Equitable and Sustainable Pensions
Chapter

Chapter 15. Reforming Pensions to Ensure Equitable and Adequate Retirement Incomes in China

Author(s):
Benedict Clements, Frank Eich, and Sanjeev Gupta
Published Date:
March 2014
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Author(s)
Xuejin Zuo

Introduction

China is facing many challenges in its pursuit of a prosperous and harmonious society. In the presence of increased income disparity and the progressive aging of the population, one of these challenges is how to reform the country’s pension system to enhance its equity, efficiency, and financial sustainability.

This chapter first provides an overview of the different schemes in China’s pension system. It then assesses the impact of demographic changes on the future development of China’s pension system, and follows with a discussion of previous and current reform efforts and future reform options for achieving a more equitable, efficient, and financially sustainable pension system.

The Current Pension System

Pension for Urban Workers and Staff

China’s current system consists of three major public pension programs: the Pension for Urban Workers and Staff (PUWS), the Pension for Urban Residents (PUR),1 and the New Rural Pension (NRP). The PUR and NRP are relatively new; the PUWS originated in the era of the planned economy.

For many years before the reform of the pension system in the late 1990s, two pension schemes were in place in China: Labor Insurance funded by individual enterprises, and Government (Public) Insurance funded by different levels of government. Labor Insurance provided the formal employees of urban enterprises with comprehensive benefits, including pensions, health care, insurance for work injury, child bearing, and others. Some of the benefits, such as health insurance, were partially extended to the dependents of the covered employees. For instance, dependants could get 50 percent of their medical expenses reimbursed. Government Insurance provided similar benefits to employees of the government and public institutions (shiye-dan-wei, such as public universities and research institutes).

Urban Pension Reform: From Enterprise Funded to Locality Pooling

In the early 1980s, when China’s economic reforms extended from rural to urban sectors, urban enterprises were given more autonomy, and came under increasing pressure to enhance performance and profitability. Labor Insurance became a source of unfair competition between established and emerging new enterprises, because of the differential age structures of their employees and hence burdens in supporting retirees. Furthermore, in the early 1990s many loss-making state-owned enterprises and urban collective enterprises were closed down or restructured, leading to a wave of lay-offs. Pension reforms became necessary so that the pension benefits of those laid-off workers could be protected.

The government responded by upgrading the pooling of the pension scheme from individual enterprises to localities. In a manner similar to the three-pillar pension system suggested by the World Bank (1994), and based on pilot projects in some localities in the 1980s and 1990s, the State Council (1991, 1995, and 1997) outlined the framework of the new pension scheme, and amendments were made several years later (State Council, 2005).

The new pension scheme that evolved from Labor Insurance is the PUWS. The PUWS is pooled at the prefecture or even the county level.2 The scheme has two pillars. The first pillar is the social pooling account based on defined-benefit and pay-as-you-go (PAYG) principles. This pillar is financed by employer contributions equivalent to 20 percent of the total payroll.3 The second pillar comprises individual saving accounts operating on a defined-contribution principle and full funding. This pillar is financed by employee contributions of 8 percent of their individual wages.

Workers who contribute to the pension fund for 15 years or longer by the time of retirement are entitled to receive monthly pension benefits from both the first and second pillars. The benefit from the first pillar is calculated based on the worker’s years of contribution and wages relative to the average wages in the locality. The benefit from the second pillar is an annuity derived from the balance of the worker’s individual saving account upon retirement. People who contributed to the pension fund for fewer than 15 years by the time of retirement are not eligible for any benefits from the first pillar; they can only receive a lump-sum payment from their individual saving accounts equal to the account’s balance upon retirement.

In practice, the determination of pension benefits is more complicated because of the transitional arrangement for those who had already retired or had contributed under the old pension system, and because of the frequent increase in pension benefits mandated by the central government. During 2005–12, the average PUWS pension increased from 700 yuan (Y) to Y 1,721.4 It will increase an additional 10 percent in 2013 as mandated by the State Council (Office of the State Council, 2013). Such centrally mandated increases tend to invalidate the rules for the determination of pension benefits.

To avoid financial risks involved in the investment of pension funds by the local governments, the central government mandates that all funds be deposited in state-owned commercial banks or invested in government bonds. Consequently, the lower financial risks of the pension assets are achieved at the price of very low or even negative real returns.

In the late 1990s, the prefectures established their own PUWS. However, the schemes’ high required contribution rates tended to induce contribution evasion among the employers of migrant and low-income workers. Some big cities with large concentrations of migrant workers, such as Beijing, Guangzhou, and Shanghai, initiated their own, less expensive pension schemes for migrant workers. For instance, Shanghai introduced Comprehensive Insurance for Migrant Workers, requiring that the employers of migrant workers contribute 12.5 percent of the migrant workers’ wages, of which 7 percent was allocated for pension insurance and the remaining 5.5 percent for health and work injury insurance. Since July 2011, the Social Insurance Law (National People’s Congress, 2010) has mandated that all locally initiated insurance schemes for migrant workers merge into PUWS. See Tables 15.1 and 15.2 for more information.

