including a funding scheme.
Box 2: Structure of pension systems; the World Bank’s three-pillar model
Structure of pension systems
Public
pensions
Occu pational
pensions
Voluntary
pension
savings
1st pillar
2nd pillar
3rd pillar
• The world Bank’s three pillar model
– First pillar: Publicly managed,
financed by general taxes/social
securities contributions, pay-as -you -go
and defined benefit
– Second pillar: Privately managed,
funded and mandatory
– Third pillar: Privately managed,
voluntary retirement savings
• Two basic types of occupational /
private pension plans
– Defined benefit (DB): Benefits are
defined, sponsor/financial institution
bears longevity/investment risk
– Defined contribution (DC): Con tributions are defined, plan member
bears investment/longevity risk
Source: Allianz Global Investors, OECD seminar, November 14 2007
Based on State Council Document 26 of 1997, the central government outlined a national basic
pension insurance system consisting of three pillars. It should be noted that the precise percentages
below are based on adjustments made in Document 38, which was published in 2005. According to
Document 38, two relevant changes were implemented. First, the employee pays 8% of his/her wage
into his/her personal account rather than the 3% as indicated in 1997. The second adjustment relates
to the social pool replacement rate, which was fixed at 35% (instead of 20%) of the city’s average
wage after 35 years of service.
The mandatory first pillar consisted of two tiers: a social pool (DB scheme) and an individual account
(DC scheme). The social pool is a PAYGO system financed by employers. Contributions are 20% of
the employee’s wages. According to State Council document 38, a social pool ensures a fixed replacement rate of retirement of 35% of the city’s average wage after 35 years of service and is paid out by
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the pension insurance fund. It should be noted that this 35% has been changed in the past 10 years
based on various experiments in different provinces. The second tier of the first pillar is managed as
fully funded individual accounts and is now funded solely by employee contributions of 8% of his or
her wages. It pays out in equal installments over 120 months, which is not a very long period considering the retirement age, average lifespan and interest rate. Again, there are some differences per
province. Once the account is depleted, all benefits are paid out of the pension insurance fund. The
replacement rate from this tier is maximized at 24% after 35 years of service. However, this depends
on the investment return. The maximum total replacement rate from pillar 1 is therefore projected to
be 59%. It should be noted that this replacement rate is a kind of nominal replacement. The real replacement could be much lower because the official replacement rate depends on the definition of the
wage and how much it accounts for the total compensation of an employee. The total compensation
includes wages, bonuses, and allowances. In some enterprises, especially private enterprises, wage is
not a majority of the compensation. In that case, the real replacement rate would be lower than the
figures above. In the case of a civil servant, the real replacement rate is relatively high because wage is
the primary part of compensation. The example below makes this clear:
Box 3: Nominal and real replacement rate
Mr. Lu has worked in a private enterprise since 1996, and he and his employer joined the national old-age insurance system in
2000. His total compensation is 3000 Yuan per month, of which wage is 1500 Yuan. According to Document 38 (2005),
every month he pays 8% of his wage to his personal account, which is 120 Yuan. If he retires in 2025, the social pool replacement rate is 25% of the city’s average wage because he has paid contributions for 25 years. His pension from social pool and
individual account is calculated as following:
Social pool: 1500*25%=375 (suppose the average wage then is 1500).
Personal account: 120*25*12/120=300 (Suppose there is no inflation, no interest rate, no wage change, pension factor is
120)
Total pension: 375+300= 675 per month.
Nominal replacement: 675/1500=45%
Real replacement: 675/3000=22.5%
The second pillar is a voluntary or supplementary pension benefit called the enterprise annuity. Both
employers and employees can contribute to the fund, but only employers are required to do so.
Contributions by the employer can be treated as costs for a maximum of 4% (or more, depending
on the city) of the total payroll. The balance is payable as a lump sum or an annuity. The assets of
the EA plans are under private management have EA administrators and set up as trusts. Companyfunded pensions are free in their design of such annuities, as parameters such as contribution rates,
vesting periods and payment methods are left entirely to individual companies. Although there is a
great degree of freedom for enterprises, the investment policies of the pension fund established by the
company are restricted by government regulations. Equity investments are capped at 30%, with direct
investment in shares limited to 20%. At least 20% must be invested in money market instruments.
Up to 50% can be invested in fixed-income securities but at least 20% must be kept in government
bonds.
The third pillar consists of voluntary complementary pension savings. Despite China’s extremely high
savings rate (estimated at 40% of GDP), this will not be a solution to increasing pension and health
care expenditures. Household savings only compromises a fraction of total savings, and much of it is
invested in the family home.
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Box 4: Design of the Chinese urban pension system
Pillar
Contribution rate (%)
Target
Replacement
rate (%)
Financing
Mandatory or
voluntary
Status
1A
Enterprise: 20
Individual: 0
35
PAYG
Mandatory
In operation
1B (Individual
accounts)
Enterprise: 0
Individual: 8
24
Funded
Mandatory
In operation*
2 (Enterprise
annuities)
Max. tax exemption: 4%
20-30**
Funded
Voluntary
In operation
3 (Private
individual)
n.a.
n.a.
Funded
Voluntary
Not finalised
Pension coverage rates
• Urban pension system: 50%
• Rural pension system: 9%
National Social Security Fund
• Reserve Fund to bolster demographic
development (established in 2000)
• Current AuM: EUR 27.5 bn (RMB 283 bn)
expected to grow to EUR 97.2 bn (RMB 1tr)
Current reform projects
• “Refilling” pillar 1B
• Pilot projects to cover migrant workers / larger
parts of the rural population
• General harmonisation of the pension system (tax
exemption rules for Eas differ considerabely as do
contribution rates)
(*) Although the individual accounts are in operation, many of these are (partially) empty accounts
(**) As estimated by the State Development Planning Commission. Other estimates are more conservative
Some notes on these percentages and figures
1. Contribution rate of the 1A and 1B pillar may varies
2. Current AuM: EUR 50 bn (RMB 500 bn)
3. Newest data on coverage rates are not available yet
Source: Allianz Global Investors, OECD seminar, November 14 2007
The three pillar concept dramatically changed the pension system with its implementation in 1996,
creating distinct pre- and post-1996 periods. Essential features of the new system include mandatory
state pension coverage for all urban employees, comprising all private enterprise and self-employed
workers; and a formal separation between enterprises and pension payments. Instead of working at
the level of individual enterprises, the pension system now operates at the level of local governments
(and must in terms of efficiency be broadened into a provincial and eventually a national level).
However, due to the large geographic differences in wages and welfare level this is not possible in the
medium term. The retirement age, however, stayed the same under the new system.
3.2
Situation between 1997 and 2004
The changeover from the PAYGO system, where current pension contributions today represent a liability for the state, into a partially funded system, where workers’ contributions are held in individual
accounts, earn a rate of interest and accumulate over the working life of contributors, is essentially a
switch from a transfer system towards a savings scheme. The transition was not without the usual associated transformation problems. This section describes the main barriers and policy reactions to the
hurdles of developing such a saving scheme based on individual accounts.
How to deal with differences in the pension design?
As stated before, the new legislation in 1997 resulted in a “pre 1997” group participating in the
old system and a “post 1997” group that entered the labor market after 1997. In between are the
employees who began working before 1997. One of the experts we interviewed divided these groups
into “old”, “middle” and “new”. The “old” group consists of all those who retired prior to 1997.
They receive their pension benefits according to the old pre-existing rules. The “middle”- group are
the workers who joined the workforce before 1997 and had not yet retired by that year. They will
receive pension based on social pooling and the individual account but also will receive compensation
for their lost contributions to individual accounts. The approximately 60% replacement rate of pillar 1
is much lower than the generous replacement rates for SOE employees in the old system. The “new”
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group includes all those who joined the labor force after 1997 and are part of the multi-pillar system.
A discussion revolves around the compensation for this middle group, which includes workers from
SOEs and civil servants. Furthermore, the present situation is that the system is administrated mostly at
provincial or country level, leading to inconsistency in rules and contribution rates.
Box 5: Pension plan for the different groups and in the new system
Old group
The pension plan of the old group is relatively simple. Most people of this group worked in SOEs before they retired and they still benefit from the previous/ old social security system. For example, Ms.
Wu worked in a SOE for 250 Yuan a month until 1993. She receives a pension of 215 Yuan a month;
a replacement rate of 86%. The pension she receives after retirement is indexed according inflation
and change of average wage level. In the case of Ms.Wu, her monthly pension increased from 215
Yuan in 1993 to 977 Yuan in 2008. But there are differences between people worked in SOEs and
civil servants. For example, Mr. Zhang worked as a civil servant, he retired in 1993 and received 245
Yuan per month in that year. In 2008, his monthly pension increased to 2170 Yuan.
New group
The pension plan for new group is in line with the State Council Document 26 of 1997 and Document 38 of 2005. However, the situation can be different depending on the type of work unit. For
example, civil servants have not been integrated into the new pension system and are still compensated under the old retirement system. In addition, the new system only partly applies to the employees
of public sector related education and health care institute, at least according to current regulations of
many regions. In line with Document 26, they will fully integrate into the new system in future.
Middle group
Under the new system, there is a transition plan for this middle group. According to State Council
Document 6 (1995), the monthly pension can be calculated as follows:
Monthly Pension = regional average wage *20% + accumulated personal contribution÷120 + transition compensation
The transition compensation = personal average wage* 1.4%*employment year before establishment
of personal account.
