The Reforming Of Chinas Pension Scheme

During the time of writing my dissertation, I have has many help from people both intellectually and emotionally. I would like to take this space to thank first of all, my supervisor, Mr. Robert Plumb, for offering me the support and guidance all the way through. I am grateful to my friends in the BSc Actuarial Science class for the great time I had during the three-year study at Cass Business School. I would like to thank all the lectures for making our lives at school so convenient and pleasant. Last but not least, many thanks to my family and other friends who have always given me encouragement and support during this process.

Abstract

The rapid ageing population in China has slowed down economic progress. Certain steps should be taken in relation to the pension system in order to cope with such a situation. There are several models of pension reform in the world, the most important one is perhaps the multi-pillar pension system advocated by World Bank. China actually reformed the current pension scheme based on this multi-pillar model. With a responsible attitude, the experience gained in Chinese pension reform will lead to a stronger and deeper national system that can eventually provide social welfare for the entire Chinese population.

In Chapter 1, I will introduce the main types of pension schemes and the historical background of China pension system and illustrate how it developed. The current situation of China’s pension system is displayed by the Melbourne Mercer Global Pension Index in Chapter 2. The four main problems of China’s pension system and the urgency of reform is explained fully in Chapter 3. The different types of reform are followed by, along with what China chose to do in Chapter 4. In Chapter 5, the performance of reform is evaluated. Chapter 6 is mainly about the problem pointed out in the recent China Two Conference and the future trend of China’s pension reform.

Table of Contents

Acknowledgements---------------------------------------------------2

Abstracts----------------------------------------------------------------3

Chapter 1 Introduction----------------------------------------------5

Chapter 2 Current situation of China pension system--------8

Chapter 3 Problems of China’s pension system and reasons for pension reform-----------------------------------------------10

Chapter 4 Different types of pension reform and what China

chose to do---------------------------------------------------------15

Chapter 5 Evaluation of pension reforming-------------------20

Chapter 6 Conclusion----------------------------------------------23

Reference--------------------------------------------------------------25

Chapter 1 Introduction

China’s population has been ageing rapidly, and financial support for the pension system is facing a number of resultant problems. The system itself is also divided unevenly across regions and sectors. Furthermore, globalization makes the transaction between countries and sectors more difficult. Therefore, reforming China’s pension scheme has become an urgent issue. This report will begin with a brief overview of the historical background of the Chinese pension system. It will move onto the pension crisis and relevant problems at present, followed by the different types of pension reform and the way China has chosen to reform. Finally it will conclude with the evaluation of China’s pension reform.

The main goal of pension reform is to ensure the elderly live a peaceful life in retirement. In order to achieve this goal, China still has to solve a lot of economic and social problems. The Chinese government started its national pension system reformation in the 1990s by setting up a three-pillar state pension system in urban areas, which is a remarkable step in pension reform. Recently, Melbourne Mercer Global Pension Index revealed that the Chinese pension system is facing a large challenge. There are five main problems occur in Chinese pension system: Financial problem; Ageing population; Institutional problem and problems occur in transaction. Several types of pension reform can be chosen and after considering the situation in China, the multi-pillar system stands out to become a wise solution. Compare to those developed countries, China’s pension reform still has a long way to go. With positive attitude, we believe that the system will become mature in the future.

The main types of pension scheme as follows:

A pension scheme can be classified as a defined benefit scheme or a defined contribution scheme according to the determination of benefits. A defined contribution (DC) scheme is dependent on the amount of money contributed and the performance of the investment. A traditional defined benefit (DB) scheme is a plan in which the benefit on retirement is determined by a set formula, rather than depending on investment returns. Another definition of a defined benefit scheme is that it is an arrangement where the benefits payable to the members are determined by the scheme’s rules.

Value of Pension Fund Assets

DB

Value of Financial Assets

DC

Value of Pension Fund Assets

Value of Financial Assets

Basically, the pension scheme in China is a defined benefit, PAYGO system for older employees and retirees, multi-pillar system combining social pooling and individual accounts for younger employees. This system includes (a) a mandatory defined benefit paid out of social pooling account, (b) a monthly annuity paid out of the defined contribution, employee individual account, and (c) a voluntary supplementary individual account.