Table 15.1Number of Working Employees and Retirees Covered by PUWS, 2000–11(Million)
YearTotal Individuals

Covered by PUWS
Covered Working

Employees (contributors)
Covered Retirees

(beneficiaries)
System Support Ratio

(working employees/retirees)
2000136.17104.4831.703.30
2001141.83108.0233.813.20
2002147.37111.2936.083.09
2003155.07116.4738.603.02
2004163.53122.5041.032.99
2005174.88131.2043.683.00
2006187.66141.3146.353.05
2007201.37151.8349.543.07
2008218.91165.8853.043.13
2009235.50177.4358.073.06
2010257.07194.0263.053.08
2011283.91215.6568.263.16
Source: National Bureau of Statistics (2012).Note: PUWS = Pension for Urban Workers and Staff.
Table 15.2PUWS Revenues and Expenditures, 2000–11(Billion yuan)
YearTotal RevenuesContributionsFiscal SubsidiesTotal

Expenditures
Annual

Surplus1
Annual

Surplus2
2000227.85227.850.00211.5516.3016.30
2001248.90248.900.00232.1316.7716.77
2002317.15276.3340.82284.2932.86−7.96
2003368.00315.0053.00312.2155.792.79
2004425.84364.4461.40350.2175.6314.23
2005509.33444.2365.10404.03105.3040.20
2006630.98533.8897.10489.67141.3144.21
2007783.42667.72115.70596.49186.9371.23
2008974.02830.32143.70738.96235.0691.36
20091,149.08984.48164.60889.44259.6495.04
20101,341.951,146.55195.401,055.49286.4691.06
20111,689.471,462.27227.201,276.49412.98185.78
Source: National Bureau of Statistics (2012).Note: Total revenues consist of contributions to both the social pooling accounts and the individual saving accounts, as well as government subsidies. “Surplus1” is defined as total revenues minus total expenditures; “Surplus2” is defined as contributions minus total expenditures. PUWS = Pension for Urban Workers and Staff.

As reported by the Ministry of Human Resources and Social Security (2012), by the end of 2011, PUWS covered 284 million people, including 68 million retirees and 216 million working employees. The latter accounted for about 60 percent of the total urban workforce of 359 million. Total revenues of the scheme amounted to Y 1,689 billion, including Y 1,462 billion in contributions from both employers and employees, and Y 227.2 billion in budget subsidies from different levels of government. In 2011 the scheme’s total expenditures were Y 1,276 billion.

Pensions for Rural and Urban Residents

The introduction of the New Rural Pension and the Pension for Urban Residents was a milestone in the creation of the current pension system. The two pension schemes, which have similar structures, cover the majority of rural and urban elderly who previously had no access to other pensions. The major component of the schemes is the noncontributory pension benefit financed by general revenue; the other component consists of individual savings accounts financed by voluntary contributions from individuals.

The New Rural Pension

Before 1992, rural households had no pension schemes. The children of the rural elderly, especially sons, had been the primary source of old-age security. Those elderly without any family support or labor power were eligible for the “five guarantees” household program, which provided households with food, clothing, housing, medical care, and burial. The program was financed by rural collectives or villages and township governments.

The origin of the New Rural Pension can be traced back to 1992, when the Ministry of Civil Affairs devised a plan for a rural pension scheme pooled and managed at the county level. The program was primarily financed by contributions from rural households, with some aid from rural collectives if available (Ministry of Civil Affairs, 1992). This scheme did not succeed because of the unattractively small pension benefits, the small risk pools, and the consequent high financial risks and management costs, and was formally abandoned in 1999.

In 2009, the central government resumed rural pension programs under the term “New Rural Pension.” The new program is different from the old one in that the central and local governments play a pivotal role in its financing, in addition to contributions from rural households and other available sources (State Council, 2009).

The noncontributory component of the scheme provides all rural elderly 60 years and older with pension benefits of Y 55 per month. The benefits are fully funded by the central budget for the elderly in the middle and western provinces, and half funded for those in the eastern provinces, with the remaining half being funded by the provincial and local governments. The provincial and local governments are encouraged to provide additional pension benefits from their own sources of funding. However, it is likely that only the more developed eastern provinces and their localities have the resources to fund such additional pension benefits.

The other component of the scheme is the voluntary, fully funded, defined-contribution component. Rural participants can choose one of five options (Y 100, Y 200, Y 300, Y 400, and Y 500) to contribute to their individual accounts each year. Local governments are mandated by the central government to subsidize each participant’s contribution by at least Y 30 per year. When participants retire, they can receive monthly pension benefits equal to the total balance in the accounts upon retirement divided by 139.

