May 11,2009

China's Long March to Retirement Reform

By Richard Jackson, Washington DC
A young nation is about to grow old.  In 2005, there were just 16 elderly Chinese for every 100 working-age adults.  This aged dependency ratio is due to double to 32 by 2025, then double again to 61 by 2050.  By 2050,  there will be 438 million Chinese aged 60 and over, 103 million of whom will be aged 80 or older.

China’s Long March to Retirement Reform, a new report by the Washington-based Center for Strategic and International Studies, warns that the aging of China’s population could impose a crushing burden on tomorrow’s workers while leaving a large share of tomorrow’s elderly vulnerable to hardship in old age.  The sheer magnitude of China’s age wave-by 2030 China will be an older country than the United States-would alone pose a serious challenge. What makes the challenge even more daunting is that the age wave will arrive while China is still in the midst of development and modernization.

China’s public pension system only covers a fraction of the total workforce and its private pension system is still in its infancy.  Overall, just one-third of Chinese workers are now earning a formal retirement benefit of any kind.  Despite China’s lofty household savings rate, only a small minority of workers are accumulating sufficient financial assets to support themselves in old  age.  For the foreseeable future, the majority of elders will continue to depend on their children for support.  But as China modernizes-and as families shrink in size-its informal old-age support networks are coming under increasing stress.  Unless China prepares for the coming age wave, a retirement crisis of immense proportions looms just over the horizon.

The CSIS report stresses that the foundation of China’s retirement system must be a universal floor of protection against poverty in old age that covers all Chinese elders, whether or not they have participated in the contributory public pension system.  Above this floor of protection, the report argues that the best solution is for China to rely more heavily on fully funded pension systems that allow elders to finance more of their own retirement income through savings set aside during the working years.

Over the past few years, government reforms have begun to push China’s retirement system in the right direction.  The government is trying to expand coverage under the "basic pension system" for urban workers beyond its original base among employees at state-owned enterprises.  Meanwhile, increased central budget subsidies are helping to fix the basic pension system’s "empty accounts" problem by allowing a growing share of contributions to the system’s second tier of personal accounts to be saved and invested.  The government has also created a national pension reserve fund and is laying the groundwork for a new supplementary system of employer-sponsored "enterprise annuities." 

Yet despite the progress, the government’s recent initiatives fall short of a complete solution.  Public pension coverage remains far from universal, even in the cities, and the government has yet to take serious steps toward extending coverage to the countryside.  The basic pension system continues to be burdened by large unfunded liabilities for legions of early retirees from China’s downsized state-owned sector.  As a result, the system’s contribution rate must be set at a prohibitively high level, encouraging widespread evasion.  The basic pension system’s benefits are not fully portable, which means that workers often face a stark trade-off between job mobility and retirement security.  And its personal accounts, though now partially funded, earn such a low rate of return that they cannot possibly generate promised replacement rates. 

Meeting the government’s goal of building an adequate and sustainable national pension system will require more fundamental reform. The CSIS report proposes a four-step plan: 

 Step 1: Create a universal floor of protection.  The floor of protection, which would be financed out of general government revenues, would guarantee a minimum level of income to all Chinese elders, regardless of their employment record or contribution history.  Elders aged 60 and over who have no other source of income would be eligible for a benefit equal to 20 percent of the average local wage.  The benefit would be reduced by 1 yuan for every 5 yuan in other household income, so that it falls to zero for elders with incomes equal to the average local wage.  This gradual phase-out means that the floor of protection would provide larger benefits and help far more elders than the current minimum living standard guarantee, which merely tops up income to the poverty threshold.

 Step 2: Socialize the cost of the basic pension system’s unfunded liabilities.  A lasting solution to China’s retirement challenge will remain unattainable so long as the basic pension system is burdened by large unfunded liabilities.  The CSIS plan therefore calls for the central government to directly assume the cost.  Specifically, central government subsidies to the local social security bureaus, which now cover about 15 percent of current basic pension benefits, would be gradually increased until they cover 100 percent of current benefits.  The legacy cost of the SOEs is a collective problem, and should be paid out of general government tax revenues, not workers?payroll contributions. 

 Step 3: Transform today’s two-tiered basic pension system into a national system of publicly regulated but privately managed and invested personal accounts.  Unlike today’s personal accounts, the reformed accounts would be fully funded, fully portable, and offer participants a market rate of return.  Under the reform, the first pay-as-you-go tier of the basic pension system would be gradually phased out, since its primary purpose-providing a secure base of old-age income support-can be accomplished more efficiently through the plan’s new means-tested floor of protection.  Meanwhile, the second personal accounts tier of the system would be enlarged.  When the transition is complete, the total contribution rate for China’s reformed basic pension system would be 18 percent of covered payroll, roughly one-third less than the current 28 percent rate.  Of this, 16 percent would flow to the personal accounts.  The remaining 2 percent would be earmarked to pay for disability and survivors benefits.  Even as the CSIS plan restructures the basic pension system, it would extend the system to the countryside in stages, beginning with workers at town and village enterprises.

 Step 4: Expand supplemental retirement coverage under China’s new enterprise annuity system. The new national system of personal retirement accounts would, over time, ensure an adequate retirement income to the majority of Chinese workers.  Higher-earning workers, however, will need to accumulate supplemental retirement savings.  It is thus crucial that China strengthen incentives for employers and employees to participate in the new private enterprise annuity system.  The place to start is to streamline the system’s burdensome licensing process; improve, clarify, and standardize its tax treatment; and authorize master trust arrangements to ease the burden on small and medium employers. 
Although the CSIS plan would require a significant up-front investment, it would cost far less in the long term than today’s system and would bring vast benefits as China ages.  The floor of protection would spare tens of millions of elders from a destitute old age-and might even avert widespread social unrest in an aging China. The national system of fully funded personal accounts would allow a growing share of tomorrow’s elderly to enjoy a comfortable retirement without overburdening tomorrow’s workers.  It would also help an aging China to meet its long-term development goals by broadening and deepening capital markets and maintaining adequate rates of savings and investment. 

The current global financial crisis and the drastic decline in world stock markets are causing some policymakers to question the wisdom of basing retirement security on funded savings.  Although this concern is understandable, it is misplaced.   An effective retirement policy must focus on the long term-and over the course of a contributor’s working life there is little question that a funded pension system will deliver higher returns and larger benefits than a pay-as-you-go system can.  To be sure, funded systems subject retirement benefits to the risks of ups and downs in financial markets.  Economists largely agree, however, that workers nearing retirement can be adequately protected by prudent regulations that require them to move into fixed income assets at older ages.  The CSIS plan includes just such safeguards. 

China stands at a crossroads.  For the past 30 years, demographic trends in China have leaned with economic growth and helped to underpin its stunning economic rise.  Within the next ten years, however, the favorable demographics will be thrown into reverse.  China’s success in preparing for its coming age wave will have profound implications for its future prosperity.  Indeed, it will go a long way toward determining whether it achieves its aspiration of becoming a prosperous and stable developed country with an expanding role in the global economic and political order.  Now is the time for China to take the next steps that will allow it to confront the demographic gauntlet ahead.

(The author is the director of the Global Aging Initiative, the Center for Strategic and International Studies at Washington DC )
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