After briefly explaining the main types of pension scheme, the historical background of China pension system will be illustrate as follows:

In 1949 the Chinese government adopted a provisional constitution of the "common Program?, which mentioned that the labour insurance system should be introduced progressively in companies; this provided a legal basis for the establishment of a unified, national labour insurance system.

On February 25, 1951, the Central People's Government promulgated "The People's Republic of China Labour Insurance Regulations", which required companies to implement pensions, medical insurance and industrial injury insurance for their employees. This was China's first social security law; it clearly defined insurance coverage, insurance premium collection, insurance items and standards, as well as the implementation and supervision of the insurance industry as a whole.

During the next three decades the government gradually improved the pension system. Then, in 1984 China overhauled the entire pension system. The change was started in some rural areas first. The system was based on being "paid mainly by individuals, supplemented by the communities, supported by government policies" and resulted in the accumulation of funds in personal accounts. In 1991, thanks to economic development, the government established a combined system with a state pension, company pension and private pension.

Basis of calculating accrual of pension insurance during that time:

Range of income

Rate of pension insurance

<60% of average income

60%

60%-300% of average income

actual income

>300% of average income

300%

In 1997 the Chinese government formulated a new policy, which started to establish a unified nationwide pension system for every enterprise employee’s insurance.

China's basic pension system is a combined model of state and individual accounts. The basic pension covers workers in urban enterprises; all urban enterprises and their employees must fulfill the obligation to pay the basic pension. At present, employers contribute about 20%, and employees 8%, of the total income. The rates paid by employers are partly used in the state pension and the rest goes into the personal accounts; the rates paid by employees are used in private accounts. In 1997, the policy became clearer. It can now be seen that the main purpose of the basic pension in the future is to protect the basic livelihood of retirees in their twilight years.

After several years of reform, the people involved in pension scheme increased from 86.71 million (at end of 1997) to 108.02 million (at the end of 2001); the number of people receiving the basic pensions raised from 25.33 million to 33.81 million. The average monthly basic pension increased from 430 RMB to 556 RMB. In order to ensure the timely and full payment of the basic pension in recent years, the Chinese government have made efforts to improve the pooling level and constantly increased the financial input into the basic pension fund. From 1998 to 2001 the central government expenditures for pension fund subsidies amounted to 86.1 billion RMB.

Chapter 2 Current situation of China pension system

Recently, Melbourne Mercer Global Pension Index revealed that the Chinese pension system is facing a large challenge. They measured the ranking according to the adequacy, sustainability and comprehensiveness of the system in each state. From the comparison of the private and public pension system's index in five continents, across eleven countries, China's system achieved relatively low ratings. This shows that China's growing pension system needs to be further developed and reformed in order to cope with continued pressure from the ageing population, and in order to remain competitive in the world.

According to the pension index (total 100) estimates, the Netherlands ranks first, with an index of 76.1, followed by Australia (74.0), Sweden (73.5) and Canada (73.2). The UK ranked fifth with 63.9, while the lowest-ranked pension systems are those of Japan (41.5), China (48.0) and Germany (48.2).

 

Melbourne Mercer Global Pension Index

Country

Overall

index value

Sub-index values

Adequacy

Weighting 40%

Sustainability

Weighting 35%

Integrity

Weighting 25%

Netherlands

76.1

80.5

62.5

88.2

Australia

74.0

68.1

71.0

87.8

Sweden

73.5

68.5

75.2

79.1

Canada

73.2

76.2

64.2

80.9

UK

63.9

56.6

56.4

86.3

USA

59.8

49.2

69.4

63.4

Chile

59.6

48.9

54.1

84.5

Singapore

57.0

51.7

68.9

49.1

Germany

48.2

60.8

44.3

33.7

China

48.0

64.7

38.5

34.7

Japan

41.5

39.2

34.4

55.2

Average

61.4

60.4

58.1

67.5

Source: Melbourne Mercer Global Pension Index

Among these countries there was no one pension system which achieved A-Level (an index of more than 80). Mercer said that this shows that even the world's most advanced pension system needs to be adjusted in order to ensure that the support is sufficient for a rapidly aging population. Although the lowest-ranked countries are not yet falling into the lowest level, the category E (an index of less than 35). However if the major defects are not resolved, the effectiveness and sustainability of all these systems will face challenges.