In reality, this scheme, as far as we know, is not fully applied to SOEs and institutes, who instead have
opted for a plan similar to the old system. For example, Mr. Wang worked in a big SOE directly under
the central government until he retired in 2008. His monthly compensation before retirement is 2100
Yuan; after retirement, he receives monthly about 1800 Yuan, which consist of 95% of his previous
wage and some allowances. The real replacement rate is 85%.
In summary, the new pension system does not significantly affect the old group and now only partially influences the middle group. In line with the government’s reform plan though, the influence of
the new system will increase.
The different situations of the three groups in the new system
Employed person in Urban, total, (2006)* Applicability of the new system (pillar1)
Number
New group
(x 100)
1 Enterprises
---SOE
--- Others
2 Institutes**
3 Government
total
7325.0
2456
4243.7
2748.0
1087.6
11160.6 ***
Percentage
65.6%
22%
Apply
43.6%
Apply
24.6%
Will apply 9.7%
Yet not apply 100%
Middle group
Old group
Partly Apply
Apply
Partly apply Not apply
Not Apply
Not Apply
Not apply
Not apply
*
Data source: China Statistical Yearbook 2007.
**Institutes refer to the organizations that are not commercially oriented; normally they receive government subsidies
for their operation, such as organizations in education, healthcare etc.
***
This number accounts for 14.6% of total employed person including rural workers.
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How to deal with the financial burden of pension related expenditures?
Although the discussion about financing the pension system is mostly driven by government expenditures, there is also the financial burden of the system for individual companies. The social
pool of pillar 1 is financed by employers. Contributions are on average 20% (ranging from 17% to
30% depending of the city) of the employee’s wages up to 3 times city average pay, which together
with other payments for basic insurance, is a heavy burden for enterprises. According to the general
manager of a foreign company in China whom we interviewed during our fact finding trip, the total
contributions to basic social security, including pension contributions, is 41% of employee wages.
This includes health, unemployment, work injury, maternity, and housing. However, there are
regional differences due to differences in local legislation. Because public retirement programs only
cover a proportion of the workforce, the cost is still modest as a share of the total economy. In 2006
China spent about 4% of GDP on public pensions. It spent roughly another 0.8% of GDP on health
care benefits for retirees, bringing the total cost of public retirement benefits to almost 5% of GDP.
Data of the National Population and Family Planning Commission of China shows that this figure will
rise to almost 10% in 2050 if China keeps the retirement age unchanged.
Theoretically, pillar 1 is partially funded by contributions from employees and employers. In reality,
local governments often use reserves accumulated in the individual accounts to pay current pension
claims, effectively turning the individual accounts into empty (notional) accounts. Earlier we referred to transition costs with the difficulty of financing existing retirees pensions. These transition costs
have been paid partly by subsidies from the central government and partly by taking money out
of the individual accounts intended to benefit future retirees. This occurred despite the fact that in
theory the funding of individual accounts and that of social pooling are managed in strict separation.
The pilot projects in Liaoning and Jilin provinces aimed to enforce segregation between individual
accounts and social pooling. However, individual accounts were only funded only because of massive financial support from central and local governments. The scandals in Shanghai make clear how
reality deviates from theory. The misuse of funds by the Shanghai pension fund was the result of the
lack of clear regulations guiding the operations in the fund management industry, and the lack and
competence of a credible regulatory body and . Thus, officials administered these supplementary
funds according to their own convenience rather than the interests of investors.
Also with respect to pillar 2, the enterprise annuity, there were hurdles to smooth development.
The assets of the EA are under private management and each company has to appoint a trustee that
supervises the company’s pension plan. However, the pension fund established by the company is
limited in its investment policy. At present EA funds can only invest in mainland Chinese financial
instruments, and regulation results in very conservative investment allocation. Furthermore, tax
deductibility is limited to only 4%. Most larger foreign enterprises participate in this program, but
the number of local enterprises that participates in this second pillar is small. Lack of tax incentives for
employers and employees are seen as an obstacle to the development of the EA market. It should be
noted. however, that more SOEs are setting up EAs than private enterprises. While modest deductions
are offered to employers at the provincial level, expert indicate that offering incentives for individuals
together with high investment returns is essential. The scheme is also costly. Each scheme will need to
be audited annually by a qualified accountant, and lining up the different players (trustee, administrator, custodian, fund manager) is difficult, complex and therefore costly, despite the maximum fees
indicated by law.
Faced with the increasing pressure from social security expenditure, the usual practice is to either
increase the contribution rate or lower the benefit level. However, the situation in China is different.
First, companies are not able to increase the contribution rate. Second, lowering the benefit level
would have a negative impact on economic growth and social stability. The choice was to choose
another way to finance the new system. Therefore, the National Social Security Fund (NSSF) was
established in 2000 as a national long-term strategic reserve fund to meet future pension obligations.
The mission of the NSSF is to raise funds through various channels, accumulate funds through investment activities, provide an important financial reserve for social security provisions and guarantee the
sustainable development of social security in China. The National Council for Social Security Fund,
which is responsible for managing and operating the fund, was established at the same time as NSSF.
The NSSF is not expected to make any major expenditure at this time or the foreseeable future, most
definitely not before 2010. In the event that some provinces have insufficient funds for pillar 1, the
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NSSF is a “fund of last resort”. Money into the NSSF comes mostly from budget allocations by the
central government. However, there has been more diversification in the past few years. A second
source is the income from sales of SOE shares. Other sources include lottery license proceeds and
investment income.
Box 6: Top 25 European pension funds
The largest pension funds in Europe, based on total assets, in 2006 are shown in the table below.
Fund name
Country
Value
Eur million
1 Government Pension Fund - global
Norway
218239.61
2 ABP
Netherlands
201000.00
3 Philips
Netherlands
145000.00
4 Government Pension Fund - Norway
Norway
100000.00
5 ATP – Arbejdsmarkedets Tillaegspension
Denmark
99900.00
6 PGGM
Netherlands
90000.00
7 British Telecommunications plc
UK
55636.36
8 Alecta
Sweden
46655.90
9 ATP Ejendomme
Denmark
45000.00
10 Scottish Public Pensions Agency
UK
44965.45
11 Universities Superannuation Scheme Ltd.
UK
41463.75
12 Coal Pension Trustees
UK
36502.75
13 Bayrische Apothekerversorgung
Germany
34500.00
14 Electricity Pensions Services Ltd.
UK
32158.58
15 Fonds de Reserve pour les Retraites (FRR)
France
31100.00
16 Pensioenfonds Metaal en Techniek
Netherlands
30000.00
17 PFA Pension
Denmark
28643.07
18 Victoria
Germany
27634.00
19 AMF Pension
Sweden
27000.00
20 Varna Mutual Pension Insurance Company
Finland
26900.00
21 Siemens Pension Trust
Germany
26306.00
22 Railways Pensions Trustee Company
UK
25118.74
23 Danica Pension
Denmark
25000.00
23 Folketrygfondet
Norway
25000.00
24 Royal Bank of Scotland
UK
24587.29
25 AP Fonden 2
Sweden
23500.00
It should be noted that while there is a difference between sovereign wealth funds and pension funds
in terms of objectives, investment strategies and sources of funding. Sometimes the two types of
funds are difficult to distinguish. For example, Government Pension Fund-Norway and Government
Pension Fund-Global, both established in 2006, are the result of the re-structuring of the Norwegian
pension reserve funds (formerly, the National Insurance Scheme Fund) and a SWF (formerly, the
Government Petroleum Fund). Although the Government Pension Fund-Global is identified as the
largest pension fund of Europe, it actually has the characteristics of a sovereign wealth fund. It only
invests in foreign assets and has a mandate beyond financing pension expenditures. In the overview
below, which gives the largest sovereign wealth funds, based on the OECD definition, the Norway
Government Pension Fund is included.
12
Sovereign wealth funds by size
800
(USD billion)
700
SWF point estimate
600
500
400
300
200
100
er
n
Ot
h
Ch
i
Ira
ad
ne
a
U
se
SA
T
(N
ai
p
ew
ei
M
ex
ic
o)
a
ay
si
M
al
Ca
n
a
an
re
hs
t
za
k
ei
)
un
Br
ar
sk
a
Qa
t
(A
la
Ko
Ka
g
Si
n
U
SA
si
(T
a
em
as
ek
)
Li
by
a
Al
ge
ria
na
Ru
s
Ch
i
(G
IC
)
Ku
wa
it
Sa
ud
i
wa
y
g
Si
n
N
or
U
AE
0
In particular these sovereign wealth funds are growing fast and starting to alarm some policymakers
and commentators. In an interview on American television (April 6 2008), Mr. Gao Xiqing, CEO
of China investment Corporation, indicated that these sovereign wealth fund are not invading Wall
Street or the American economy, but saving and helping the financial system. Related to this criticism
towards sovereign wealth funds, one of the experts we spoke during our May trip to China indicated
that to counteract a new sort of “financial protectionism”, China should set up a new sovereign pension fund and invest abroad; like the Norway Government Pension Fund.
Sources:
P ensionfundsonline.co.uk and OECD (2008), A sovereign wealth and pension fund issues”, working paper on
insurance and private pensions, number 14
The NSSF can either directly invest the assets or appoint licensed investment managers. If the NSSF
chooses to directly invest in assets, it can only invest in bank deposits or government bonds. For all
other types of investments, the NSSF needs to appoint fund managers and custodians approved by
the Ministry of Human Resource and Social Security (MOHRSS). No less than 50% of the NSSF assets must be invested in bank deposits and government bonds, and no more than 10% in corporate
bonds. Given China’s low interest environment, returns are modest, significantly less than China’s
salary inflation rates. Since mid-2006, the NSSF has also been authorized to invest in overseas assets.
