China should move towards pre-funding urban pensions to better serve its aging population. However, Beijing must take over payment of the legacy pensions before current contributions can be properly used to fund future benefits.

 The legacy pensions were retirement benefits state-owned enterprises provided to their employees without regular contributions before 1997, a year when China established a contributory pension system managed by local governments. The system, which covers more than 280 million urban workers now, also incorporates the legacy pensions. Most local governments have found current contributions insufficient to pay for those benefits. The Chinese Academy of Social Sciences says account shortfalls have surpassed $330bn in 2011.

In the absence of major policy changes, China will be at a crisis point in as early as a decade, says Robert Pozen, a senior lecturer at Harvard Business School. Pozen is the former chairman at MFS Investment Management and recently contributed to a Paulson Institute policy paper on China’s pension system.

China’s working-age population shrank by 3.45 million people in 2012 and the Chinese population aged 65 or older will double by 2030. There will be fewer than 1.6 workers for every retiree by 2050. These demographic pressures will severely strain both the government-run pension system and the traditional family support of retirement. “Unfortunately a large amount of contributions that have been coming in from employers and the employees has been used to pay the benefits for the legacy era. Therefore they haven’t been using the contribution to build up funding for retirement benefits for the people that are in the current system,” Pozen says.

He adds: “You can’t have a good system operating as long as a large amount of the current contribution is being siphoned off to the legacy benefits. If we make the obligation explicit and transfer it out of the local and provincial governments to the central government, then the central government is really in a much better position to deal with it.”

Recently, China seems to be more open to pension reform. The Ministry of Human Resources and Social Security has reportedly made “big developments” in centralising the pension system, a step that some local officials object to for fear of losing their influence within the pension system.

Pozen says after Beijing takes over the legacy pensions, it should then be feasible to invest current contributions to fund future benefits. The transitional costs to pre-funding pensions are likely to hit several trillion dollars. But China, with a foreign exchange reserve of $3.4trn, is in a relatively “strong” financial shape and could allocate more resources, such as the proceeds from the initial offerings of state-owned enterprises, to pension funding, according to the policy paper.

National Social Security Fund, now entrusted to invest $16bn of pension assets from Guangdong province, can become the chief investor of the country’s pension assets. Pozen says it is “critical” that it moves away from low-return bank deposits and government bonds to a more diversified and balanced investment portfolio.
“The NSSF is a professional group. They could have a diversified global portfolio, more Asian portfolio. The returns are now being earned from bank deposits and government bonds are about 3% a year, it is below inflation. It is really not sufficient to support the benefits we want people to have at retirement.”

Pozen says he is hopeful the Guangdong programme will prompt the NSSF to play a much bigger role in the investment of assets.

To better face the pension challenge, China should also ease the one-child policy and gradually rise women’s retirement age to 60 to increase the size of its working-age population. In addition, it should expand tax subsidies for enterprise annuities, according to the policy paper. China must also develop enterprise annuities, a second pillar of its retirement savings similar to the 401k plan in the US, it adds.

Currently, only a fraction of Chinese companies has adopted enterprise annuities. There were 18.47 million account holders in 2012-about 6 percent of the participants in urban pension programmes. “The problem is there is very few tax benefits associated with that,” Pozen says.

To boost participation of enterprise annuities, the Chinese government could give tax credits to employers who contribute and exclude employee contribution from income until retirement. However, these incentives should be conditional upon holding funds within the account for a long period of time, such as 10 to 20 years, according to the policy paper.

“More participation in Enterprise Annuities would not only increase supplemental retirement savings, but also would create a class of long-term investors who could help move the Chinese stock markets from a “trading” approach to an “investment” approach,” the paper says.