The Chinese authorities are pressing ahead with the implementation of a pension reform that is intended to build a sustainable system for all employees, according to Wang Dongjin, vice-minister of labour and social security.
The reforms are part of the transformation of communist China’s economy and society that began in 1978 with Deng Xiaoping’s modernisation drive, which he later summed up in an admonition to “build socialism with Chinese characteristics”.
There is a sense of urgency about the exercise. China’s population is ageing, due to the one-child policy, limiting couples to only one offspring, and improved healthcare. The size of the population and the generally low incomes level mean that a failure to put a functioning pension system in place in good time would not only result in a failure to offset the sort of demographic problems faced by many other countries but could also give rise to social disturbances. And Chinese governments have shown themselves to be unwilling to countenance any challenge that could destabilise the regime and threaten the current political system.
In the spring of 1994, pensioners took to the streets of Wuhan to protest against their shrinking pensions. According to a recent World Bank report: “Some observers see China’s 20m state pensioners as ready recruits for a major social protest movement.”
“We are faced with the challenges of a population that has been ageing since 2000,” Wang told a September conference on China’s pension reform, the International Seminar for China Pension Development/ the 2nd Forum for Corporate Annuity & Insurance Development in Dalian, which was co-sponsored by ING and Taiping Pension Insurance. “And the pace is appalling. The dependence ratio between workers and retirees is worsening and the urban working population will be surpassed by retirees by 2020.”
There appears to be no definitive figure for the potential fiscal cost of not reforming the pensions system. “Various figures are bandied about and they are all horrendous,” said one observer who preferred not to be identified. “But the implicit pension debt, or IPD, that is the present-day value of future liabilities, are the size of the black hole. It is completely unfunded.”
A report from market intelligence provider Access Asia1 noted that the government’s Development Research Centre estimated the national pension deficit in 1997 at CYN7bn (E708m) across 21 provinces, municipalities and autonomous regions and that in 1999 after the pension fund was extended to 25 localities, it had grown to CYN18.7bn and to CYN87bn by 2000. A recent World Bank report2 suggested that subsidies from central and local government budgets amounted to CYN31.84bn in 2000, CYN35.3bn in 2001 and CYN55.3bn in 2002. It also noted that “based on the existing pension provisions and under a no coverage expansion scenario, current IPD amounts to some 141% of the GDP for 2001, or approximately $1.6trn.” A 1997 World Bank paper estimated the net pension liability would exceed $1trn by the year 2010 and the Access Asia reported that the ministry of finance (MoF), which is funding the deficit, feared that the pension shortfall could reach CYN1.8trn by 2025.
But whatever the figure, the implications are of a magnitude to ensure that pensions have been high up the reform agenda for some time. A new pensions architecture that draws heavily on the example of the World Bank-recommended three-pillar system was outlined in 1997 as part of an overhaul of the social security system.
“In the old planned economy it was mainly the employees of state-owned enterprises who participated in pension schemes,” Wang told the seminar. “But the programme has since been widened.”
In fact, as the Access Asia report noted: “Under the planned economy, workers received their pensions directly from their work units but in the 1990s, the government switched to a system whereby individuals and their work units contribute towards the pensions in a national scheme. However, this has led to shortfalls, lack of contributions and – most damaging – corruption.”
This first pillar coverage was extended to include foreign-invested, private and other urban area enterprises, and in 2002 was expanded to bring immigrant workers drawn to urban areas from the countryside into the net. By 2003, some 155m people out of a total population of 1.3bn were participating in the basic old-age insurance scheme. Of these 116.46m were active employees who are required to contribute to a ‘social-pool-plus personal-account’ scheme for 15 years to qualify for an old-age pension. And there have been parametric reforms, including the lifting of the retirement age for men to 60 from 55, and although it is still 55 for women that is reported to be under review.
In addition, a reserve fund, the National Council of Social Security Fund, has been established. It receives funding from three sources: a variable amount from the general budget decided by the finance ministry each year, 10% of the proceeds from the state lotto has been ring fenced but is not a significant amount and, most significantly, a proportion of the shares from privatisation IPOs. Currently, the reserve fund has assets of around €17bn, and the government has pledged to increase funding significantly in the future. The local press has reported the target figure to be CNY700bn (€71bn), although it is not clear just how authoritative this is.