This and the increase in domestic equity prices resulted, according to the NSSF homepage, in a much
higher rate of return since 2006.
Although we will return to this subject later in the paper, here are some words on the NSSF investment policy. With low risk as its top priority, the NSSF has a target rate of return for the coming five
years higher than that of the inflation rate for the corresponding period. In general, in-house investment is made by the Council in bank deposits and ordinary market government securities and outsource investment is made in equities, corporate bonds and financial notes, meaning these activities
are entrusted to specialized investment managers. The situation changed in 2003 and 2004 when
NSSF appointed a few domestic fund managers for domestic equity and bond mandates. Furthermore, a few managers for “stable allocation” mandates were appointed. At the end of 2004, 25% of
the Council’s investment was outsourced investment. One of the more eye-catching moves made by
NSSF are pre-IPO strategic investments into larger Chinese companies, especially banks, at extremely
attractive prices. This generated massive windfall profits for the NSSF.
13
3.3
Situation after 2004
The year 2004 in this section is chosen because the EA regulation was introduced in that year and the
investment rules were changed. According to legislation, new EA funds in China should be managed
based on the trustee model. As with the earlier discussion of old, middle and new group of employees, the EA legislation also resulted in an old and new types of supplementary pension.
Box 7: Enterprise Annuity framework Trust form
Enterprise
Sign Trust Contract
Plan Trustee:
EA Council comprising representatives of employee, management and /or
professionals OR: Other authorized institutions
(Trust co., fund mgt co. & pension services co)
Sign Service Contract
Investment Manager(s)
(Fund co., securities co.,
trust co., Insurance co’s
and other investment (co)
Investment Custodian
(Banks only)
Account Administrator
(Any legal entity with
Rmb. 50 m registered
capital)
Source: OECD (2005)
Many of the funds were set up by companies before the EA regulation was passed in 2004. These
funds are generally known as “legacy EA” and are administered under one of the following entities:
• Social security bureaus (or EA administration centers) which administer and manage supplementary
pension funds accumulated in a particular region such as the Shanghai EA administration center.
• In many other regions, these assets were simply handed over to and managed by the local social
security bureaus.
• Industry funds (e.g. power and electricity), managed internally by the industry itself. They established their own EA administration center or department.
• Directly buying insurance products from insurance companies. These are not viewed as EA funds
and consequently not entitled to the tax relief benefit.
According to regulation, new EA funds in China should be managed based on the trustee model-either external or internal trustee. Existing EAs are still allowed to exist, though they (theoretically)
are not subject to favorable tax treatment. Based on new laws, the assets currently managed by the
insurance companies are not viewed as EA assets and therefore are not entitled to tax benefits. The
government’s plan is to externalize the EA assets currently controlled by local governments. Therefore,
the local administration centers are now being restructured from being de facto local governmental
agencies to independent commercial trustees. For example, the Shenzen Administration Centre transferred all assets to China Merchants Bank (as custodian and account administrator), and PingAn Life
(as trustee and asset manager).
14
Box 8: Overview of the world-wide pension market
In the figure below, taken from BCG, the main markets in terms of pension assets are given. The United States, Japan and the United Kingdom are the three biggest markets, followed by the countries in
Western Europe, including the Netherlands. In terms of pension reserve per capita, The Netherlands
and Switzerland are ranked number 1 and 2 in the world. In particularly, the second pillar is relatively
large and mature in the Netherlands.
If we focus on Asia, below is an overview of the assets of public pension funds in the Asian region.
With total assets of 860 billion euro (2007), the Japanese government pension investment fund is the
largest fund both in Asia and the world. Important to note is that more and more is being outsourced
to private asset managers.
600
500
400
300
200
100
0
Australia
China
Japan
Singapore
South
Korea
Taiwan
Thailand
Source: OECD global forum on private pensions, November 2007
China’s supplementary pension is an area that represents tremendous opportunity for service providers; combining asset management, trusteeship and administration The experts we spoke during our
fact finding mission in May 2008, indicated that this EA pillar is extremely interesting for the fund
management industry but not in the near future. Presently, the NSSF has grown significantly and
become China’s Number one institutional investor and the largest source of business for fund managers operating in China’s pension sector. About 30% of the fund’s assets are managed by external
firms. Although the focus of fund managers is now on NSSF mandates, the expectation is that EA will
emerge as the largest source of new funds under management.
15
Box 9: Investment strategies of pension funds
Investment strategies are described through developments in asset allocation (long versus short term
assets) and domestic versus foreign investments.
Asset allocations
For most of the countries for which data are available, bonds and equities are the largest components
in the portfolios of public pension funds. The table below gives information regarding the asset
allocations in certain countries divided in equities, bonds and cash in 2007. It does not sum up to
100 percent due to alternative investment in, for example, real estate. The conservative investment
strategy in countries such as the United States and Spain is the consequence of legislation. In general,
with the exception of Australia and Denmark, cash does not account for a significant share of pension
fund portfolios.
%
Australia
Canada
China
Denmark
France
Japan
Korea
Norway
Russia
Spain
Sweden
United States
Equities
Bonds
Cash
26
58
24
1
65
37
14
48
0
0
53
0
0
28
54
26
34
63
83
51
100
100
39
100
73
0
10
67
1
0
0
0
0
0
1
0
Over time, there is a tendency of more investments in equities and less in bonds. Countries such as Canada, France, the Netherlands
and Sweden relatively increased their equity portfolio encouraged by the equity bull market of the 1990s.
Foreign assets
For cuntries where statistics are available, there is a clear trend of increasing overseas investments both
in absolute and relative terms. For example, France’s FRR began investing in foreign assets (assets denominated in non-euro currencies) in 2004. In 2007 almost 35% of total assets were invested abroad.
Also Korea’s NPF increased foreign investments and its share increased to 11% in 2007. The share of
foreign assets in Japan’s pension fund portfolios increased to 26% at the end of 2006.
Source: OECD (2008), Sovereign wealth and pension fund issues, working papers on insurance and private pensions, no. 14
Licenses were given to 41 investment managers and entities providing custodial, trustee and administration services, including some joint ventures with foreign participation. Some have already
launched their first funds. These foreign investors may either invest in an existing domestic fund management company by purchasing shares from an existing shareholder or jointly establish with one or
more domestic companies a new fund management company. Since late 2004 ,foreign parties have
been allowed to own up to 49% of the equity in joint ventures. Foreign companies such as Deutsche
Bank, Royal Bank of Canada, ING Group and Fortis are already active. Most foreign companies have
chosen to form partnerships with Chinese securities firms to build a new fund management company
rather than buying into an existing one. Fund managers or security companies acting as investment
managers must be authorized by the China Securities Regulatory Commission (CSRC) and have a
certain amount of registered capital and net assets. The role of custodians is all filled by commercial
banks. Administrators are institutions with capacity for account administration. Trustees are trust
companies and enterprise annuity administrative council. The trustee is selected by the employer and
the local social labor department. This trustee in turn selects, based on input from the employer, the
accounts administrator, custodial and investment manager. Listed trustees are for example: China Cre-
16
dit Trust Company Limited and Ping An Pension Insurance Company. Licensed account administrators
are: China Merchants Bank, Shanghai Pudong Development Bank, China Life Insurance company.
Licensed custodians: Bank of china, China Merchants Bank. Licensed investment managers: China Life
Fund Management Company, Ping An Annuity Insurance, Harvest Fund Management.
Currently there are ten banks licensed to take custody of investment funds. These custodian banks are
the main channel of distribution for funds in China. In exchange for their custody business, banks will
promote fund manager’s new products through their branch network across the country. Insurance
companies are able to convert their investment departments to investment management subsidiary
companies. Foreign fund managers have been permitted to access China’s fund management industry
through joint ventures.
The types of funds available to investors in the china market are limited despite the various creative
fund names that may suggest otherwise. The major players all have primarily the same product offerings. Officially there are six types of funds: money market, fixed income, closed ended, equity,
balanced and guaranteed. In reality however, there are only four: money market, fixed income,
balanced and guaranteed. All existing closed ended and equity funds should have an asset mix similar
to balanced funds given the previous regulations that required all products to maintain at least 20%
of total assets in government bonds. Although this rule was eliminated in 2004, the conservative allocation structure will only change gradually. Not only is legislation slow but the deeply conservative
attitude of plan sponsors also ensures most Chinese pension money will initially flow to cash and
bond markets. During the first three quarters of 2006, the NSSF had significantly increased (share of
37%) its equities allocations.
There are five types of pension assets in China’s pension system that fund managers can potentially
manage: social pool contributions made by employers, individual account contributions made by
employees, enterprise annuities, other supplementary pensions and the NSSF. The social pool pillar is
PAYG based and any funds are tightly held by the provincial social security bureaus. So in effect there
are only four possibilities for fund managers. If we zoom in on the funded individual account contributions (pillar 1B) and the enterprise annuities, there is strong consensus on the growth of assets and
consequent market potential.
