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)
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 transfor- mation 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 pen- sions 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 popula- tion 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. Howe- ver, 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.
As laid out in the summary above, there are many related factors influencing the pension discus- sion. 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. Further- more, 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 handicap- ped 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, globaliza- tion 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 pro- blems 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 establis- hed 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.
2. Earlier changes and choices
In the early 1950s, the first insurance measures for employees of SOEs and collectively owned en- terprises 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 employ- ment 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 mo- ney 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 insu- rance 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 he- alth 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 increa- singly 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 go- vernment 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 to- ward 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 sy- stem 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,
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
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.
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 for- med the central theme of Document 26.
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
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)
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 ma- croeconomic 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 unemploy- ment
• 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
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 replace- ment rate of retirement of 35% of the city’s average wage after 35 years of service and is paid out by
Public pensions
Occu - pational pensions
Voluntary pension
savings
1st pillar 2nd pillar 3rd pillar Structure of pension systems
• 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
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 con- sidering 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 re- placement 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 replace- ment 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. Company- funded 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.
Box 4: Design of the Chinese urban pension system
(*) 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 lia- bility 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 as- sociated 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”
Pillar
1A
1B (Individual accounts) 2 (Enterprise
annuities) 3 (Private
individual)
Contribution rate (%)
Enterprise: 20 Individual: 0 Enterprise: 0 Individual: 8
Max. tax exemption: 4%
n.a.
Target Replacement rate (%) 35 24 20-30**
n.a.
Financing
PAYG Funded Funded Funded
Status
In operation In operation*
In operation Not finalised Mandatory or
voluntary Mandatory Mandatory Voluntary Voluntary
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)
Box 4: Design of the Chinese urban pension system
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 be- fore 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 Docu- ment 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 compensa- ted 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 + transi- tion 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 parti- ally 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 Percentage New group Middle group Old group (x 100)
1 Enterprises 7325.0 65.6%
---SOE 2456 22% Apply Partly Apply Not Apply
--- Others 4243.7 43.6% Apply Apply Not Apply
2 Institutes** 2748.0 24.6% Will apply Partly apply Not apply 3 Government 1087.6 9.7% Yet not apply Not apply Not apply
total 11160.6 *** 100%
* 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.
How to deal with the financial burden of pension related expenditures?
Although the discussion about financing the pension system is mostly driven by government ex- penditures, 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 refer- red 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 mas- sive 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, administra- tor, 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 invest- ment 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
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.
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.
24587.29 UK
24 Royal Bank of Scotland
100000.00 Norway
4 Government Pension Fund - Norway
23500.00 Sweden
25 AP Fonden 2
25000.00 Norway
23 Folketrygfondet
25000.00 Denmark
23 Danica Pension
25118.74 UK
22 Railways Pensions Trustee Company
26306.00 Germany
21 Siemens Pension Trust
26900.00 Finland
20 Varna Mutual Pension Insurance Company
27000.00 Sweden
19 AMF Pension
27634.00 Germany
18 Victoria
28643.07 Denmark
17 PFA Pension
30000.00 Netherlands
16 Pensioenfonds Metaal en Techniek
31100.00 France
15 Fonds de Reserve pour les Retraites (FRR)
32158.58 UK
14 Electricity Pensions Services Ltd.
34500.00 Germany
13 Bayrische Apothekerversorgung
36502.75 UK
12 Coal Pension Trustees
41463.75 UK
11 Universities Superannuation Scheme Ltd.
44965.45 UK
10 Scottish Public Pensions Agency
45000.00 Denmark
9 ATP Ejendomme
46655.90 Sweden
8 Alecta
55636.36 UK
7 British Telecommunications plc
90000.00 Netherlands
6 PGGM
99900.00 Denmark
5 ATP – Arbejdsmarkedets Tillaegspension
145000.00 Netherlands
3 Philips
201000.00 Netherlands
2 ABP
218239.61 Norway
1 Government Pension Fund - global
Value Eur million Country
Fund name
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 pen- sion fund and invest abroad; like the Norway Government Pension Fund.
Sources: Pensionfundsonline.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 as- sets 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 invest- ment 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 invest- ment is made by the Council in bank deposits and ordinary market government securities and out- source 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. Further- more, 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.
800 700 600 500 400 300 200 100 0
Sovereign wealth funds by size
(USD billion) SWF point estimate
UAE Norway
Sing (GIC) Kuwait
Saudi China Russia Sing (Temasek)
Libya Algeria
Qatar USA (Alaska)
Brunei Korea
Kazakhstan Malaysia
Canada Chinese Taipei
USA (New Mexico) Iran
Other
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 employ- ees, the EA legislation also resulted in an old and new types of supplementary pension.
Box 7: Enterprise Annuity framework Trust form
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 establis- hed 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 trans- ferred all assets to China Merchants Bank (as custodian and account administrator), and PingAn Life (as trustee and asset manager).
Plan Trustee:
EA Council comprising representatives of employee, management and /or professionals OR: Other authorized institutions
(Trust co., fund mgt co. & pension services co)
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)
Enterprise
Sign Service Contract Sign Trust Contract
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 Uni- ted 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.
Source: OECD global forum on private pensions, November 2007
China’s supplementary pension is an area that represents tremendous opportunity for service provi- ders; 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 ma- nagers 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.
600 500 400 300 200 100
0
Australia China Japan Singapore South
Korea Taiwan Thailand
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.
% Equities Bonds Cash
Australia 26 0 73
Canada 58 28 0
China 24 54 10
Denmark 1 26 67
France 65 34 1
Japan 37 63 0
Korea 14 83 0
Norway 48 51 0
Russia 0 100 0
Spain 0 100 0
Sweden 53 39 1
United States 0 100 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 de- nominated 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 ad- ministration 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 ma- nagement 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-
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 of- ferings. 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 al- location 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 contri- butions (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
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”.
2006 2010 2015 2006 2010 2015
600
400
200
0
49.8 464.2
53.4 8.9 62.3
144.9 18.7 163.6
53.4 8.9 62.3
136.9 18.7 155.6
49.8 403.8
Funded 1B pillar accounts Enterprise Annuities (EUR bn)
Optimistic scenario Conservative scenario
• CAGR 1B pillar:
23.4% to 25.6%
depending on participation (between 55 and 75% by 2015
• CAGR Enterprise Annuities:
21.2%
414.4
354.0
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 Bo- sera), Changsheng, China Asset, Harvest, Penghua and Southern Fund Management. Later, two Sino- foreign 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 sche- me 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 domes- tic 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.
Box 11: Working age population (left) and rural population ages 15-29 (right)
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 mana- ger. 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 regu- lation 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 ar- gue 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 favo- rable 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.
Working age population (millions) Rural population aged 15 - 29 (millions) 950
900 850 800 750 700 650 600 550
500 95 00 05 10 15 20 25 30 35 40 45 50 55 60
250
200
150
100
50
0 95 00 05 10 15 20 25 30 35 40 45 50 55 60
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.
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 aver- age 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.
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Child dependency ratio Elderly dependency ratio Demographic ‘golden age ’ Total dependency ratio
Box 13: Mandatory pensions (first and second pillar); as a percentage of final wage for different wage groups
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
45 29 33 39 45
57 US
90 65 65 66 69
93 Sweden
5 58 58 58 58
58 Italy
46 18 22 30 35
51 UK
- 48 54 65 72
80 France
46 26 32 38 38
50 Germany
91 70 70 70 70
70 Netherlands
Fraction of workers covered 2.5 x
2.0 x 1.5 x average
0.5 x
Box 13 : Mandatory pensions (first and second pillar); as a percentage of final wage fordifferent wage groups