And in 2000 the shape of a second pillar segment was unveiled. Some companies, mostly large state-owned enterprises (SOEs) or those with a foreign participation, were already offering supplementary pensions to important employees. A recent survey by Watson Wyatt of 130 multinationals in Shanghai and Beijing found that 23% already provided a supplementary scheme. “All sectors of the economy suffer from a lack of key managers, so they usually already have some tailor-made system in place,” says a foreign player in China. “This is either a sort of long-term incentive plan that has been organised by their employer with an insurer or they receive a substantial amount of cash every two or three years with which to make their own investments. But to be honest, nobody cares about the rest of the employees.”
But the new structure, notional defined contribution funds known as enterprise annuity schemes or corporate annuity pensions, are intended to fill the gap between the minimal state pension and a decent post-retirement income.
They have been piloted in three provinces in China’s depressed north-east, starting in Liaoning in 2001 and subsequently trialled in neighbouring Jilin and Heilongjiang, based on different models that use either government contributions or changes in the method of calculating the basic pension. “It is part of the revitalisation process for the rustbelt region, resulting in adjustments to local government budgets, improving the collection of benefits and establishing uniform procedures,” said vice-minister Wang.
For members, the schemes are intended to provide an accrued benefit that is portable between employers, contributions from both the employer and employee that are immediately vested in those of the employer and a final benefit that is only payable on reaching the statutory retirement date.
And the most notable feature of the new model is that it is wholly operated, managed and administered in the private sector. Pension services have been ‘unbundled’ into four functions – those of a trustee, an investment manager, a custodian and an administrator – the intention being to provide an element of transparency. The regulations require that these functions be performed by appropriately capitalised China-domiciled entities.
In August, in preparation for the system’s eventual roll out across China, some 37 licenses were granted to perform these roles from 126 applications. Financial services companies, many being joint ventures between Chinese and western groups, are jockeying for position in anticipation of another tranche of licenses being granted in the not-too-distant future.
The custody licenses were awarded to the six banks already approved to perform the role for securities investment funds. The administrator function is seen by some as the Cinderella role, as the fees for the service are capped and there are suggestions that they will barely cover the costs involved. The prime roles are those of trustee and fund manager.
Local insurers, including Taiping and Ping An, have established pension fund units to rebundle the non-custody functions. Last month China Life, which has some 60% of the local life assurance market and had already established an asset management company, announced it intended to form a pensions subsidiary. It had been awarded administration and fund management licenses but not a trusteeship. Others, including Generali China, a joint venture between the Italian insurer and local petroleum group CNPC, are also planning to launch a pensions business.
“We have two licences,” says Ong Lean Wan, general manager of Taiping Pension Co Ltd, a joint venture between Taiping and Belgian-based financial group Fortis. “We were among the first group of financial institutions that were granted licences, and we have been given the two most important – we are one of the five organisations to be awarded a trustee license and we also have a fund manager licence. This is a brand new industry and the number of players is relatively small, and although at the beginning the market size is quite limited you don’t have to be a rocket scientist to see that in a country of 1.3bn people the potential is massive.”
Indeed, the potential is huge but there are also many challenges. The first key factor is that the scheme is not mandatory and the second is that the enterprise annuity schemes carry no tax incentive.
“The authorities felt that they could not make the pension schemes mandatory because companies already pay more than 20% of their wage bill towards the social security system, it varies substantially from province to province, and to demand extra amounts would be to impose an unacceptable burden,” explained a Chinese attendant at the Dalian seminar.
But the lack of compulsion is definitely a challenge, concedes Ong. However, he is optimistic. “We have talked to several of our existing clients and we have noticed that once they understand the benefits and the workings of the occupational pension schemes they are pretty supportive,” he says. “And they do see it as beneficial for the companies as well as their employees because many firms, especially the large state-owned enterprises, have huge numbers of employees, often a few hundred thousand. And they feel that if they don’t put the money aside now to fund their employees’ pension needs the problem will just be compounded because a lot of SOEs already have a lot of retirees that they have to support on a pay-as-you-go basis.”
Getting current pension clients to switch to the new corporate pension schemes is also Ping An’s strategy. “We already have existing pensions insurance contracts and of course in the early stages of the new enterprise annuity pension funds we believe that there will be co-existence with the earlier forms of pension policies,” says Wang Liping, chairman and general manager of Ping An Annuity Insurance Company of China. “But we will now focus on selling the new enterprise annuity pension funds, for which I see great potential, although not in the first one or two years. It takes time.”
Ong also sees the lack of a uniform national tax policy to encourage companies to set up second pillar occupational pension schemes as a major drawback. “But then this is normal for a developing country and I am sure that the appropriate policies will be introduced as the industry develops,” he says. And he underlined the point in his address to the Dalian seminar. “With the decrees of the ministry of labour and social security in 2004, regulations in the provincial and municipal policy area are becoming quite developed, except in the area of tax incentives,” he said. “A unified national taxation system for occupational pensions must be established.”