Box 10:Pension assets under management, billion euros, optimistic and conservative projection
(EUR bn)
600
Optimistic scenario
Conservative scenario
464.2
49.8
403.8
49.8
400
163.6
200
18.7
18.7
62.3
8.9
0
354.0
62.3
8.9
144.9
53.4
2006
155.6
414.4
• CAGR 1B pillar:
23.4% to 25.6%
depending on
participation
(between 55 and
75% by 2015
• CAGR Enterprise
Annuities:
21.2%
136.9
53.4
2010
2015
Funded 1B pillar accounts
2006
2010
2015
Enterprise Annuities
The figure shows that China’s pension assets will increase at least 6.5 fold 2006 to 2015. It is clear that acceptance among small
and medium sized enterprises will be crucial for success of the EA market. In that respect, the interview we had with a foreign
manager of a SME shows that progress is needed. He was not aware of this second EA pillar and his employees were not asking
for it: “Chinese workers have a preference for cash and present wages/bonus. Our young workforce is not interested in pensions.
Furthermore, we developed our labor contract in cooperation with FESCO and they did not inform us about this possibility”.
17
According to Stirling Finance (CLSA, 2006), the total EA assets in China could grow to 700 billion Yuan by 2015. They
indicated that this is a conservative estimate.
There are strict investment regulations concerning the EA market:
• Minimum 20% in liquid investments
• Maximum 50% in term deposits and bonds and minimum 20% in government bonds
• Maximum of 30% in equities, insurance funds and equity funds in aggregate.
• Maximum of 20% in equities
• Investment manager to retain 20% of management fees in investment risk reserve under trust to cover investment losses (up to
10% of assets)
Source: Allianz Dresdner Economic Research, 2007
The National Council for Social Security Fund, which administers the NSSF, announced its intention
to outsource funds to qualified asset managers. Ultimately six were selected: Boshi (renamed to Bosera), Changsheng, China Asset, Harvest, Penghua and Southern Fund Management. Later, two Sinoforeign JV were added: China Merchant and China International Capital Corporation. Five mandates
were given to the managers: money market, fixed income, equity, E-fund and guotai.
3.4
Competing for talent
As stated earlier in this paper, there is no incentive for private companies to participate in the EA scheme due to high costs, complex regulation and limited tax benefits. However, on the flip side, more
and more companies are finding it difficult to attract and retain capable employees. We asked our
experts about this development and the consequence for the EA system development. The following
is a summary of the discussions: there are signs of labor shortage within the Chinese industry such as
significant difficulties in hiring additional workers and expanding capacity. A good example is sectors
in the light manufacturing. The consequence is a large increase in nominal wages. Although China’s
population will be ageing, it seems strange that this labor shortage is already the actual situation at a
time when such a large pool of labor is available.
By looking at aggregated figures, it is unlikely that China will face a labor shortage in the coming
years. First, the decline in the working-age population can be offset by facilitating migration into
cities. Second, the wide income gap between rural and urban areas will continue to attract workers
from farms to factories and 50% of the population still lives in rural areas.
Based on productivity patterns that 150-200 million farmers would be enough to support domestic agricultural production, the theoretical excess rural labor (not unemployed but underemployed,
in the sense that China could easily redeploy these people elsewhere without suffering a decline in
agricultural output) is between 250 and 300 million, which is large enough for the next decade
and more. But there is a mismatch between demand and supply of labor; this migrant labor pool is
not evenly distributed across age groups. The preferred group is unmarried, below 30 years of age;
mostly unmarried young women working in sectors such as electronics and young unmarried male
migrants in construction. An important characteristic of this migrant worker flow is that after six or
seven years, the migrants will return home where there is an allocated plot of land waiting to build a
family and take care of the parents.
18
Box 11: Working age population (left) and rural population ages 15-29 (right)
Working age population (millions)
950
Rural population aged 15 - 29 (millions)
250
900
200
850
800
150
750
700
100
650
600
50
550
500
95 00 05 10 15 20 25 30 35 40 45 50 55 60
0
95 00 05 10 15 20 25 30 35 40 45 50 55 60
Source: UBS (2005)
So the picture is clear and may explain the different views on labor shortage in China. If we look at
the overall working age population between 15 and 59, we still see plenty of underemployed labor
resources. However, if we look at the supply of rural working age population between 15 and 30, we
get a very different picture. This demographic is relatively small (185 million rural residents in this
age group) and partly already absorbed in the industry (nearly 100 million are already working in
factories). Education is another drain. The numbers in the 15-30 age group are already declining.
For China in macroeconomic terms, this means that the days of inexpensive labor-intensive growth
may be coming to an end. As population growth slows, so should the economy. China would still
see a shift out of agriculture and into manufacturing and services, but no longer at zero cost. This
also implies that the rapid trade expansion driven by low wages drops off. With rising wage costs in
export manufacturing and a shrinking base of young migrant labor, the country will eventually begin
to give up low end labor intensive industries to economies such as Vietnam, India and Indonesia.
China will respond by moving into more medium and high tech industries. This is a logical economic
process but a process for which companies need human capital--not just labor and low wages but
educated people, training on the job and job loyalty. This is an important reason why more and more
private companies participate in the EA scheme. Lenovo Group established an EA corporate pension
plan for its China based employees, selecting Harvest Fund Management Co. as its investment manager. China Europe International Business School has also started its own EA scheme.
3.5
Sub conclusions
In general, the choices for the pension system are clear, but the transition from the old to the new
three pillar system is a bumpy road. The general impressions of our experts is that China going in the
right direction with its reforms. Some of them indicated to us that the speed of reforms and regulation could or should be faster than in previous years. One explanation is the complex institutional
framework related to pension decisions. We will come back to this in the next chapter. One could argue that speed is not essential at this moment. Although large demographic challenges are ahead and
will strike China at a comparatively early point in time compared to more developed countries, there
is no need for panic. Although the old age dependency ratio is rising sharply, China does have some
breathing room because its overall dependency ratio is actually declining. If one looks at the number
of non-working age people relative to the working age population, there is until 2013 a very favorable situation. According to the OECD (2007), this dependency ratio will decrease to 39% in 2013,
meaning that 100 working age people would need to take care of 39 non-working age people. This
is a temporarily favorable age structure and may explain in part the very high growth figures. Until
2015, there is a demographic golden age with declining elderly dependency ratios. China’s pension
problem is not an immediate one; in fact, the real negative impact of demographic changes will not
be felt for another two or two decades. (By 2035 China will become a super aged society with 20%
of population being older than 65 year.) China is not facing an imminent fiscal problem.
19
Box 12: Total dependency ratio
The child dependency ratio (ratio of under-15 population / working-age population has been falling
due to decline in birth rates. This caused the total dependency ratio (defined as total non-working
population / working population) to fall since it has not been matched by an increase in the elderly
dependency ration (number of retirees to working-age population). The total ratio declined to 0.47
today. This is called “the demographic bonus”: low dependency ratios mean that a large proportion
of the population is at an economically productive age.
Total dependency ratio
0.9
0.8
Demographic ‘golden age ’
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1950
1960
1970
1980
1990
2000
Child dependency ratio
2010
2020
2030
2040
2050
Elderly dependency ratio
Source: UBS Investment research (2005), The aging of China
Due to corruption and misuse of retirement funds however, there is low public trust in individual
accounts as effective investments for retirement. The mistrust in the system is also the result of the
lower replacement rate in the previous years. The level of pension benefits has fallen markedly since
2002. While pensioners in the 1990s could expect to receive on average 70% of the wage of an average SOE worker, this level has decreased to less than 50% in 2005. It is clear that traditional pension
replacement rate in China was high, maybe too high.
20
Box 13 :
Mandatory pensions (first and second pillar); as a percentage of final wage fordifferent wage groups
Box 13: Mandatory pensions (first and second pillar); as a percentage of final wage for different
wage groups
0.5 x
average
1.5 x
2.0 x
2.5 x
Fraction
of workers
covered
Netherlands
70
70
70
70
70
91
Germany
50
38
38
32
26
46
France
80
72
65
54
48
-
UK
51
35
30
22
18
46
Italy
58
58
58
58
58
5
Sweden
93
69
66
65
65
90
US
57
45
39
33
29
45
Average pension in China as percentage of SOE wage
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
72
66
67
70
73
72
76
70
61
61
56
51
48
Source: CPB, 2005 and OECD (2007), Pension reform in China; progress and prospects
In summary, we have discussed three interconnected challenges in the system. First, the costs are
relatively high, which is the consequence of the old system with generous pension benefits without
funding. Also the costs are relatively high due to low coverage. Low coverage is problematic because
savings are needed for financing investments with high return rates. The third challenge is how to
invest in assets in such a way that they earn returns that keep pace with wage inflation. The current
trends in the pension reform in China are:
•
More funding
•
More private management
•
More individual choice
21
4. Challenges ahead
4.1
Two views of the future
There are two points of view on the future of China’s pension system. Proponents of the first view
do not believe that the pension crisis can be solved with today’s legislation and reforms. The main
pension “crunch” is still two decades way, but by 2030 the proportion of people over 60 and 65
will be 23% and 16% of the total population, respectively. By 2050 the number of people aged 60
or over is expected to rise to more than 430 million or 31% of the population, from just 148 million
or 11% today. The ratio of workers to retirees will decline from six to one in 2000 to two to one in
2040. This will happen before China can build up enough assets in either its public or private plans
to support the number of retirees. Part of this problem is the low worker coverage ratio relative to the
number of pensioners already in the system, meaning that China is not able to generate substantial savings. Therefore, the social security fund has been forced and will be forced to “borrow” funds from
individual funded accounts to pay current pensions. This in combination with the low rate of return
on pension savings creates the problem. This first view hinges on the belief that this implicit pension
debt is so large that it cannot be solved through fiscal policy. There are three essential assumptions
in this view. Firstly, the parameters of the pension system such as the contribution rates and the
replacement rates will not be adjusted because of the social tensions that would result. Secondly, the
economic growth will slow down due to higher wages and reduction of international trade. Thirdly,
investments allocation will stay very conservative and therefore these investments will not achieve a
high rate of return. Domestic bonds and bank deposits earn 2 to 3% per annum, and we don’t expect
radical increases in the return structure any time soon. Even allowing equity investment will hardly
help; domestic equity markets have been falling on average for the last four years.