By the end of 2011, NRP programs had been initiated in all 31 provincial-level administrations. The program had 326 million participants, including 85 million pensioners. In 2011, the total revenues of the rural pension programs amounted to Y 107 billion, of which Y 41.5 billion was from rural households’ contributions, with the remainder funded by the central and local governments. Its total expenditures amounted to Y 58.8 billion (Ministry of Human Resources and Social Security, 2012).

The Pension for Urban Residents

The PUR is designed to cover all nonworking urban residents. Similar to the NRP, the PUR consists of two components: the noncontributory pension and individual saving accounts. The noncontributory component provides qualified urban elderly with pension benefits of Y 55 per month, financed by the central, provincial, and local governments in the same manner as the NRP. The other component is the voluntary, fully-funded, individual savings accounts. Participants are able to choose from among 10 options (Y 100 through Y 1,000 in Y 100 increments) for contributing to their individual accounts. Local governments generally subsidize each participant’s contribution by at least Y 30 per year. When participants retire, they can receive from their own individual accounts monthly pension benefits equal to the total balance in the account divided by 139 (State Council, 2011a).

By the end of 2011, the PUR had been instituted in all 31 provinces, with 5.4 million participants, of whom 2.4 million were pension recipients. In 2011, the total revenues of the pension scheme amounted to Y 4 billion, with only Y 600 million from residents’ contributions. The total expenditures amounted to Y 1.1 billion.

Other Pensions

The government pension

Government Insurance for government and public employees has remained largely unchanged. Funded by government employers, it continues to provide government and public employees with generous pension benefits. This program is not explicitly an insurance scheme—the covered employees are not required to pay any contributions or premiums, which has increasingly been a source of public complaint about the unfairness of the pension system. The central government is considering merging the government pensions with the PUWS. However, no concrete steps have been taken so far.

Voluntary enterprise annuities

The general principles of the supplementary pension programs were established in the mid-1990s (State Council, 1995, 1997). Operational details for enterprise annuities were laid out in 2003 (Ministry of Labor and Social Security, 2003). Companies may contribute a maximum of one-twelfth of their total payrolls, while employees can contribute a maximum of one-twelfth of individual wages to the annuity plans. Both contributions are taxable, whereas pension benefits are tax exempt. The management of the annuities is entrusted to government-authorized asset-management firms.

Projected Developments in China’s Public Pension System

Demographic Changes

The most important factor shaping the future of the public pension system is demographic change.

Declining population

China’s population grew from 540 million to 1.3 billion between 1950 and 2010. During this period, the population growth rate declined from more than 2 percent per year to less than 0.5 percent today (Figure 15.1). The population is projected to decline in the coming decades according to the medium and high variants published by the United Nations.

Figure 15.1Total Population Size and Birth, Death, and Growth Rates, 1950–2100

(Historical trends and projections under different population variants)

The major force driving the transition from high to low population growth was the decline in the total fertility rate, which dropped from five to six children per woman in the 1950s and 1960s to two to three children per woman in the 1970s (a fertility decline unprecedented in human history) and below replacement level by the early 1990s. In the most recent decade it dropped below 1.5 (Guo, 2010). Both fertility control policies and socioeconomic changes favoring lower fertility contributed to the decline. Socioeconomic changes have been the major factor explaining the persistent fertility decline in the absence of changes in fertility control policy since the late 1980s.

Population aging

An inevitable consequence of slower population growth is population aging. Those ages 65 years and older accounted for only 4.4 percent of the population in 1954 and 3.6 percent in 1964, growing to nearly 7 percent in 2000, and further increasing to more than 9 percent in 2011 (Figure 15.2). By contrast, the population ages 0–14 years fell from more than 40 percent of the total in 1964 to a mere 16.6 percent in 2010, indicating the future trend of progressive aging.

Figure 15.2Share of Those Ages 65 Years and Older in Total Population, 1950–2100

(Percent; historical trend, and projections under different population variants)

According to the United Nations’ medium variant, those ages 65 years and older would account for 28 percent of the total in 2055, and about 30 percent of the total in the following three decades. In the low variant, the elderly would account for more than one-quarter of the total in 2040, increasing to more than 40 percent during 2070–90. Such an unprecedented “super aging” of the population would produce severe challenges to society.

As a result of population aging, the old-age dependency ratio increased from 6.4 percent in 1964 to 8.0 percent in 1982 and further to 11.9 percent in 2010. In the UN’s medium variant projection, the old-age dependency ratio is projected to increase to 42 percent by 2050 and 54 percent by 2080. In the low variant, the ratios would increase to 48 percent and nearly 90 percent, respectively.

The Financial Sustainability and Equity of the Public Pension System

Provincial deficits and government subsidies

Today, all three public pension schemes in China are in surplus. However, the reported surpluses cloud the fact that all are heavily subsidized by the government: in 2011 government subsidies accounted for 13.4 percent of the total revenues of PUWS, 61.2 percent of NRP, and 85 percent of PUR (Ministry of Human Resources and Social Security, 2012).

