Reformation of Chinas Pension Scheme

Reformation 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 Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢s pension system is displayed by the Melbourne Mercer Global Pension Index in Chapter 2. The four main problems of Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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 Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢s pension reform. Table of Contents Acknowledgements2 Abstracts-3 Chapter 1 Introduction-5 Chapter 2 Current situation of China pension system8 Chapter 3 Problems of Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢s pension system and reasons for pension reform10 Chapter 4 Different types of pension reform and what China chose to do15 Chapter 5 Evaluation of pension reforming-20 Chapter 6 Conclusion-23 Reference25 Chapter 1 Introduction Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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 Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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 Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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, Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢s pension reform still has a long way to go. With positive attitude, we believe that the system will become mature in the fu ture. 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 schemeà ¢Ã¢â€š ¬Ã¢â€ž ¢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 Programà ¢Ã¢â€š ¬?, 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 Peoples Government promulgated The Peoples Republic of China Labour Insurance Regulations, which required companies to implement pensions, medical insurance and industrial injury insurance for their employees. This was Chinas 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% 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 employeeà ¢Ã¢â€š ¬Ã¢â€ž ¢s insurance. Chinas 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 systems index in five continents, across eleven countries, Chinas system achieved relatively low ratings. This shows that Chinas 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 worlds 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 Chinas pension system is actually still in personal accounts, which are kind of on a à ¢Ã¢â€š ¬Ã‹Å"PAYGOà ¢Ã¢â€š ¬Ã¢â€ž ¢ 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 Govern ment 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 à ¢Ã¢â€š ¬Ã‹Å"PAYGOà ¢Ã¢â€š ¬Ã¢â€ž ¢ 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, Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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 otherà ¢Ã¢â€š ¬Ã¢â€ž ¢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, peoples 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 worlds 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 à ¢Ã¢â€š ¬Ã‹Å"one-childà ¢Ã¢â€š ¬Ã¢â€ž ¢ 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, Chinas 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 Chinas 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 à ¢Ã¢â€š ¬Ã‹Å"netà ¢Ã¢â€š ¬Ã¢â€ž ¢ value (pension income minus the money paid to retired employee) into funds, the contribution rates b etween 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 Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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 states basic pension systems are mostly being legislated by state first, then organised by the Central Government. However, Chinas 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 mana gement 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, Chinaà ¢Ã¢â€š ¬Ã¢â€ž ¢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 countryà ¢Ã¢â€š ¬Ã¢â€ž ¢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 employees personal account, as the money paid by active employees is used to pay retireesà ¢Ã¢â€š ¬Ã¢â€ž ¢ 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 à ¢Ã¢â€š ¬Ã‹Å"Averting Old Age Crisisà ¢Ã¢â€š ¬Ã¢â€ž ¢ 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 à ¢Ã¢â€š ¬Ã‹Å"21st Century Elderly Income Securityà ¢Ã¢â€š ¬Ã¢â€ž ¢. 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 privatel y 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 à ¢Ã¢â€š ¬Ã¢â‚¬Å" 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 eradicati