Chapter 3 Problems of China pension system and reasons of pension reforming

China's pension system is actually still in personal accounts, which are kind of on a ‘PAYGO’ system, combined with some public administration. The system is presently in a transition period. Of the results, the following problems stand out:

3.1 Financial Problems

Firstly there are the financing problems. The actual payment rate is low and it keeps decreasing. Since the payment of the transition cost is still a problem, the pension accounts in many places have fallen into financial bankruptcy. According to the statistics from the Ministry of Labour and Social Security, the state-owned enterprises owe 38 billion RMB to the state in unpaid pensions all over the country. That is why the money raised in personal accounts is being used to pay current retirees. Even so, the funding is still not enough and when there is a deficit in financing, the local tax revenue is used to bridge the gap. In fact, the local and central government is working to save a lot of places where the pension co-ordination is already in bankruptcy. If the situation does not improve, it could threaten the sustainability of the central government. Another financial problem is that the personal account is actually just a name, which means it guarantees nothing. Since the Government has not clearly informed us how they will pay for the transition costs over the past few years, all the money that has been raised in these accounts for funds has been used to pay the current pensions of retired employees, which turns personal accounts into empty accounts.

One of the biggest progresses in Chinese pension reform is the introduction of a defined contribution scheme. It is compulsory for the workers to join the savings plan, therefore the welfare responsibilities are transferred from the government and enterprises to individuals. However, an important question makes people pause for thought: will the funding of this defined contribution plan really indicate the fulfilling of the fund, or it is just a fanciful ‘PAYGO’ plan with no actual fund that plays the same role as the pillar I scheme. This issue has already led to misbehaviour in some local authorities. Some of the contributions to personal accounts have been used to pay current retirees, which leads to empty accounts and all the time the transition costs remain unclear.

Implicit pension debt from the restructuring costs arose in the process of the old PAYGO pension system through the accumulation scheme. After we established the partly-accumulated system with social pooling combing individual accounts, the pension included two parts: a basic pension and an individual account pension. However, people who retired before the pension reformations did not have sufficient accumulation in individual accounts, while those who started to work before reform but retiring after reform only have limited personal accounts accumulated, and the basic pension can only provide a limited level of protection.

Although there are no or only limited personal accounts pension accumulation for these two kinds of retirees, the commitments made under their old pension scheme still have to fulfilled, therefore this formed a pensions debt. Under the current PAYGO system, because the right of pensions is implied, the debt is called a hidden debt. However, when the pension system transferred to a whole or partly accumulation based one, the implicit debt became obvious. In order to ensure the continuity and fairness of the pension system, the new system must assume the responsibility for the debt. The Government has to fulfil the pension rights of those retirees. In our country, apart from these two parts of pensions, the additional pension to the retirees caused by inflation or wage increasing also belongs to the scope of implicit debt of the pension, generally speaking, China’s implicit pension debt includes payments to retired employees, transitional pension contribution to those who started work before the reform, as well as the adjustment fee applied to inflation and wage growth.

Another important cause of the financing problems is that there are no specific responsibilities for historical debt between different levels of government. Our government did not specify the individual responsibilities between companies and governments with regard to the debt caused in transition period. The greatest problem of dealing with implicit debts is a lack of motivation and unclear responsibility allocation. Not only in the experimental areas, but also in other cities. Every party attempts to avoid its responsibilities. Both parties rely on each other’s financial input and lack of motivation in terms of the pension supervision. Therefore an increasing deficit became inevitable.

3.2 Ageing Population

Secondly, the ageing of the population has now become a huge issue for many countries in the world. The problem is however, much more serious in China. Since China has a large population base, plus nearly 30 years of reform and opening up, people's living standards have increased greatly. Health and medical conditions have been markedly improved. People expect to live longer and the elderly population increases every year; it is now more than 160 million. China has become the world's largest elderly populous country, accounting for 1/5 of the total elderly population of the world, and 1/2 of Asia. Currently about 12% of the total population in China is aged over 60, although it is expected that this number will increase to 26% by 2050 because of the ‘one-child’ policy and the improvement in life expectancy. Now, the ratio of the working-age population to the retirement-age population is 8:1 and it will decrease to 2:5 by 2050. The average age in China is now 31 and it will reach 40 in 2050.