Wang of Ping An agrees with Ong. “We need a nationwide tax incentive policy, we just have some provincial incentives,” she says. She notes that a tax incentive is being offered to enterprises with existing pension funds to encourage them to switch to the new system but adds that the size of the incentive has direct implications for the strength of the system. “To encourage companies to set up such a plan the authorities allowed contributions of 4% of a company’s annual salary bill to be tax free. This will not only have an impact on the companies’ enthusiasm about whether to establish a scheme or not but also in terms of their contribution rate. For example, if the tax-free rate is set at 4% a participating company might just decide to give 4%, but if the incentive were set at 8%, a company might be willing to pay 8%. Consequently, this 4% or 8% could determine the rate of contributions a company would be willing to make.”
Ong raised this point in his seminar address, saying: “The 4% tax deductible rate is not enough, I suggest we should increase it.”
Campaigning to influence government policy is a delicate exercise in China. The formation of a non-governmental association that formulates proposals that by the nature of the exercise implies criticism of government policy is not encouraged. But conferences at which foreign guests can detail their experiences are a welcome occurrence. And if local players take the opportunity of the attendance of high-level officials to make spirited representations for policy change, so much the better. And that was clearly an aspect of the Dalian seminar that should not be overlooked.
“This is a lobbying exercise, this is how we do it,” said one local player. “And the fact that there is such a high level of attendees indicates that the authorities are willing to listen. It was the first time that such senior officials had been brought together to discuss the issue. There have been high-level representatives at discussions before but never all together.”
“Of course, private sector participants should actively communicate with the government, the authorities, their clients and so on,” says Ong. “I think it’s our duty. And once this system is fully developed it will be to the benefit of the country.”
And foreign entrants to the market also see the benefits of such an approach. “What we see here is a coalition of the willing in that it brings together a company like ours that has a story to tell and a long-term interest to defend with a regulator, the CIRC, that is very interested to increase awareness of these issues, a city government, Dalian, that believes that it has the potential to become an attractive location for many of the services that will be established over time, and people from all over China that see an opportunity in such a development,” Alexander Rinnooy Kan, chairman of ING Insurance Asia/Pacific and co-host of the Dalian conference, told IPE. “Of course the numbers are very modest right now but if you look ahead and if you believe in the liberalisation process that takes place then sooner of later something enormous will grow here. From the start we have tried to establish ourselves as a company with a long-term interest in China and, as both a company and as a member of various delegations and conferences, eager to share insight and experience with a government that is obviously ready to accommodate growth opportunities that is sees but at the same time aware of its own inexperience in certain domains, for instance issues around appropriate regulation. And in return we have benefited from a lot of goodwill and an opportunity to be among the first allowed to move into these domains.”
And Ping An’s Wang feels there is the possibility that the tax situation will change. “So far this decision rests with the provincial authorities,” she told IPE. “Currently, the central government is carrying out research on a tax-incentive policy and that might be implemented nationwide.”
“My understanding is that the Chinese government accepts the need for a tax incentive but that the details and whether it will be a national or provincial responsibility still have to be settled,” Rinnooy Kan says. “It’s early days yet but I’m sure that as soon as the authorities have recognised that clarity and predictability is necessary so that companies get a real incentive to make it work, it will receive very high-level attention and be sorted out.”
Ong also highlighted another issue: “Restrictions on investment are rigid,” he told the seminar. “We want more flexibility.”
Regulations require pension fund assets to be invested in Chinese instruments. “Part of the challenge facing the pension fund and trust fund industry in China is that it does not have a mature capital market to work with,” says another foreign observer. “If you look at UK or US pension funds most of the assets are invested in stocks or bonds. In China, because the stock market has performed very badly since 2001 and because of questions about transparency and other governance issues, a significant portion of the staff of pension fund and trust fund companies is involved in finding almost private equity projects, so indirect funding of provinces, what we in more mature markets would see as venture capital or merchant banking-type of activities because they have more money than they can feel comfortable in putting into the stock market. So one of the issues is the depth and the breadth of the stock and bond markets.”