Box 14: Pension fund allowed to be used in investment
BEIJING - China’s national pension fund has been approved by the country’s State Council to invest
in industry funds and private equity funds, the National Council for Social Security Fund (NSSF) said
Thursday. The pension fund could invest both in industry funds approved by the National Development and Reform Commission (NDRC) and market-oriented equity funds filed with the NDRC, the
NSSF said in a statement posted on its website. However, such investments were capped at no more
than 10 percent of its total assets.
By the end of last year, the market value of the fund’s assets under management had risen to 516.2
billion yuan (US$ 74.81 billion). This meant more than 50 billion yuan could be invested in industry
and private equity funds. Analysts expected it would make the social security fund the largest source
of capital on the country’s private equity fund market.
“The green light given to the pension fund is definitely good news for the domestic private equity
(PE) market,” an insider told the China Securities Journal. “The approval could really mean something, as the pension fund had always been prudent in making investment,” he said. “It might be
possible that commercial banks and insurance firms would also be allowed into the PE market, as
securities firms already did.”
The pension fund earlier invested 10 billion yuan in the domestic Bohai Fund in 2006, the country’s
first industry fund, with special approval from authorities. The 21st Century Business Herald reported
last month the fund would invest in two domestic private equity firms, CDH Investments and Hony
Capital. CDH Investments is formerly an investment department of the China International Capital
Corporation. Hony Capital is affiliated with the country’s PC maker Lenovo.
Source: China Daily, June 5 2008
The second view is more optimistic. The main pension deficits are two decades away and the government still has several courses of action available. One may adjust the pension system itself; a relatively small increase in contribution rates (of say three to five percentage points) could go a long way
towards resolving China’s pension worries. The same holds for reducing the relative level of pension
22
benefits. Lowering wage replacement rate from 60 to 55% has the same effect as a four percentage
point rise in the contribution rate. Another adjustment of the system is the retirement age. While formal retirement age is 60 for men and 55 for women, the effective retirement rate is much lower. This
is problematic because life expectancy is far above 70 years. An average pension lifetime of 20 years
at a replacement rate of 59% seems difficult to finance, even with a high contribution rate of 28%. An
additional challenge is the fact that the urban population has longer than average life expectancies.
Another option is to raise taxes and divert resources from other budget revenues. Looking at past
experience, this should not be a problem. For example, the large budget deficits from 1999 to 2001
were resolved in 2004, and for the time being, fiscal capacity looked strong indeed. A third alternative is the issue of debt. China has a low debt situation. Of course, the official numbers (30% of GDP)
do not include the implicit costs of cleaning up China’s banking system, which could add as much
as 30% of GDP in additional government liabilities over the next decade. Nonetheless, China could
spend an additional 3% of GDP per year without much strain on its financial system. This relates
to the implicit pension debt mentioned earlier as it is the government’s obligation to satisfy future
pension claims in present value terms. There are many estimates but the consensus is that it is more
than 100% of GDP. This is the “hole” in China’s pension system. The movement to a funded system
means taking a portion of current contributions and setting them aside in individual accounts. These
funds are no longer available to pay current pensions, and this creates a further “hole” in pension
finances during the transition period. The pension system is burdened by a large amount of legacy
debt that are unfunded liabilities from the old pension system. In general, it relates to pensioners who
had retired before 1997 and workers who started working before 1997, all of whom are still entitled
to a replacement rate of 75 to 80%. Clearly the role of NSSF is essential to solve this problem. Another
solution would be selling state assets. China is not only unique in its demographics and liabilities but
also in its asset holdings. The book asset value is estimated to be nearly RMB 10 trillion or around
80% of GDP.
Box 15: Rebuilding the first and second pillar in a few selected countries
First pillar
• Gradual shift to funding but politically difficult to implement.
Also required are:
o Labor market reforms: the Netherlands and Germany
o R educing the replacement rate: Japan reduced the benefits and increased contributions, also reductions in Germany and Italy
o I ncreasing the role of supplementary funded pensions
o I ncreasing the retirement age: United States from 65 to 67 within 20 years, gradual increase in Japan, from 60 to 65
Second pillar
• Mostly voluntary and funded (United States and the majority of the EU)
Dominant financing method
Countries
Pay-As-You-Go
France
Book reserves/Funding
Germany, Austria, Luxembourg, Sweden, Spain
Funding
The Netherlands, Switzerland, United Kingdom, Ireland,
Denmark, Belgium, Italy, Norway, Finland, Portugal
• DB in decline and DC on the rise
• Increasing investment in foreign assets
• If coverage is insufficient, intensive discussions about the need to make supplementary pensions mandatory
Sources: OECD (2007), World bank (2005)
23
The experts we spoke with during our trip in May pinpointed three challenges for an affordable,
sustainable, adequate and robust pension system. Affordability refers to the financing capacity of individuals, enterprises and the society. Sustainability refers to the financial soundness of the scheme; now
and in the future. Adequacy refers to both the absolute level (preventing old-age poverty) as well as
relative level (replacing sufficiently life time earnings). Robustness refers to the capacity to withstand
major economic and demographic shocks. To create this affordable, sustainable, adequate and robust
pension system, three challenges are on the way. How to increase coverage? How to implement and
raise portability? And how to change the institutional framework?
4.2 Coverage
From the 1990s onwards, there has been an increase in the number of people contributing and receiving pensions and a rising coverage rate among urban employees. In 2005 almost 50% of the urban
workers participated but because coverage in the rural areas is extremely low or absent, the coverage
rate among the total population is only 20%. Although there exist some small and voluntary rural
pension schemes, the rural workers are excluded from the basic pension system. This low coverage
implies limited possibilities for risk pooling and consequently higher contribution rates. Throughout
the paper we have already touched upon the barriers for participating. In this section we will detail
the main reasons for this low coverage.
Box 16 : Old age insurance coverage, 1993-2005
Percentage of urban employees
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
43.9
45.5
45.9
44.0
41.7
39.2
42.4
45.1
45.1
44.9
45.4
46.3
48.0
Source: OECD (2007), Pension reform in China; progress and prospects
First, there is an incentive problem. Employees are reluctant to participate because corruption cases in
past years have eroded public trust in the system. Mismanagement connected to the handling of individual accounts was a prominent news item. Another disincentive to participation is the unattractive
return on the individual accounts. The nominal return on the individual account was 3% compared
to a 12% increase in wages. Funds from the first pillar are currently invested in government bonds
and bank deposits, and the immature capital market make it difficult to find suitable investments with
high returns. This low return may also explain the risky investments made by the pension funds.
Employee contributions to the EA scheme are not tax deductible.
On the employers side the support is low due to the increase in labor and administration costs.
Administrative procedures that are too difficult to understand may hinder participation. One expert
indicated to us that he was not able to follow all the regulatory changes over the last 10 years or so.
Extra pension contributions increase labor costs while lowering competitiveness, and there are hardly
any tax incentives. The employer contribution rate of 20% of total salary is high by international
standards. In particular, firms with a young workforce will resist participation in the system because
they feel they are being used to subsidize other enterprises. The government is also not eager to
stimulate to force companies into compliance, which would substantially increase monitoring costs.
A final obstacle for participation is the hukou system. In the past also migrant workers were excluded from the urban pension system. The system was that these migrant workers should contribute
to the old age insurance in their home country or province which they left to find work in the city.
It is questionable if migrants are willing to entrust part of their salary to build up individual pension
accounts in various administrative units, and this is the problem of portability. There have been some
changes in the hukou system but it is still a barrier for participation.
24
Second, there is an institutional problem. One of the formal criteria to participate in a pension fund
is that the company has already participated in the social security system and that there should be
a sound collective bargaining mechanism in place. This is not the case for many small and private
companies. In the previous years, they avoided contributing to social security and they did not have
trade unions or regular meetings with representatives. Setting up a pension system involves going
through a lot of administrative regulatory and supervisory authorities. For example, the State owned
Assets Supervision and administration Commission is the main administrator of the largest SOEs, but
the power of setting tax policies rests with the State Taxation Administration. Exceptions with respect
to tax relief are set by Ministry of Finance.
Box 17: EA provisional regulations
The overview below are the main features of the EA conditional rules in China
• EA is confined to DC plans
• Preservation of benefits until retirement or death
• Portability of benefits upon change of employment
• EA plans are to be trust-based with four kinds of providers: trustee, scheme administrator, investment manager and custodian
• Fees for EA plans and services are regulated
• Service providers may apply for multiple licenses
• Strict investment restrictions with limits towards equity investments
Source: Taiping Life and pension, seminar Taipei, May 30 2005
4.3
Portability
In general, if employees who change jobs have the accounts the account assets will be transferred to
the new employer. However, the decentralized set up of the pension system leads to high fragmentation and opacity in the process. As mentioned earlier in the paper, most pooling occurs at the municipal level and implementation is left to the discretion of local authorities, creating many differences
in the system. It is almost impossible for the employees to transfer their pension entitlements in such
a fragmented market. This also reduces labor mobility and makes restructuring of SOE even more
complicated.