The distribution of population in China

Source: World Bank Institute (Dr. Wang Yan)

This scenario showed that with a gradual decline in future population growth, China's labour force in 2020 to 2025 will stop growing, and decline thereafter. However, the population aged 65 and over will continue to grow. Therefore, the elderly dependency ratio will rise from 11% to 25% by 2030 and 36% by 2050. The system dependency ratio will not be less than the current 30%, which means that three workers support one retiree; by 2030 the ratio will rapidly reach 69% and 79% by 2050. The PAYGO system in 2000 has a 60 billion surplus, but the gap in pension income and expenditure will be significantly expanded.

Over the next few years, the accumulation of pension reserves will become negative, and in 2050 it will reach 102,730 billion RMB. It is clear that the growing pension deficit will pose a threat to financial stability, and has already brought instability to China's future economic development. It has significantly increased the financial pressure on the system and makes the need for further reforms even more urgent. Nowadays, there are only 170 million employees are members of a pension scheme; that is less than 15% of the population.

As the population grows older, if the current pension provision remains the same, the pension funds in China will have a deficit in next five years; furthermore, this can lead to a deficit in trillions by 2040. The national pension funds could be short 2.5 trillion RMB (which is around US$ 368 billion) over the next 20 years if nothing is done to remedy this now.

3.3 Institutional Problem

Thirdly, the system itself is not well developed. The pension system is divided at all administrative levels. In 1999, 27 provinces were supposed to achieve co-ordination of the provincial funds according to documentation, but in fact only 5 (Beijing, Shanghai, Tianjin, Chongqing and Hainan) out of 27 provinces fully realized this co-ordination. In the other 22 provinces, only 1%-2% of the money from different cities was gathered in order to establish public funds. Due to the lack of co-ordination there are five provinces that have yet to establish such a fund, which means the policy was not really working out. Furthermore, the current co-ordination is not perfect in many ways. The collection and expenditure of pensions were not administered separately by different organizations. Also because of the payment strategy, which is that companies pay the ‘net’ value (pension income minus the money paid to retired employee) into funds, the contribution rates between provinces and cities, in some cases even between companies, have great differences.

Moreover, the coverage of pension systems is narrow and they have regional imbalances. Until the end of 1998, the basic pension provision covered only 78.4% of employees of state-owned enterprises, 16.2% of group companies and 5.4% of other urban enterprises. There were no pension plans for self-employed and individual entrepreneurs in cities. For rural areas, there are some creative plans by local officers, but again coverage is very limited. The coverage of pension scheme in China is restricted based on employment in the work unit, rather than on citizenship, which means the reform only targets a small number of the population.

This is in contrast to developed countries, where the pension system is relatively mature and covers nearly all of the workforce. In these countries, what they need to do is to avoid large future deficits and unsustainable ageing populations. However in China, there is far more to consider. More than half of China’s population lives in rural areas. As a bequest of past economic and pension policies, there is great inequality in both economic development and pension coverage between the urban and rural areas (urban areas are mainly the eastern coastal areas and rural areas are mainly the western part of China); the urban population is generally better covered than rural and migrant populations. The special household registration system, which was used to control the movement of people between urban and rural areas, helped split the population into urban and rural. The productive workers from the rural areas migrated to cities for more attractive working opportunities and higher incomes. However they will not be able to benefit from the urban social security since they were not under the registration of the special system.

The lack of regulation is another issue. Since there is no social insurance law in China, the local social insurance agencies are weak enforcers of power. This makes collecting payments even more difficult. Also since there is no such law, it is hard to apply penalties. From the international point of view, the state's basic pension systems are mostly being legislated by state first, then organised by the Central Government. However, China's pension system formed gradually under the basis of summing up experiences of local reform. It is only written in the Constitution of the nationals that citizens have the right to receive substance. Other pension systems were implemented in accordance with regulations promulgated by the State Council. "The Social Insurance Law", as it has already been called for many years, is still in the process of taking advice, which means that pension rights are infringed due to lack of legal protection. This further led to a large number of arrears and made management of the pension system even harder, without any strong legal grounds.

3.4 Problems occurring in transaction

Finally, another challenge will be the transfer between pension accounts. The disadvantage of migrant workers is that their accumulated benefits in their pension accounts from their previous employers cannot be moved. It is therefore a risk for them to give up their accumulated benefits in one work place and take another new position in a different city or province. It is difficult for the government to transfer the pension accounts from one city or province to another, especially when such workers tend to move frequently for immediate job opportunities. Therefore, the migrant workers cannot receive their pension benefits from past employment and finally lose out financially when they return to their homeland at the end.