“Part of the problem is that the stock exchange was created not primarily to enable listed companies to gain funding for development, modernisation or expansion but as a means of relieving state-owned banks of the funding risk of often-bankrupt SOEs by spreading it throughout society,” says Michael Shelley, a Shanghai-based independent adviser engaged in development of applications of trust law and provision of pensions administration. “Only 30% of issued stocks were tradable ‘A’ shares, the rest being held by various state entities. As well as diluting shareholder value an allowing various malpractices, this has given rise to fears that the non-tradable shares could be dumped on the market to fund the state pension black hole and has raised questions about their fair value at a time when it became evident that blue-chip IPOs favoured foreign rather than domestic listings. At the end of 2004 the Shanghai Stock Exchange estimated the capitalisation of traded shares in China at around $140bn compared with that of Chinese companies with an overseas listing at about $260bn.”
Requiring local pension funds and other investors to invest in China is seen as part of the government strategy to stimulate the domestic equity market. Indeed the authorities, or rather part of them, are clearly willing to change the rules to facilitate such a revival. Until recently banks could not hold stakes in fund managers, and this exclusion was backed by the China Security Regulatory Commission (CSRC), which regulates fund managers, but was resented by banks. But in an evident attempt to strengthen institutional investment in local equities the government has lifted the ban on condition that banks form fund management joint ventures with foreign partners.
But the shift on banks touches on other challenges that are inherent in China’s political system and so are more difficult to address, inter-organisational rivalries and a regulatory vacuum. With the proposed enterprise annuities arrangements being left to the private sector, it is not clear whether there will be any directly responsible regulatory body. And in the absence of a nominated regulator, all official actors have felt free to exert their influence. The enterprise annuities regulations have been issued by a number of bodies, including the ministry of labour and social security (MOLSS), the China Insurance Regulatory Commission (CIRC), the CSRC and the China Banking Regulatory Commission (CBRC), with an apparent understanding being that the overarching decision maker would be the MOLSS.
But the various organisations that have won enterprise annuity licenses answer to different financial authorities, for example the CSRC and the CBRC, which may interpret regulations differently. “This means that if I want to get one of these agreements I need first to get the prior approval of my authority and then apply to the MOLSS,” says a joint venture executive. “So in the future we will have to make two different kinds of reporting.”
And typically pension companies are set up by the provincial governments, which can highlight the different agendas between the centre and the provinces. The issue of tax is a case in point. “The finance ministry is in favour of having one tax system for all China, but some provinces are fully against this,” says a foreign China hand.
“Before I went to China I assumed that if Beijing asked anyone to jump then the question back would be how high,” says another China market player. “But when I got there I realised that there was a huge element of devolution in practice and the provincial barons seem to do pretty much as they like. It is really astonishing to be sitting in a conference with senior civil servants from Beijing and see them spring to their feet when the local party secretary walks in and then takes the floor and speaks to his own agenda.”
A local observer agrees. “We have an old saying that the mountains are high and the emperor is far away,” he says.
And provincial authorities appear willing to flout their independence even when they know they will come under the centre’s authority.
“Pension funds are set up through the provincial ministry of labour and social security, and when they set up the pilots in the three provinces the Liaoning provincial government took money out of the provincial individual accounts and used it to pay the basic pension,” says a foreign observer. “When this came to light the finance ministry was asked to replace the money and now there is a political struggle over who now controls that money. Liaoning has second pillar liabilities on its books that it has minimal funds to meet. The ministry has provided the funding, but to ensure that no more funds will be raided it insisted that the funds be ring fenced and said that it would give a portion of the money to the National Council of Social Security Fund to manage.”
Nevertheless, many of these issues are teething problems, even though they involve big teeth, and will be resolved as the scheme gets underway.
“We still need the government to pass the enabling legislation,” says Ping An’s Wang. “So far we have the regulation but we don’t have the law setting up the enterprise annuity pension funds. Also we are waiting for the operational details from the authorities.”
But she is confident that the problems will be ironed out. “Ping An sees the emerging enterprise annuity pension as a new profit centre and so we have a substantial commitment to this business,” she says. “It takes time to educate the decision makers within the companies. But we are not worried about the market, the market potential is certain. We just need to speed up the development of this new product.”
Ong is confident too. He told the seminar that a Taiping survey found that 81.6% of companies polled said they would consider setting up an enterprise annuity scheme, 10.5% rejected the idea and 7.5% had not yet taken a position. He added that the Taiping survey also found that 73.7% found the 4% tax incentive for switchers attractive, while “a majority of employees think that enterprise annuity schemes would have a stimulating influence on their job”.
But in his address to the seminar he warned the fledgling sector that it needed a governance mechanism. ”The objective would be to ensure the safety of retirement assets and to build trust in the complex legal relationship that is involved,” he said.
1 Pensions in China: A Strategic Briefing, Access Asia Ltd, 2001
2 China: Pension Liabilities and Reform Options for Old Age Insurance, World Bank May 2005.