In the absence of government subsidies, many local pension schemes would be unable to pay benefits. For example, for the PUWS, of the 32 provincial administration units, 14 would have been in deficit in 2011 without government subsidies. Moreover, most of the surpluses are concentrated in coastal provinces such as Beijing, Guangdong, Jiangsu, and Zhejiang, which are the destinations of internal migration. In 2011, while the PUWS had a total surplus (net of government subsidies) of Y 41.3 billion nationwide, Guangdong had a surplus of Y 51.9 billion (Zheng, 2012).

“Empty individual savings accounts”

By design the PUWS has two pillars: the PAYG, defined-benefit, social pooling accounts and the fully funded, defined-contribution, individual saving accounts. The existence of two pillars suggests that the authority should provide two separate reports rather than one report mixing the two pillars. In practice, however, nearly 90 percent of the funds in the individual savings accounts have been used to pay current pension benefits. In China, the difference between the recorded balance and the actual balance in the individual PUWS accounts is called “empty individual savings accounts” or simply “empty accounts.”

The size of the empty accounts has been growing rapidly in recent years. As reported by Zheng (2012), it reached Y 1.10 trillion at the end of 2007, increasing to Y 2.22 trillion at the end of 2011, equal to nearly 90 percent of the recorded balance in individual saving accounts. Despite increasing government subsidies, the size of the empty accounts exceeded the total surplus of the scheme, as shown in Table 15.3.

Table 15.3Overview of China’s Pension System, 2012
ProgramPUWSNRPPUREnterprise Annuities
Targeted participantsUrban enterprise employees and self-employedRural residents 16 and olderUrban nonworking residentsUrban enterprise employees (voluntary)
Total coverage (million)283.91326.435.3915.77
Recipients (million)68.2685.252.35
Revenues (Y billion)1,689.5107.04.0
Contributions (Y billion)1,395.641.50.6
Government subsidies (Y billion)227.265.53.4
Expenditures (Y billion)1,276.558.81.1
Accumulated surplus (Y billion)1,949.7119.93.20.36
Source: Ministry of Human Resources and Social Security (2012).Note: NRP = New Rural Pension; PUR = Pension for Urban Residents; PUWS = Pension for Urban Workers and Staff.

Estimates of implicit pension debt

Several studies have projected the PUWS’s contributions and expenditures, and estimated the implicit pension debt (Zuo and Zhou, 1996; World Bank, 1997; Wang and others, 2001). In a study of China’s national balance sheet, Ma and others (2012) conclude that in the baseline scenario, if there are no reforms, the deficits in the PUWS would become a heavy fiscal burden. In 2050, the annual deficit would account for 30 percent of fiscal expenditures, and the present value of total deficits during 2013–50 would sum to 83 percent of 2011 GDP. This study did not take into account the deficits in NRP and PUR; otherwise, the burden on fiscal expenditures would be much heavier.

Fragmentation of the public pension system and the rural-urban duality

One key distinguishing feature of public pension schemes in China is the fragmentation of pension pools by locality and social group. Public pensions are generally pooled and managed by prefectures, or even by counties. Each locality manages at least three pension schemes—PUWS, NRP, and PUR—plus Government Insurance. This fragmentation has resulted in thousands of small pension pools, which, in turn, has led to high management costs and potential financial risks.

To avoid financial risks arising from inappropriate investments by local pension management, the central government mandates that all pension funds be deposited in state commercial banks or invested in government bonds. This might be a rational decision to control for financial risks, given the lack of economies of scale and management skills at the local level. However, such restrictions are implemented at the price of low or even negative real returns. In addition, this practice has prevented pension funds from being important investors in the capital market, thereby impeding the full-fledged development of the capital market in China.

The fragmentation of the pension system also creates barriers to free mobility in the country’s labor market. When workers migrate across localities, they have difficulty carrying their entitlements with them. Some studies find that the PUWS tend to aggravate income inequality in the country (e.g., Zhu, 2010).

Disparities in pension benefits

Evidence shows that differences in pension benefits across the thousands of existing schemes are significant, even startling. The China Health and Retirement Longitudinal Survey, conducted in 2011 by the CHARLS research team (2013) at Peking University, finds that the median NRP benefit was Y 720, accounting for 21 percent of average per capita expenditure of rural households; that of PUR was Y 1,200, accounting for 38.7 percent of the average per capita expenditures of urban households. By comparison, the median pension benefit of PUWS was Y 18,000; and that of government pension was Y 24,000, accounting for, respectively, 192.9 percent and 242.2 percent of average per capita expenditure of urban households.

This is consistent with findings from a survey conducted in five provinces by the Chinese Academy of Social Sciences (Wang, 2012). Xiamen City in Fujian Province provides an apt illustration. The survey finds that the monthly pension benefit received by retirees in the sample ranges widely, from Y 200 to Y 10,000.

