Breathing new life into China's pension fund

Robert Pozen says besides easing its one-child policy, China must address its demographic time bomb by reforming and centralising its pension scheme to fit the needs of a rapidly ageing population

PUBLISHED : Wednesday, 21 August, 2013, 12:00am
UPDATED : Wednesday, 21 August, 2013, 2:23pm

The end appears to be in sight for China's policy of one child per family. A government official recently announced that China is considering more exceptions to the policy for urban couples; other officials and academics have more broadly raised questions about its merits.

The one-child policy is being reconsidered because China is facing a demographic time bomb. The ratio of the working population to total population peaked in 2010 and is rapidly declining. The percentage of the population aged 65 or older will double by the early 2030s. By 2050, it is projected that there will be fewer than 1.6 workers for every retiree in China.

These trends will not only undermine the efforts of the government to establish a viable pension system, but will also force widespread adjustments in the nation's health and welfare programmes. China faces a monumental challenge in figuring out how to take care of its large and growing legion of elderly citizens.

To improve the ratio of workers to retirees, China should adopt a two-child policy. This change would not overwhelm hospitals. Indeed, China would need a fertility rate of 2.1 children per family to maintain a constant population size. Many Southeast Asian nations have fertility rates below 1.5 children per family - even without restrictions on family size.

The national government is in a much better position to finance the legacy benefits

However, moving to a two-child policy would not be sufficient to address the demographic challenges to the pension system.

Other key suggestions to put the pension system on a sustainable path include: raising the retirement age, centralising pension administration, more advance funding for pensions, and fewer restrictions on pension investments.

For a start, China could increase its ratio of workers to retirees by raising the normal age of retirement for women to the same as for men. For several decades, the retirement age for women has been 55 for managerial or technical workers and 50 for other female workers, while the retirement age for men has been 60.

After female-male parity is achieved, China should move back its retirement age for all workers to reflect its large gains in life expectancy. The current policies have been in effect since the 1960s, when life expectancy at birth was below 60. Now, life expectancy is almost 74, and rising.

The largest part of the pension system by asset size is the urban enterprise pension. It is managed by each city and province, each with different rules. This presents a significant barrier to workers who want to take jobs elsewhere. By moving without receiving a new hukou (residency permit), workers often lose a share of their accrued pension benefits.

While recent regulatory guidance promotes pension portability, more dramatic action is needed. Specifically, the national government should build a centralised computer system to track all wages and pension payments. This is the essential first step towards switching the pension system from the cities and provinces to the national government.

Under the urban pension scheme, employers contribute 20 per cent of wages to a collective pool and workers contribute 8 per cent of wages to their own individual accounts. However, local governments use most contributions by employers to pay legacy benefits from before 1997. In that era of the "iron rice bowl", state-owned enterprises promised pension benefits with few or no contributions.

To fund these legacy benefits, most local governments have also "borrowed" contributions from individual accounts. This has led to the widespread phenomena of "empty accounts". Despite pilot programmes in 13 regions to top up these individual accounts, most are still not fully funded.

Thus, I propose the "Big Swap" for the Chinese pension system. Before the end of this decade, the national government would take over the collection and investment of pension contributions from the cities and provinces.

In exchange, the cities and provinces would be relieved of their responsibility to pay legacy benefits from before 1997. The swap should make sense because the national government is in a much better position to finance the legacy benefits and move the urban pension scheme towards a system with more advance funding.

After the swap, the national government should strive to allocate most pension contributions to two segregated trust accounts - one for employer contributions and the other for individual accounts.

The assets in these trust accounts should be invested by the professionals at the National Social Security Fund, which already manages a large portfolio for Guangdong.

Under current rules, if pension contributions are invested, they are generally restricted to bank deposits and government bonds with low interest rates.

To prudently increase investment returns, the social security fund should establish a balanced fund, in which half of the assets would be invested in a diversified portfolio of high-quality corporate and government bonds, while the other half would be invested in a broad portfolio of global stocks.

None of these changes will be easy to accomplish; all will be opposed by entrenched forces. But China is sitting on a demographic time bomb, which will predictably blow up within a few decades. In order to prevent that crisis, China needs to start soon by moving to a two-child policy and adopting the other reforms suggested here.

Robert C. Pozen is a senior lecturer at Harvard Business School. He is author of a recent paper on Chinese pensions, published by the Paulson Institute, from which this piece is adapted