In many cases, workers changing jobs between administrative units are not entitled to take their
savings in their individual accounts with them to another pension fund in the next province. This is
due to the administrative difficulty of transferring individual accounts and pension claims across local
borders. There also appears to be fragmentation between different levels of administrative hierarchy.
There is clearly a trade-off: pooling on local level is the simplest approach to organize social insurance
but it hinders the portability. This is directly connected to the problem of insufficient protection of
migrant workers.
Another problem of this local pooling is that there may exist surpluses in one county or city pension
but deficits in another. The central government cannot maneuver those surpluses to subsidize the
provinces where pension systems run into deficit.
4.4
Institutional issues
The 1991 resolution was a guideline and not so much a binding directive. While the aim was to
create a uniform pension scheme, the effect was fragmentation. One can say that the social security system is regulated by administrative guidelines instead of laws. To correct this problem, local
governments established their own ordinances and provisional regulations for administrative systems;
they vary significantly by area because they are tailored to local circumstances. Even the names of
administrative organizations differ: the social security bureau might be a center, commission or of25
fice. In addition, a variety of affiliated agencies may be involved, including the labor bureau, personnel
bureau, welfare bureau or health bureau. Under these conditions, administrative disarray is inevitable.
This relates to the aforementioned portability problem. For example, if staff or workers should move
to another area, it is doubtful whether appropriate administrative measures would be taken due to the
lack of uniformity. Furthermore, the administrative structure consists of multiple layers, and there are
three or four layers of upper management above the local insurance administration that actually carries
out operations. The more administrative layers that exist, the lower the system’s operating efficiency.
This institutional issue is also visible on the central policy level. At different stages of the social security
system there are three central ministries involved: the Ministry of Human Resources and Social Security
(MOHRSS), Ministry of Civil Affairs (MOCA) and Ministry of Finance (MOF). This results in political
conflict. An important observation of our experts is that there are too few qualified staff personnel at
the working level.
Box 18: Roles of key players in EA market
In the table below an overview is given about who can be what within the EA market, divided into
Trustee (T), Custodian (C), Investment Manager (IM) and Administrator (A). In general, insurance
companies are the dominant players in the pension market today because they have experience in the
administration of pension plans, provide actuarial services to pension plans and can offer annuity products to cover pension obligations.
T
C
IM
A
Trust Companies
•
•
•
Fund Management Companies
•
•
•
Pension Services Companies
•
•
•
Commercial Banks
•
•
Securities Companies
•
•
Life Insurance Companies
Partial
•
Ins Co. ’s Asset Management Co.
•
•
Investments Companies
•
•
Non-financial Services Companies
•
Others
•
Trust companies approved for new trust certification license
(as at February 2008)
Dongguan Trust and investments, Dalian Huaxin Trust, Guolian Tru st, National Trust, SDIC Trust, Huachen
Trust, Hangzhou Industrial and Commercial Trust, Equity Trust, F ortune Trust, Jiangsu International Trust and
Investment, Bank of communications International Trust, Yingda International Trust, Shandong International
Trust and Investment, Shanxi Trust, Hefei Xingtai Trust, Shangha i International Trust, Xiamen International Trust,
Yunnan International Trust, New China Trust, Suzhou Trust, China Credit Trust, CITIC Trust, Zhonghai Trust Co.,
Zhongrong International Trust, Guangdong Yuecai Trust, Zhongyuan Trust, China Foreign Economy and Trade
Trust and Investment, Xi ’an International Trust, Beijing International Trust, Chongqing International Trust, China
Zhongtou Trust and Bohai International Trust.
There is an important potential role for trust companies on the EA market. Current regulations call for
licensing in the four indicated areas to serve the EA market, but no single firm in the financial sector
has been granted all four licenses. However, more and more alliances are being built to cover the
whole range of products. As of January 2008, only a small number of trust companies have received
the go ahead to act as trustees for EAs (including CITIC Trust, Fortune Trust, SDIC Trust and China Credit Trust), and only Fortune Trust and CITIC Trust have obtained approval to administrate EAs. There
are large barriers to entry related to capital and asset requirements and internal governance rules.
Sources: Yan Hu (2005), Regulatory framework; China’s pension system and KPMG (2008), China’s trust sector
26
Another effect of the institutional design is the large number of irregularities of social security funds
in China, which we have talked about earlier in the paper. The Shanghai scandal makes clear that
there is some illegal use of the funds; mainly risky, irregular investments and shifting of funds from
different accounts. Both are the result of institutional design. An important problem lies in the low
level of social pooling. In most countries, the social security fund is pooled nationally and managed in
designed accounts. As for national social pooling, social security contributions are collected and distributed by the central government. In China, social pooling occurs only at country (city) level, which
generates more than 2000 pooling units. Social security funds under such a low level pooling regime
are much less safe than under the direct control of the central government on a national pooling level.
Another problem results from the strict stipulation that confines investment to contractual deposits
and treasury bonds. The rate of return under such rules is quite low, only 2 to 3%. This is too low to
meet expenditures and local governments are motivated to make unauthorized investments.
27
5.Some reflections and recommendations from experts
In the previous sections, we have diagnosed the existing pension system in China. In this section, we
will shift the focus towards evaluating the reforms and system by summarizing the interesting talks
we had during the fact finding mission in May 2008.
Despite unfavorable demographic trends, inadequate contributions and low returns to pension funds,
the consensus view of our interlocutors is that the reforms are moving in the right direction. However, at the same time, government action is needed. Today’s demographic situation has declining
elderly dependency ratios, which provides a “demographic window of opportunity” until 2015 to
address current short comings. Even though China is already an aging society--measured as the proportion of population older than 65 has reached 7% --it is expected to become an aged society after
2025 (14%) and a super aged society by 2035 (20%).
One of the key risks is lower than expected economic growth which would increase the pension
system’s financing gap and worsen the burden on contributors. We are not very worried about
this macro risk. Earlier in the paper we mentioned the effect of ageing on economic growth. We
discussed the labor paradox of a very large pool of underemployed rural population yet evidence of
labor shortage in light manufacturing. In the discussion in chapter 3 we explained this paradox by
dividing the labor force in two groups. If we look at the overall working age population between 15
and 59 we still see plenty of underemployed labor resources. However, if we focus on the supply of
rural working age population between 15 and 30, the picture differs and some of the shortage can
be explained. This labor shortage also implies that China’s rapid trade expansion based on low wages
will disappear. The increase in wages will affect trade negatively, and trade is seen as one of the main
contributions to China’s economic growth. We do not agree with this negative picture on China’s
future economic growth potential because it assumes that international trade, measured as export
as percentage of GDP, is extremely important for China. However, this is not the case. The ratio of
exports to GDP is very misleading. It compares apples and oranges: exports are measured as gross
revenue while GDP is measured in value-added terms. It is necessary to calculate exports in valueadded terms by correcting for imported components used in the export flow. Once these adjustments
are made the “true” export share is just under 10% of GDP. Many articles have concluded that China
is not export-led. Consequently, the rising wages will affect the export sector, but the macroeconomic
effect will not be very significant. Besides, domestic consumption, driven by an increasing and dynamic middle class will take over export and investments as the main driver for the economic growth.
Therefore, economic growth figures around 8% are expected in the medium term. In the long term,
say after 2020, the ageing of the population and the reduction of migration from the rural sector to
the manufacturing and services will negatively affect growth rates. In line with the “demographic
window of opportunity”, there is also an “economic window of opportunity”.
Some priorities and choices
The priorities indicated by our experts are summarized below. We shall first discuss their conclusions and recommendations as standalone factors. You could say that we are building Chinese walls
between these topics. In the remaining part of this section, we will integrate these elements and then
it will become clear how complex it is to develop and execute a consistent pension system within
China’s economic, social and political environment.
Expanding coverage is a top priority. Steps are needed to improve the incentives to contribute to the
system. Firms today pay a payroll tax rate of 20% and workers 8% to finance pensions. Not only
is hits 28% high compared to other countries, but there are also only small tax incentives for the
employers. In general, China has a relatively high pension liability level compared to other emerging
markets. The current situation is that today’s workers bear the entire burden of financing these legacy
costs, so they are reluctant to participate. Increasing coverage is possible though reducing the payroll
tax rate by separating the legacy costs and funding the social pooling benefit with a different source.
This conversion of implicit pension debt into explicit public debt is economically logical. Since the
28
benefits of this transition will be shared by many future generations, it is appropriate to share the
costs over many generations as well, particularly because the next generations will be much richer
than current ones. Therefore, these legacy costs should be separated from the social security pension
system and seen as national debt.
Another aspect of coverage is the lack of SME participation in the system, as most enterprise annuities
are sponsored by large and profitable SOEs, while SMEs find these plans either too expensive or administratively complicated. Therefore, stimulating participation through collective pension funds would
increase efficiency, take advantage of economies of scale and improve portability. Besides the high
social security expenditures, the lack of tax incentives and the complicated administration process to
participate in the EA segment, there is a final obstacle for participation: low return on investments.
Funds in the first pillar receives a very low return on investment, between 3 and 4%. Data from NSSF
indicates that it earned a return less than the rate of wage increase. It is questionable whether the pension funds’ low returns can attract many contributors. A more mature capital market, with liberalized
financial markets and new financial products may increase return on investments. One of the main
problems of China’s capital market is the lack of institutional investors. It is therefore extremely positive to note that the government has created the NSSF. Growing pension funds will increase the size
and the liquidity of the country’s capital market. It is also essential that there be fewer restrictions on
investment, so international investment can become an important means of getting high returns with
low risk. Assets for the basic pension should be kept separately from those of the individual accounts
to ensure good governance and transparency. Adequate diversification of risks and appropriate rates of
return is essential. Therefore, it is good that NSSF is now able to invest in overseas assets. In fact, NSSF
accumulated a significant amount of foreign capital from overseas listing of Chinese SOEs, which is
now partly invested abroad and resulted in higher returns. In general, the investment regime must be
reformed to improve rate of return of the funds in individual accounts. In essence this relates to the
institutional design of the pension system.