The survey also finds significant differences in the perceived adequacy of pension benefits across pension schemes. On average, about 40 percent of pensioners complained that the benefits were not adequate, or do not even meet basic needs. Only 3.8 percent of the retirees of the government pension scheme made such complaints, while 56 percent of beneficiaries of the PUR and 79 percent of the beneficiaries of the NRP made such complaints.

The central government provides the retirees covered by NRP and PUR with noncontributory pensions of Y 55 per month. Additional benefits can be provided by local governments at their own discretion. Obviously, local governments’ capacity to provide additional benefits depends on the localities’ level of development, hence, the low-income and poor elderly, who concentrate in the less developed hinterland provinces, are less likely to receive additional benefits.

In addition, the pension benefits from NRP and PUR individual saving accounts tend to be small. Because most participants choose to contribute the minimum Y 100 per year, they would accumulate pension assets of only Y 4,000 over 40 years of work. Assuming a real rate of return of zero, upon retirement they can receive Y 4,000/139 = Y 28.80 per month or Y 345 per year from their individual saving accounts. This is far too little to provide meaningful support to the elderly.

Internal migration and portability of pension benefits

Because the PUWS is pooled at the local level, participants’ entitlements to benefits are less portable, if portable at all. Migrant workers lose their entitlements quite often when changing localities.

As discussed, some larger cities have initiated special social insurance programs for migrant workers. The 2011 Social Insurance Law requires all local insurance programs for migrant workers to be merged into the PUWS, but because the PUWS is pooled at the local level, the merger cannot resolve the portability problem.

To improve portability of the entitlements to the PUWS’s social pooling accounts, in 2009 the central government mandated that when a participant moves across localities, he or she can transfer to the place of destination the entire balances in his or her individual saving account, and the employer’s contributions to the social pooling accounts equal to 12 percent of the individual’s total wages after 1998 (The Office of the State Council, 2009). In reality, however, because most migrants were not covered by the PUWS before July 2011, the above rule can hardly apply to them.

Because migrant workers contribute to the pension schemes but often lose their entitlements, a de facto transfer from migrants to local pension schemes has been created, and from the places of origin to the places of destination. For 2010, interprovincial migration created estimated pension revenues of Y 52.6 billion for provinces of destination, averaging Y 3,424 per migrant covered in urban pension programs (Zheng, 2012). Consequently, the coastal provinces gained pension revenues of Y 32.4 billion from immigration, at the costs of Y 23.9 billion in the middle provinces and Y 8.4 billion in the western provinces. This outcome aggravates interregional income disparities.

Reform Efforts and Future Options

Previous and Current Reforms

Expansion of the coverage of pension programs

Great efforts were made in the past decade to expand the coverage of public pension systems, with the PUWS’s scope widened to include the employees of foreign-funded enterprises, private enterprises, and the informal sector; and the NRP and PUR were introduced to cover rural and urban nonworking residents. Although these steps, in principle, suggest significant progress, migrant worker participation in PUWS has remained very low: by end-2011, there were 253 million peasant workers, including 159 million migrant workers (Ministry of Human Resources and Social Security, 2012). Although the Social Insurance Law mandates that all peasant workers participate in PUWS beginning in July 2011, only 41 million participated, accounting for fewer than one-sixth of total peasant workers.

The scheme’s very low participation rate may be attributed to the PUWS’s high contribution rates, which often lead to contribution evasion among low-income workers. The uncertainty of being able to access their pension benefits when needed—arising from the portability problem—also discourages migrant workers from participating.

Enhancing the financial sustainability of PUWS

To control for the fiscal risks caused by the “empty accounts,” the central government initiated pilot projects to “refill” those accounts in 2001, 2004, and 2006 (Ministry of Labor and Social Security and Ministry of Finance, 2005).5 The major reform measures in the pilot were the following:

  • To separate the operation of individual saving accounts from social pooling accounts, and refill the individual saving accounts with funds equal to 5 percent of the participants’ wages, mostly financed by the central government;

  • To strengthen the link between individual worker’s pension benefits and contributions; and

  • To encourage enterprises to set up the annuities by exempting their contributions, up to 4 percent of total payroll, from taxes.

Unfortunately, the efforts to refill empty accounts did not succeed. In 2009, Liaoning Province, the first province involved in the pilot, stopped subsidizing PUWS and again began to borrow from the individual saving accounts to pay current pension benefits. By 2011, the first three provinces involved in the pilot had the first, second, and fifth largest pension deficits among the 31 provinces (Zheng, 2012).

Pooling the first pillar of PUWS

The government’s objective is to unify the pension system at the national level. However, progress toward the intermediate objective of unifying at the provincial level has been weak. There are several possible explanations for the lack of progress. Given the interprovincial and interlocality disparities in average wages, contribution rates, and replacement ratios, the better-off provinces and localities are leery of national pooling because of their concerns about possible losses from redistribution of resources. The PUWS high contribution rates tend to intensify such concerns. Even the central government might be concerned about the possible moral hazard of local governments shifting their pension debts to the central government. National pooling would reduce the fragmentation of the current system, which has an adverse impact on the efficiency of China’s labor market and impedes healthy development of the capital market.