At present, in a large number of cities, pension consulting business is processed by computers. In more developed cities, pension consulting networks have been established. But as a whole, China’s pension-collection policy still has a lot to improve; information system coverage is still below average. It specifically shows in the following ways. Firstly, information authorities and management systems are not adapting to the overall development trend. Also, the lack of a complete and versatile information operating system of social security results in slow delivery of information and finance data, as well as slow construction of the reconciliation system among departments.

Chapter 4 Different types of pension reform and what China chose to do

Since the last century, many countries worldwide started to reform their pension systems. The following graph shows that most countries made parameter adjustment without changing the basic framework of the pension system, including the change to the fee structure, revenue structure and method of management reforms. In addition, about 21% of the countries made a fundamental structural change to the national public pension system.

Proportions of different types of pension reform

Source: Schwarz & Demirguc-Kunt (1999)

Different countries chose various forms of pension reform according to their country’s basic economic and social conditions. However, to sum up, there are five main types of pension reform, which are as follows:

Parametric Reform

Parametric reform is the adjustment of parameters of the existing public pension system, including adjustments of payment, remuneration, and benefit eligibility. The main purpose of such a system is to reduce the public pension expenditure

Privatization Reform

In order to alleviate the pressure on the public pension system, in recent years a major trend has been to expand the market for private pension funds. A number of countries have taken many measures to encourage voluntary private pension systems, such as giving preferential tax policies, reducing the size of the public pension system and other steps.

Notional Account Reform

The state transferred the PAYGO, defined benefit public pension system to a notional accounts system. Under such a pension system, employees are just like those in a private pension system, as its contribution is credited to individual accounts, and receives interest. Workers receive a pension upon retirement, depending on the amount of money in their personal accounts. However, there is no actual accumulation of funds in the employee's personal account, as the money paid by active employees is used to pay retirees’ pensions. That is, the notional accounts system benefit has a defined contribution, but its means of financing is still PAYGO; therefore it is called a Notional Defined Contribution system.

From Defined Benefit to Defined Contribution

Although the transformation from the current PAYGO defined benefit system to a fully funded defined contribution system is one of the main trends of reform, a small number of African and Asian countries have chosen to do it the other way round. They have changed from a fully funded defined contribution system to a PAYGO defined benefit system. This is because these countries have accumulated a fund, which is managed by the Government provident fund system. Due to a lack of regulations and governments often abuse their powers, and such pension funds not only failed to obtain a reasonable rate of return, but in some countries also suffered serious diversion and erosion. In order to limit the rights of the government, these countries decided to change the pension system to a non-funded PAYGO system. Since under such a scheme there is no accumulation of funds, therefore the Government tends to be unlikely to abuse the funds.

Multi-Pillar System

After 100 years of development, the pension system has shown a wide variety of forms. Different forms of pension system have their own advantages in achieving their goals, but some shortcomings are inevitable. Therefore, the World Bank has been advocating the establishment of a multi-pillar pension system, allowing complementary advantages and risk diversification.

In 1994, the World Bank proposed in ‘Averting Old Age Crisis’ the establishment of a three-pillar pension system: (a) the first pillar is a public, PAYGO, usually defined benefit and redistributive pension system; (b) the second pillar is a private, funded, almost always defined contribution pension system; (c) the third pillar is a private, funded, voluntary, supplementary, preferably defined contribution pension system. In 2005, the World Bank extended the establishment of the three-pillar system to a five-pillar system in the report of ‘21st Century Elderly Income Security’. Among them, the zero pillar is to provide a minimum protection, non-contributory national pension system, the fourth pillar is the informal supporting system within the family to the elderly, or formal social welfare system.

The five pillars have their own characteristics and different functions; and can be able to cope with different types of risk. Zero pillar is helping to eliminate poverty for the poor segment of society, as well as secure those groups working in informal sectors with low incomes. It is regarded as a part of the social safety net. The aim of the first pillar is to respond to a short-sighted individual risk, low-income risks, uncertainty in life expectancy and investment risks in financial markets, but it is vulnerable to demographic changes and political fluctuations. The second pillar through a mandatory savings system can prevent the short-sighted individual risk, while the privately managed pension system would avoid influence from political risks. However, the second pillar pension system is vulnerable to the impact of financial market risks, and transaction costs are relatively high. The third pillar can compensate for the rigidity in the design of the other pillars, but privately managed pension funds may have financial risk and agency risk. The fourth pillar has the main function of family protection, and through the social welfare system to provide medical care and housing protection to the elderly.