Another priority is the needed changes in the institutional design and the role of a formal social
security law. The use of guidelines instead of official laws resulted in the aforementioned regional
discrepancies. To create credibility with citizens, the government will need to provide sufficient resources to ensure efficient administration, better accounting, more rigorous governance and financial
controls, increased computerization, and training of staff. Administrative costs and the economic
behavior of social security agencies must be regulated. Most experts were positive about the actions of
the National Social Security Fund. However, the role of NSSF is still unclear when it comes to pensions, and questions linger about the scope of their operations. For example, does it focus only on pensions or does it have a broader mission including medical care and unemployment? It is also not clear
under what conditions the Fund will step in as the lender of last resort. Another institutional issue of
the NSSF is that it is not established under trust. Consequently, there are no defined beneficiaries for
the Fund and no guidelines regarding distribution of benefits. Fiduciary duties, a key concept of trust
law, is therefore not binding for the NSSF. This is rather strange because the EA system legislation of
2004 refers to the fact that EA must be managed under trust. Internationally, there is a heavy focus on
a more transparent and democratic governance structure within the pension market. The disclosure
and transparency of operations and investments results of the NSSF could be improved. Currently,
results are only released once a year, and the annual report in 2005 was only 9 pages in total.
Under the current system that combines social pooling with individual accounts, it is necessary and
feasible to separate the assets of individual accounts from the whole fund and to adopt a market
investment regime under a centralized management framework. Part of the institutional issue is the
administrative burden of setting up an EA scheme and receiving approval to start a pension fund,
whether collectively or as a company. The success of the supplementary accounts will largely depend
on the existence of a well-established fund management industry. Also when creating new financial products or institution, you need permission from the three separate and independent financial
regulators in China. An one-stop shopping arrangement involves the vertical integration of various
functions related to the operation of the pension fund within a single entity, and it is permitted under
the current Chinese legislations, except for the case of custodian services that cannot be conducted by
the asset managers.
29
Box 19: Responses of pension funds to pension crisis
• Closing of DB plans and switch to individual DC plans in countries such as the United States and
United Kingdom
Comparison of pure DB and DC; Before and after retirement
Before retirement
After retirement
DC
DB
Inflation risk
Individual
Sponsor/participants
Inflation risk
DC
Insurer
DB
Sponsor/participants
Longevity risk
Individual
Sponsor/participants
Longevity risk
Insurer
Sponsor/participants
Investment risk
Individual
Sponsor/participants
Investment risk
Insurer
Sponsor/participants
Discontinuity
Individual
Individual
Discontinuity
Individual
Individual
• Hybrid DB-DC plan in the Netherlands
o DB aspect: yearly accrual of pension rights is specified in the same way as a traditional DB plan. Contributions are
flexible, depending on the financial position of the pension fund
o DC aspect: yearly indexation is related to the financial position of the fund and therefore is related to investment
returns
o Reason for the switch in Dutch pension funds:
- Traditionally, risk management by Dutch pension funds was done primarily by adjustments in the contribution rate. However, the ratio of pensioners to workers is increasing and so is the ratio of liabilities to
total wages. These tendencies undermine the effectiveness of the contribution rate as a steering instrument
- Trade unions accepted the spreading of risks towards workers and pensioners. They represent workers and
pensioners on pension boards and are involved in wage negotiations. The reliance on contribution rates to
absorb risks would run the risk of alienating younger workers and put a heavy burden on wage negotiations
The hybrid pension plans that have evolved in the Netherlands offer a promising way to balance risk
between employers, active workers and retirees. Going forward, the current hybrid schemes will
likely evolve towards collective DC pension plans. The governance related aspects of the Dutch system
are described in the appendix.
Source: Ponds & van Riel (2007), “Sharing risk: the Netherlands’s new approach to pensions”,
center for retirement research, Boston
Some of the parameters of the pension system must be changed. It is desirable that the formal and
more importantly the effective retirement age be increased in order to achieve a sustainable contribution-benefit ratio. There will need to be negotiations between central and local governments to decide
this and other parameters such as replacement rate. Such a settlement will be politically challenging to
achieve.
A complex discussion
In most of the talks we had, sustainability of the system was pegged as an essential benchmark for
a successful pension system. Two features of the new system are essential to ensure that this new
pension system is sustainable: it should be largely, if not fully funded, and it should be administrated
nationally, not locally as at present. In the analysis above it became apparent that there are many connected challenges to building a sustainable pension system. Part of the solution is a combination of increasing coverage for the first pillar and a higher return on investment for the capital accumulating in
the second pillar. Although this is a challenging task, the basic requirements for such a sustainable system are in place. First, there is a strong and reliable macroeconomic environment. Second, the basic
legal environment is in place. Third, the pension reforms are part of a broader restructuring program
including capital liberalization, labor mobility and economic restructuring. Precisely this fact that the
pension reforms must fit into other restructuring programs draws a very complex picture. Below are
many examples that highlight the complexity of transforming the economy towards a socialist market
economy and the role of pension market reforms in it.
30
The connection between SOE restructuring, hukou system and portability of pension schemes:
High economic growth is needed to create jobs for China’s large working age population. The number of working age adults is now growing by about 10 million each year. In addition, the SOEs are
shedding about 5 million jobs each year. To keep unemployment rate from rising, China thus needs
to create 15 million jobs annually. Moreover, this figure does not take into account the rural migrants
who leave China’s countryside each year to look for better jobs in the cities. This “floating population” is now growing at a rate of at least 5 million a year. The pressure on creating jobs will become
more severe in the years to come because of the acceleration in the restructuring of SOEs. At the same
time, labor market mobility and flexibility is needed to absorb the floating workforce. Pension market
reforms are able to help. Increased portability will help labor mobility. However, this portability issue is strongly connected with the hukou system. Reform in the hukou system is a precondition for
increasing portability.
Box 20: Employees in State Owned Enterprise
Year
Number (million people)
1995
109.55
1996
109.49
1997
107.66
1998
101.09
1999
83.36
2000
78.78
2001
74.09
2002
62.94
2003
43.12
2004
45.82
2005
42.88
2006
41.25
Source: National Bureau of statistics
The connection between inequality, economic growth and pension benefits
There is a growing inequality in the Chinese society. Although economic growth reduces poverty for
many people, it is also increasing income inequality. Pension market reforms may solve part of this
inequality. A sufficient replacement rate and pervasive coverage would reduce the social tensions,
not only within the cities but also between urban and rural regions. The migration of many young
workers to the cities is part of the reason for the low level of income in the countryside. Nowadays
these migrants represent about 15% of total labor force. Because of the migration into the cities, there
was relatively low growth in rural areas and now a second adverse impact could be that in the absence
of pensions, old migrant workers will return to the countryside with no source of income. Pension
payments and increased portability could help to reduce income inequality.
The connection between economic growth, capital market and savings
The “easy” path to growth by increasing labor and capital is not sustainable. In the medium term,
labor and capital shortages will emerge, so other routes to create economic growth are needed, including increasing of productivity through better allocation of capital. For long term economic growth
there needs to be a bridge between private savings and long term capital needs in the private and State
sector. Consequently, capital market reforms are an essential driver behind medium and long term
economic development. In many developed countries, funded pensions have played a crucial role in
broadening and deepening capital markets. The fund management industry is expected to serve as the
much needed intermediary. As pension funds grow, so will the size and liquidity of China’s capital
market.
31
Over the longer term, development of capital markets is unlikely to occur without the growth of insurance companies and pension and mutual funds. All the institutional investor segments are at an early
stage of development. Although growing rapidly, the insurance market is still relatively small and remains dominated by the commercialized enterprises emerged from the People’s Insurance Company
of China (PICC). Pension funds are just developing. Products institutional investors can offer are quite
limited and, in the case of insurance companies, have traditionally been regulated through a system of
approved contracts and prices. Insurance companies and pension funds investments were restricted to
bank deposits and government bonds. The authorities have been relaxing these restrictions, but slowly. This conservatism is understandable given the early stage of development of institutional investors
and their governance structures, even though it is also risky. The financial difficulties encountered by
a number of insurance companies in the late 1990s, when falling interest rates caused the yields on
their assets to fall below rates they had contracted to pay on some of their liabilities, underscored the
lack of access to long term higher yielding assets.
Box 21: Development of EA market
China’s corporate annuity fund will experience robust growth during the coming years, and may reach 1 trillion yuan by 2010
and 8 trillion yuan by 2030, according to a government forecast. China’s corporate annuity scale was less than 100 billion yuan
($14.63 billion) before 2007, but it reached 150 billion yuan at the end of 2007 and is expected to reach 200 billion yuan at
the end of this year, said Cheng Siwei, former Vice-Chairman of the Standing Committee of the National People’s Congress, at
China’s Annuity Research High-level Forum.
This increase may be attributed to commercial banks, which are making more and more of a presence in the corporate annuity
market. During the past two weeks, several domestic commercial banks have released five annuity management products, hoping
to share a slice of the lucrative pie. Earlier this month, Agricultural Bank of China teamed up with China Life, Ping An and
Taikang Insurance to launch three annuity products, while Citibank released its first whole-life annuity product. China Merchants
Bank launched a tour promotion Friday in Chengdu for its corporate annuity product Golden Life No 1, which targets small and
medium enterprise clients.