Developing a multipillar pension system

Regardless of the central government’s intention to build a multipillar pension system in China, participation in voluntary company schemes has remained very low among both employers and employees. The PUWS’s very high mandatory contribution rates leave little room for the development of other pillars; thus, it should not be surprising that enterprise annuities and other components of the third pillar are underdeveloped.

Future Reform Options: A Five-Pillar System

The official guideline for further reforms to China’s social insurance system is to “expand coverage, ensure basic retirement incomes, develop a multi-pillar system and to enhance sustainability” (National People’s Congress, 2010). Successfully meeting these objectives would help a more equitable and sustainable pension system to be achieved. The question is how to devise feasible and operational reform measures to fulfill these objectives.

Building on the existing three-pillar pension system, a new, five-pillar system could be established by adding a “zero pillar” and a fourth pillar. In the new system, the zero pillar would be a noncontributory pension available to all senior citizens age 65 years and older, funded by the central budget. The first pillar would be a unified, nationwide, PAYG, defined-benefit scheme. The second pillar would be individual accounts held in fully funded, defined-contribution schemes. The third pillar would be the voluntary enterprise annuities and individual retirement accounts, which should be encouraged by exempting contributions from taxation. The fourth pillar would be traditional familial support to the elderly.

Zero Pillar: Noncontributory pension for all elderly

China’s present pension system cannot provide the low-income elderly, especially the rural elderly, with adequate retirement incomes. Recent studies (e.g., Holzmann and Hinz, 2005; Barr and Diamond, 2010; World Bank and Development Research Center of the State Council, the People’s Republic of China, 2013) have suggested that China introduce a zero pillar or noncontributory pension into the system. Countries such as Australia, Canada, Chile, Korea, the Netherlands, and New Zealand have already established such a pillar, funded by general tax revenues. In fact, some elements of a noncontributory pension are embedded in China’s NRP and PUR schemes. The question is how to upgrade these noncontributory elements into a full-fledged zero pillar.

One option would be for the central government to provide all citizens 65 years and older with benefits equal to 5 percent of per capita GDP, regardless of residence, gender, or income level. This would be equivalent to about a quarter of rural household per capita income and close to 10 percent of urban. Although rural and urban elderly would receive the same absolute amount, the rural elderly would benefit more relative to their per capita household incomes. The amount could be increased later, for example, to 6 percent of per capita GDP, which is just above the official rural poverty line. Although more costly, an important argument for universal (rather than means-tested) noncontributory pension benefits for all individuals age 65 years and older is that it can foster public consensus on the new pillar, can simplify administration, and can avoid discouraging the elderly from engaging in paid jobs.

The noncontributory pension could be funded solely by the central budget. A centrally funded system can foster the development of an integrated labor market in the country and alleviate this barrier to labor mobility, as compared with the alternative of locality funding. In fact, an appropriate increase in central spending can help reduce the imbalance in allocating revenues and expenditures across different levels of government. In 2011, for instance, the central government accounted for about half of total fiscal revenues but for only 15 percent of total expenditures.6 By comparison, local governments accounted for about half of total fiscal revenues, while accounting for 85 percent of total expenditures (National Bureau of Statistics, 2012).

A tax-funded, noncontributory pension could be financially sustainable. In 2012, spending would have been less than ½ percent of GDP, equivalent to 2.2 percent of general government revenues and 4.5 percent of central government revenues. Because the central government has been providing enormous transfers to provincial governments every year in the form of earmarked funds, central provision of noncontributory pensions would, to a large extent, merely be a change in the form of the transfers.

Even when the share of those age 65 years and older doubles to 20 percent of the total population, noncontributory pension spending would increase to 1 percent of GDP, which is still affordable. If the population ages more dramatically, the eligibility age for the noncontributory pension could be raised to 67 years or more.

Moreover, noncontributory pension expenditure would be a substitute for certain other types of expenditure. For instance, the centrally funded Y 55 per month benefit through the NRP and PUR, and the government subsidies for contributions to the individual saving accounts in these two schemes, could be eliminated for the most part by the proposed zero pillar of the pension system. In addition, the noncontributory pension would lift the majority of the elderly poor out of poverty, and hence reduce government expenditures on poverty-alleviation programs.

National pooling of the first pillar at a lower mandatory contribution rate

To overcome the PUWS’s problems caused by its fragmentation and high mandatory contribution rates, the new first pillar should be pooled nationwide and across all urban workers, including employees of all levels of government, public institutions, and private and public enterprises. All of these workers, together with the self-employed, should be required to participate.7 Employers should contribute for all their employees; self-employed should contribute for themselves, possibly with government subsidies. A lower contribution rate would encourage higher participation of migrant workers. This pillar could be called the National Basic Pension (guomin jichu yanglaojin).