Compared to a single pension system, the greatest strength of a multi-pillar pension system is its ability to withstand risks, which is significantly enhanced. This is because the factors affecting each pillar are not entirely relevant to each other. In many cases, the relevance is very small, even negative. For example, if the first pillar is a PAYGO, defined benefit pension system, the main factor affecting this pillar is the growth rate of wages. While the second and third pillar may be a completely accumulation based, defined contribution pension system, and the main factors influencing it will be the investment rate of return. As the correlation between the rate of wage growth and return on investment is very small, it is efficient to distribute the pension assets in these three pillars.

In addition, there is also a complementary relationship among the different pillars. For example, in the individual defined contribution pension system, workers need to take an amount of savings in their personal accounts and convert it into an annuity. At this time, employees have to bear the risk of changes in interest rates, as well as the risk of death. However, defined benefit pension systems can spread the risk of death. Again, the third pillar – a voluntary occupational pension system is vulnerable to income fluctuations and job changing, but the first and second pillar pension system can offset these effects.

Many countries adopted the multi-pillar pension system because the World Bank recommended the concept of such a model. However, the specific choice of a mix of pillars depends on the national situation, including the status of the existing pension system, reform objectives, administrative capacity, the level of development of financial markets, the level of restructuring costs and other factors. In low-income countries, the goal of a pensions system should be defined as the eradication of poverty. As public and private sectors are unable to provide adequate pensions, the zero pillar should be used to serve the poorest groups of the basic old-age security, and on this basis to encourage and promote voluntary action in the third pillar.

In middle-income countries, the government can set up the first pillar pension system to make most of the citizens set to receive a pension which is associated with their income and to encourage the development of the second and third pillar in order to ensure that the consumption level of retirees remains relatively stable before and after their retirement. In high-income countries, the full establishment of the five-pillar system can be set up, so that citizens can obtain more favorable treatment of pensions.

The Chinese government started its national pension system reform in the 1990s by setting up a three-pillar state pension system in the urban areas. This pension system was controlled under the local government level instead of by the central government. The three-pillar plan is applied as follows:

Pillar I (1) – a defined-benefit social pension provided through compulsory contributions only by employers, with about 20% coming from employees’ income. This pension scheme was managed on a provincial level by social security bureaus. The retirees received 35% of average monthly income. This pension scheme was designed as a PAYGO system.

Pillar I (2) – a mandatory, defined-contribution individual system provided through contributions from employees who contribute 8% of their monthly income. These contributions accumulate in individual employee accounts until retirement and the employee cannot take it from the account before retiring. This system was also managed at a provincial level.

In addition to Pillar I, the Chinese government also introduced Pillar II and III plans for the urban sector with the long-running achievement of creating more private, voluntary occupational pension schemes and achieving less dependence on government funding for China’s national retirement needs.

Pillar II plans are voluntary, defined-contribution plans. These plans are commonly known as voluntary occupational pensions. The voluntary occupational pensions were introduced in China in 2004. The administration centers were found in some cities and areas to manage their local pension funds, while in other regions, the funds were managed by local social security bureaus and invested in bank deposits or government bonds. In addition, a few state-owned industries in China - for example electricity, petroleum and railways - set up internal voluntary occupational pension plans with their own administration centers. By the end of 2005, there were more than 24,000 companies which had set up such plans, covering more than 9 million employees.

Pillar III plans includes other, voluntary, private schemes that do not adjust to voluntary occupational pension plans. Some forms of these private pension plans have already been enforced in China.

Summary of the Multi-Pillar System

Contributions

Benefits

Pillar I(1) (PAYG)

Mandatory employer contribution of 20% of employee’s income

35% of average monthly income (after 15 years of employment)

Pillar I(2) (individual account)

Mandatory employee contribution of 8% of monthly income

Target replacement rate of 24% of average monthly income

Pillar II (voluntary occupational pension)

Voluntary contributions by employers and employees

Individual account

Pillar III (other)

Voluntary contributions by employees

Individual account

Source: CFA Institute

Chapter 5 Evaluation of pension reforming

Pension reform has both a negative and positive point of view. On the one hand, reform may reduce the redistribution element in the social welfare system, leading to higher risk for individuals and greater social inequality, compared to the old PAYGO system, especially for the lower income class. On the other hand, reform is necessary at this stage for both economic and politic development. During the same time, the fund of pension system needs to be fulfil by any resources, such as redistribution, general revenue, as long as can protect the social welfare program.