“The annuity product will invest in currency and bond markets as well as equity funds. It will target long-term stable gains
with lower risk,” said an analyst with China Merchants Bank. “The Golden Life No 1 annuity plan will include a number of
enterprises, which can help to diversify risk and cut management fees while enlarging the fund scale.” Corporate annuity, also
known as pension, assures employees quality retirement and can help to build a long-lasting relationship between the employer and
its employees. Such a plan will increase employee loyalty to serve the company in the future. As firms must endure part of the fees,
most annuity applicants are those with better benefits. This hampers development for domestic annuity business to some extent. But
if a corporation is qualified to try the annuity project and is in good standing, banks can seize the chance to lend to this firm by
providing annuity service, creating competition among the banks, an industry insider said.
China Daily, July 24 2008
The links between issues discussed in previous sections shows that the situation is and will become
more complex. Therefore, it is necessary to address the challenges of building a national pension
system from several angles and a coherent approach is needed in future policy regulation and implementation.
To conclude, the aim of the paper was to cover the key issues in the reform and development of the
pension system in China. In most sections, we used a comparative analysis to link this development
with what we see in other countries. We indicated in many parts of the paper the complexity of building a sustainable pension system and although many issues are important, three (interrelated) key
elements should be highlighted.
First, the basis structure of the pension arrangement is there but coverage is low. A widening of coverage is an essential step and a precondition for other reform and development issues. One barrier to
increase coverage is the absence of fiscal support to deal with ‘legacy cost’ and consequently the low
incentive for individuals to join the system.
Second, it is essential to increase portability across regions. A single new national pension administration would help not only this portability issue but also reduce the hurdle to labour mobility. Clearly,
the lack of portability also limits the increase of coverage.
32
Third, the importance of investments in overseas assets should be highlighted. Throughout the paper
we stressed this need to invest abroad and to achieve higher rate of return. The case was argued on
the basis that the domestic capital market is not well developed and that diversification is helpful for
spreading risks. But there is another longer term driver that makes overseas investments essential. The
aging population implies a lower rate of economic growth and thus a lower rate of return on domestic assets in the long run, even if the domestic capital market is well developed. This future demographic burden also increases the need to think of ways to allocate part of the savings and the foreign
exchange reserves into a national pension system.
The April 2009 seminar, organized by Mn Services, will discuss these interrelated subjects concerning
the pension reforms in China.
33
Appendix
Occupational pension markets in the Netherlands, institutional framework
Pension funds, including industry funds, in the Netherlands are established on the basis of a pension
foundation. The main difference between a foundation and a trust (on which pension funds are based
in Anglo-Saxon countries) is that the former originates from civil law, while the latter has its base in
common law. Nevertheless, industry funds in the Netherlands have a legal personality and should be
operated separately from the employers‘ assets and solely for the interests of beneficiaries.
The current legislations allow both employees and employers jointly to set up an industry fund.
Furthermore, if the social partners (i.e. representatives from employees and employers) agree, they
could ask the Ministry of Social Affairs and Employment to impose an obligation on all employers and
employees in their industry and require all of them to participate in this industry-wide fund. In this
context, however, such a request to establish a compulsory industry fund has to be approved by the
employer representatives who represent the interests of employers who employ at least 60% of the
total workforce in that industry. There are no similar corresponding requirements on the employee
representatives. Such compulsory participation, however, could be waived, if a particular company
within the industry has already set up an individual pension fund, or when the performance of
the industry fund is not satisfactory to meet the statutory requirements (i.e. matching of assets and
liabilities). This system of compulsory participation is in line with the rulings of the European Court
of Justice on the relation between competition law and labour law in connection with compulsory
membership in a pension scheme. There are three key components regarding the governance structure of the industry funds:
1. Management
This refers to executives or professional managers who manage the pension funds under supervision
of the governing body. They are mainly in charge of the day-to-day management of the industry
funds. The current legislation requires that the funds should be in the hands of at least two persons.
Meanwhile, in order to ensure the smooth running of the pension funds, the management of the
funds must prove to the satisfaction of the pension regulator (i.e. De Nederlandsche Bank) that at least
two of its members possess specialized expertise, such as
• The governance of an organization
• Legal and regulatory issues
• Financial investment and actuarial knowledge
• Accounting and auditing
2.
Governing body
For this layer of the pension funds, stakeholders (i.e. plan members and employers) should be equally
represented on the so-called governing board, and they are normally nominated and appointed by the
relevant trade unions and industry associations. For example, the governing body of Pensioenfonds
Horeca & Catering has equal numbers of representatives from the employer organization, i.e. Koninklijke Horeca Nederland and the trade union organizations, FNV Horecabond and CNV BedrijvenBond.
Due to concerns about conflict of interests, the following persons should not serve as members of the
board of foundation:
• Employees of the pension funds
• Members and former members of the governing body and committees of the pension funds
• Advisors of the pension fund
34
Normally there is one chairperson on the board of foundation. However, the dual-chairperson system
has been implemented in some Dutch industry funds. For example, the Pensioenfonds Horeca & Catering has two chairpersons: one (called employee chairperson) is appointed by and represents the employees and the other one (called employer chairperson) represents employers. The two chairpersons,
however, rotate to chair the board on a yearly basis during the term. This is especially important, in
that the chairperson has an extra vote in the event of a tied vote, but full consensus still remains the
basic objective of any Dutch board of foundation.
3.
Advisory board
It mainly advises the governing body or board of foundation on various issues (e.g. investment strategies) of the funds, either on a specific request from the board of foundation, or on their own accord.
As for the member composition of the board, representatives from both employers and employees
frequently sit on the board. This board serves the same purpose as the policy committees set up by the
Australian master trusts.
4.
Funding of defined benefit plans
Meanwhile, all funds in the Netherlands are subject to the financial supervisory requirements laid
down in the Pension Act (which came into force on 1 January 2007) and the regulations based upon
this act. Under the new requirements, pension funds will be required to achieve a coverage ratio
(i.e., the ratio of the present value of assets over liabilities, based on marked-to-market calculations)
implied by a 971⁄2 percent probability of meeting their obligations. In cases where the indexation of
benefits to inflation/wages is not guaranteed, this implies a coverage ratio, on average, of 130 percent, to be met within a period agreed on with the supervisor not exceeding 15 years. (The required
coverage ratio would be higher if funds provided guarantees). However, if the ratio falls below 105
percent, it has to be restored within a given time period--likely between one and three years, but this
is being discussed in parliament--except at times of severe macroeconomic downturns or systematic
risk.
Source: OECD (2007), Working Paper on Insurance and Private Pensions, number 9
35
References
Articles and research papers
Farrell, D. and Grant, A. (2005), “Addressing China’s looming talent shortage”, McKinsey Global
Institute, October.
Feldstein, M. (2006), “realizing the potential of China’s social security pension system”, China Economic Times, February 24
Greenwood, C.L. (2008), “Challenges for pension reform and public pension fund management in
Asia”, speech at the Global pension Summit, February 28, Suzhou
Hu, Y., Stewart, F. and Yermo, J. (2007), “Collective pension funds; international evidence and
implications for China’s enterprise annuities reform”, OECD working papers on insurance and private
pensions, no. 9
Jackson, R. and Howe, N (2004), “The graying of the middle kingdom; the demographics and
economics of retirement policy in China”, Center for Strategies and International Studies/ Prudential
Foundation, April
KPMG, “The heavenly mandate: winning a piece of China’s pensions market”,
Leckie, S. and Yasue Pai (2005), “Fund management opportunities in China’s pension market”,
Pensions, an International Journal, volume 10, pp. 317–330
OECD (2005), “Reforming the financial system to support the market economy”, Economic Surveys:
China
UBS Investment research (2005), “How to think about China”, February 7
Salditt, F., Whiteford, P., and Adema, W. (2007), “Pension reform in China: progress and prospects”,
OECD Social, Employment and Migration working papers, no. 53
Trinh, T. (2006), “China’s pension system; caught between mounting legacies and unfavorable demographics”, Deutsche Bank research, February 17
Yinhua Sha (2000), “China’s social security system; present status and issues”, NLIResearch Institute
Zheng Bingwen (2007), “The origin of China’s partially funded social security scheme and its future
direction”, The Chinese Economy, vol. 40, no. 4, July-August, pp. 6-28
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Presentations:
Allianz Global Investor/ Miksa, B. (2007), “Asia-Pacific pensions 2007; systems and markets. Beijing,
November 14
Bovenberg, L. (2007), “Frontiers in pension reforms: institutional innovation in the Netherlands”,
DNB-Netspar-IOPS conference, March 23
Cui, J., de Jong, F. and Ponds, E (2005), “Intergenerational transfers within funded pension schemes”, Silverstone June 19-21
Ewijk, van. C. (2004), “Dutch pension funds ate risk”, Louvain-la neuve, May13
Leckie, S. H. (2001), “Pension funds in China”, International pension seminar, June 6-7
Leckie, S. H. (2003), “China’s pension system”, Hong Kong, March 22
Palacios, R. (2005), “Pension funds in emerging Asia”, Islamabad, December 9
Yermo, J. (2004), “OECD principles and guidelines for occupational pension systems”, Paris, April 2
Websites:
http://www.chinadaily.com.cn
http://www.reuters.com
http://www.shanghaidaily.com
http://www.xinhuanet.com
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