Assuming an average replacement rate of 40 percent, a contribution rate of 12 percent would allow the system to break even or perhaps run a surplus as long as the old-age dependency ratio remains less than 30 percent. The 12 percent rate would also be consistent with the “portable” contributions in the social pooling accounts when migrants move across localities (Office of the State Council, 2009). It should be emphasized that the replacement ratio of 40 percent is an average across all retirees; to encourage participation, it will vary by individual, and depend on individual wages and years of contribution.8

To face the challenge of population aging, China can learn from the experiences of other countries and increase the mandatory retirement age, increase the years of contribution required for entitlement to the first-pillar benefits, and subsidize the pension scheme with general tax revenues.

Properly managing the transition period will be important. To ensure a politically popular and smooth transition from the old to the new system, high priority should be given to two principles. First, the replacement ratio should remain unchanged, if not improved, during the transition period. Second, the financial responsibilities should be shared between the central and local governments, with the center playing the pivotal role.

In 2010, the average replacement rates was 39.3 percent for the 32 provincial-level administrations (Zheng, 2012). Of all the provinces, 18 had replacement rates below 40 percent. Therefore, the proposed system’s replacement rate of 40 percent will make the retirees in these provinces better off, even if the provinces or localities do not provide any additional pension benefits. The remaining 14 provinces have replacement rates higher than 40 percent. Among them, eight had replacement rates between 40 and 50 percent, four between 50 and 60 percent, and two about 65 percent. Accordingly, these three groups of provinces should make up the difference in the replacement rates. To do so, the local governments should set up local transition funds to be financed primarily by contributions from the covered employers and employees, in addition to the 12 percent contribution to the National Basic Pension.

The burden of making up the difference should be manageable for the provinces and their localities, and could be financed by the local transitional funds in general. If the local transitional funds are not sufficient to cover the relevant costs, they should be subsidized by, in turn, fiscal revenues at the local level, other available local resources (such as profits from local state-owned enterprises), and transfers from the provincial and central governments if necessary. Box 15.1 discusses the suggested transitional arrangements in more detail.

Box 15.1Transitional Arrangements and Rules for Different Groups

During the transition period, individuals could be classified into four groups:

  • Already retired before transition to the new system (“old retirees”);

  • Not retired but have participated in the scheme for 15 years or longer by the time of the transition (“older workers”);

  • Participated in the scheme for fewer than 15 years (“middle-aged workers”); and

  • Participate in the scheme after the transition (“young workers”).

The suggested specific rules for these four groups are discussed below.

Old retirees would continue to receive pensions at the same replacement ratio as under the old system, with no obligation to make contributions to the scheme. Their pension benefits would grow with average wages.

The contribution rates for older workers would remain at 20 percent of the total payroll from employers, and 8 percent of individual wages from individual employees. Contributions from employers would be divided into two parts: 12 percent would go to the National Basic Pension (NBP), with the remainder, together with the contributions from individual employees, going to the local transitional funds. The whole defined-benefit scheme should be on a PAYG basis, while refilling the “empty accounts” of this set of workers should be abandoned. The NBP would provide older retirees and older workers with an average replacement ratio of 40 percent. The local transitional funds would make up the difference between the replacement ratios promised under the old system and provided under the new one so that the replacement ratio would remain the same as under the old system.

Middle-aged workers would continue to have the social pooling account and the individual saving accounts. Their employers should contribute 12 percent of total payroll to the NBP, with employees contributing between 4 and 8 percent of their wages to the second pillar. On retirement, the pension would consist of the benefits derived from the NBP and from their individual saving accounts.

One transitional issue is how to deal with the contributions that the employers of “middle-aged workers” made under the old system. These contributions are, in general, 20 percent of payroll. At least part of the difference should be transferred to the individual saving accounts of the middle-aged workers.

In addition, the exact amount of the empty accounts, including transfers from the social pooling accounts, for each of the middle-aged workers should be specified. A plan on how to “refill” the empty accounts within 15 years should be made in each of the localities. Potential sources for refilling could be contributions to the local transitional funds, subsidies from the provincial and local governments, dividends of state-owned enterprises, and central transfers to the provinces and localities.

The individual saving accounts under the new system should be funded on a defined-contribution basis. Management of the individual accounts should be transferred from local governments to licensed and competitive pension asset management companies. These asset management companies should operate nationally or even globally and have more flexibility in choosing investment portfolios. Local governments or enterprises should be allowed to choose among them to encourage competition. The operation of the pension funds should be closely monitored by the local governments that choose the pension asset management companies and the owners of the pension assets.

Employers of young workers should contribute 12 percent of their payrolls and the workers could choose to contribute between 4 and 8 percent of their wages to their individual saving accounts. When they retire, they would be entitled to receive pension benefits derived from both the NBP and their individual saving accounts. They would be able to get higher returns from the assets in their individual saving accounts because of the new management of the funds.