5.1 Adequacy

Adequacy refers to the pension system being able to provide adequate pensions for retired workers. This not only means the absolute pension level is sufficient to prevent old-age poverty, but also the relative pension level required to achieve a certain replacement rate. No matter what mode of pension reform, the system must avoid all segments of the population suffering from extreme poverty. It also can provide longevity insurance protection to those who live longer than average.

From the sufficiency point of view, universal or means-tested allowance is undoubtedly the most conducive to eliminating poverty in old age. However, such a pension system requires Government's fiscal budget as a source of funding. In China, the financial resources of government is limited, although elderly income is an important goal of reforming the pension system, but scarce government revenue also needs to be spent on other expenses, such as financing the vulnerable children, developing of public health and building infrastructure.

5.2 Affordability

Affordability refers to the financing capacity of individuals and society. Despite the higher replacement rate being able to provide a higher level of protection to the elderly, it will cause a high system cost. From direct costs, the high pay rate would cause great burden on the working staff, affecting demand for workers in other areas, such as consumer demand for child-rearing, investment in housing demand. From indirect costs, a high contribution rate would encourage employees to transfer their work to a non-formal sector in order to avoid tax. However, the excessively high proportion of non-formal sector employment will not only affect the improvement of labour quality, but also the financial revenue and economic growth. The experience of World Bank shows that in middle-income and high-income countries, mandatory pension contribution rates should not exceed 20%; in low-income countries, it should not exceed 10%, otherwise it will have a negative impact. (Holzmann &amp; Hinz 2005)

5.3 Sustainability

Sustainability refers to the pension system, whether present or future, should have financial stability. Financial pressure on the public pension system in most countries is one of the main reasons for reform, and the system should have financial sustainability after reforming. A good pension system should be financially stable, and will not suddenly need to increase the contribution rates or to decrease the pension entitlements; there is no need to budget for sudden large-scale transfers. In other words, it is necessary to publish all the parameters need to be adjusted when design our pension system, such as contribution rates, pension entitlements, retirement age and so on, and take these parameters into consideration in the reform program. The pension system should also set up adjustment mechanism to cope with various economic shocks in order to ensure that the financial situation of the pension system can adapt to a variety of macroeconomic environment.

5.4 Robustness

Robustness means that the pension system has the ability to withstand various shocks, and maintain the smooth running capability in a variety of unknown conditions and environment. In other words, the pension system is able to maintain long-term stability to the income replacement rate. The pension system may face various risks, including macroeconomic risk, population risks, financial risks and political risks. Pension system should be designed to cope with these risks. In order to achieve robustness objectives, countries need to carry out pension reform with a certain model of the various possible changes in simulation analysis, in order to determine the sources of funding and time required for the reform of the pension.

5.5 Sub goals

The reforming of public pension system is also expected to make a positive contribution to Chinese economic development. On the one hand, through the reform of the pension system should be able to reduce the adverse effects to labour market and macroeconomic stability caused in original system; the other hand, the reformed pension system reform should have a positive impact on the economic development, such as increasing national savings rate, promoting financial market development, improving the efficiency of the labour market and improving income redistribution system. Experience of many countries has shown that the design of pension system made a significant impact on economic development and the level of output.

Currently in China, almost all actuaries work for insurance and there is a lack of qualified actuaries working for the pension system. Since pension provisions involve a lot of complex statistical considerations, the actuary must make every effort to ensure that the plan is appropriate to the employees covered by different groups. Actuaries estimate the mortality rate, employee turnover rate, interest and profit rate, the frequency of early retirement, the future wage level, as well as other essential factors required for pension plans in order to value the funds. They calculate a variety of factors affecting the financial statements, such as pension liabilities, an extra cost of the annual service on the project expenditures and an administration cost.