Summary and Concluding Remarks

Since 1990, China’s public pension system has experienced a transition from enterprise-based to locality pooled programs. The present public pension system consists of the Pension for Urban Workers and Staff, the Pension for Urban Residents, and the New Rural Pension. Government Insurance continues to provide pension benefits to employees of the government and of public institutions. Coverage of the public pension system has expanded rapidly since the introduction of the NPR (2009) and PUR (2011). A relatively small number of enterprises have set up voluntary annuity programs for their employees.

Yet China’s public pension system has several problems that should be tackled through further reform. The very high compulsory contribution rates for PUWS tend to curb the participation of low-income workers such as migrant workers and those employed in small and medium-sized enterprises and in the informal sector. Locality pooling and the consequent fragmentation of the pension system lead to lack of economies of scale and high management costs, resulting in inefficient performance of the system. Central government regulations restricting investment vehicles for the pension funds lead to very low or even negative real returns. The present system is not equitable, as evidenced by the substantial disparities in pension benefits between Government Insurance and the PUWS, and between urban and rural schemes. The financial sustainability of the pension system presents another serious challenge. At present, most public pension programs are heavily subsidized by several levels of government. The “empty” individual accounts in the PUWS totaled more than Y 2 trillion at end-2011 and will continue to grow. Population aging and the consequent decline in the system support ratio will generate a large implicit pension debt in the decades to come.

The impact of the above-mentioned problems goes beyond the pension system itself. For instance, the fragmentation of the pension system places barriers to spatial and social mobility of labor, impeding the development of an integrated national labor market. The second pillar of the PUWS is not allowed to invest in the capital market, thus preventing the scheme from being an important investor in the market.

To resolve these issues, this chapter suggests a five-pillar pension system based on the current three-pillar system. In this system, the zero pillar is a noncontributory pension funded by the central budget, covering all urban and rural elderly 65 years and older. The first pillar is the national social pooling account based on defined-benefit and PAYG principles, covering all urban workers and the self-employed, at a lower contribution rate. The second pillar is the mandatory individual saving accounts operating as part of fully funded defined-contribution schemes, managed and operated nationwide by specialized pension asset management companies. The third pillar comprises voluntary occupational schemes, encouraged by favorable tax treatment. The fourth pillar is familial support to the elderly. The chapter also suggests detailed measures to ensure a smooth transition from the old to the new system.

The proposed reform of the pension system would greatly enhance the equity, efficiency, and sustainability of the system, ensure adequate retirement incomes for the elderly, and contribute to increases in domestic consumption, stable growth, and the construction of a harmonious society.

References

    Most migrants cannot have their household registration changed to their new place of residence and hence do not qualify for PUR.

    In China, the government hierarchy has five levels: the Center, the provinces (comprising the province-level municipalities under the direct jurisdiction of the Center, and the autonomous regions), the prefectures (or prefecture-level cities), the counties (or county-level cities), and the towns (or townships). At the end of 2011, there were four provincial-level cities, 332 prefectures, and 2,853 counties in China (National Bureau of Statistics, 2012).

    The employers’ contribution rate varies by locality because of the varying age structure of the participating workers. For instance, Guangdong has both a lower contribution rate and more surpluses as a result of the participation of a large number of young migrant workers. By contrast, Shanghai and Heilongjiang have the highest contribution rate, 22 percent, because of the older age structure of their urban workers.

    In mid-2013, 1 U.S. dollar was approximately 6.1 Chinese yuan.

    The original Chinese word for “refill” is zuoshi, literally meaning to “make it real.”

    Some other government revenues are not recorded in budgetary revenues, such as the contributions to the public pension and other social security programs, the revenues derived from land leasing, and other fees.

    Because high income disparities between rural and urban areas persist, peasants in the agricultural sector should not be required to participate in the first pillar. Rather, they should be entitled to the zero and second pillars. Their individual accounts should be managed by the same authorized pension management companies.

    A formula could be designed to closely associate an individual’s benefits with his or her contributions to the National Basic Pension. Following the practice in Germany and other advanced economies, the pension scheme can define an individual worker’s credit point bt for a given year t as bt=λy+(1λ)ytyt÷100=[λ+(1λ)ytytr]÷100, in which yt is the individual wage and yt is the average wage in year t. The equation indicates that an individual worker’s credit point is the weighted average of his or her own wage yt and the average wage yt (relative to the average wage yt). Λ = 0 means that a worker’s credit point is perfectly related to his or her own wage; Λ = 1 means that the credit point is perfectly flat. In reality, the policy variable Λ would be set in the neighborhood of 0.5. The equation also indicates that if an individual worker contributes to the first pillar for one year, he or she will be entitled to, on average, pension benefits equal to 1 percent of average wage. An individual worker can accumulate credit points over his or her whole working life. After retirement he or she can receive a pension equal to the accumulated credit points times a standard income measure such as the average wage. This is also an important measure for alleviating the concerns of high-income localities about national pooling.

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