In short, the accountant largely depends on the information and measurement methods provided by actuaries. Some new schemes are running into funding problems, as no proper actuarial evaluations of future costs have been made. Therefore is a big problem that China needs experts in pensions to work and train locally very urgently. With the growth and reformation of pension schemes, the need for actuaries in this area will increase very quickly. Another point is that China should use scheme derived mortality experience rather than using a standard table, which can make the pension scheme easier and clearer. In order to construct a stronger and healthier social welfare system, the government should provide more detailed and updated information about pension system to the citizens. Introduction lectures can be held if necessary in the companies and institutions. Some models are perfect in theory, but usually can not apply in reality. A lot of research has been done, but people did not understand exactly what they did. Therefore, the news of pension system should not only be provided within certain authorities, but also be understood more widely by citizens.

Chapter 6 Conclusion

The Chinese pension system has experienced many changes from the PAYGO system to the current multi-pillar welfare system. The unrealistic promise of old days stalled the progress of the development of pension system, even heavily distorted the social system. Since the late 1990s, Chinese government started to make improvement to the pension system and experiment various format of reforming in many regions.

Recently, the 2010 China two Conferences (i.e. the National People's Congress and the Chinese Political Consultative Conference) discussed about the current system in China. It pointed out that the special dual pension system in China should be repeal gradually in the near future.

Dual pension system is special product period occurred in the transaction between a planned economy to a market economy. The so-called dual system refers to the persons work in different areas adopt a different retirement pension system. There are three main differences: Firstly, the co-ordinated approach is different: people works in companies pay a certain standard themselves and by their companies, while government pay for those civil servants; secondly, the paying channel is not the same: company employers pay from their self-account, while payment is unified management for the civil servants; Thirdly, the pension standard is varied: those who works for institutions and governments have much higher pension than the those company retirees, the current difference is about 3 to 5 times.

The survey held in the two conferences showed that 81% of citizens believe that such dual system implemented between employers in companies and is unreasonable; in the social security system, 45% of the users are most concerned about the four basic social security system (pensions, medical care, unemployment, work injury) and nearly half of the users are most concerned about pension system among these four.  

Most of the discussion was about the existing dual system in social security system. Some people mentioned that the dual system should be repeal and the pension should be consistent between the civil servants and institutional retirees, otherwise it is regarded as artificially expand the income gap. Also some people mentioned that the dual system is a distorted policy causing income distribution. Many citizens called for the abolition of this unfair dual pension system. In the Two Conferences, the government started to consider about the suggestions from all strata of society.

China is not the only country in the world under pressure to reform its pension system as a matter of urgency. The lack of retirement security is one reason why China has become a nation of fervent savers, with some US$2 trillion in bank deposits. The lack of a sufficiently stable pension scheme is a driving factor behind this. And the uncertainty about future has pushed them to save, correspondingly, dampening consumption.

Although there are several of issues arise during the reforming, it is undeniable that the Chinese pension system is evolving rapidly. Indeed, most changes happen in Pillar I, reflecting the government is keen on overhauling Pillar I. However, the introduction of Enterprise Annuity in Pillar II has stalled since the issue of trial measures in 2004. Pension reform in China is, thus, far from complete. In order to cope with the inevitable ageing trend, the voluntary part of it (Pillar II and III) should be an important building block in China’s pension system, which needs to be tackled broadly. Undoubtedly, the reform of the pension system will bring valuable opportunities to financial institutions.

We have learned a lot of valuable experiences in the process of pension reforming, also the knowledge is shared worldwide, as long as we have responsible attitude towards reforming, a stronger and healthier social welfare system will be constructed in the future.

Reference

Pension Fund Reforms in China: An Opportunity to Promote Codes of Conduct and Standards of Best Practice http://www.cfainstitute.org/centre/pdf/china_pension_fund_reform.pdf

James, E, (1996). New system for Old Age Security-Theory, Practice and Empirical Evidence, The World Bank, prepared for EDI conference on pension reform

Selden,M and You, L.(1997). The Reform of Social Welfare in China. World Development, Vol. 25, No. 10,pp.1657-1668.

World Bank (1994). Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth. A World Bank Policy Research Report, Oxford University Press, New York.

World Bank(1997). Old Age Security: Pension Reform in China

Xin Wang(2001). China’s pension system reform and capital market development.Research Department, China international capital corp.

Yuan Michael Tian(2003). What can China Learn From the Pension Reforms Around the World?