China & World Economy / pp.39-53 Vol.13 No.2 March-April 2005
Rethinking Pension Reform in China
Zhigang Yuan, Jin Feng
[Abstract] In line with advice from international financial institutions, China introduced a three-pillar pension system in 1997. However, it performs badly, with high contribution levels, the funded contributions being used for current expenditures, and delays in pension payments. The problems are often ascribed to the remaining elements of pay-as-you-go (PAYG) present in the system. This paper, however, argues that the advantages of a fully-funded system (FF) have been exaggerated. The higher relative return of the PAYG system in China justifies a PAYG pension system for China. It is argued that the problems of the Chinese pension system are not caused by the use of PAYG but by the need to finance transition costs and conditions particular to the pension system in China, notably incomplete contribution coverage, a low pension age, and a high replacement rate. It is these factors, and the rate of growth of output, which determine the viability of the Chinese pension system.
[Key Words] pay-as-you-go, pension reform, productivity
I . Introduction
In the last decade, social insurance has been undergoing a process of reform in both developed and developing countries. Old age pensions have the broadest coverage and frequently the largest cost of any program in the entire social insurance system, and in many countries have become or threaten to become a major burden on public finances. Hence they have been the subject of much discussion. Attention has been concentrated on the question of which system should be chosen: should it be a pay-as-you-go (PAYG) or a fully-funded (FF) system? Debate on the disadvantages of the traditional PAYG system has concerned such matters as demographic challenges, that is the secular trend in many countries of decreased total fertility rates and increased life expectancy, which affects the dependency ratio and has negative implications for the financing of PAYG; the crowding-out effect on savings, and hence the reduction in capital accumulation and slowing down of economic growth (Feldstein, 1974,1995; Kotlikoff,1979); and distortions to the labor supply and form of compensation due to the low return implied by PAYG (Feldstein,1996). In contrast, a FF system avoids the aforementioned adverse affects on the public finances from an aging population. Moreover, the contributions will be invested in stocks and bonds and thus the capital stock will grow as a result of contractual savings. However, the potential risks implicit in FF system, such as financial risk and inadequate regulation should not be overlooked. Also, FF system has no redistributive function, unlike PAYG.
In China, a national pension scheme is available for urban employees. The most recent framework for pension reform was established in July 1997.The new pension system includes three pillars: a pooling account to redistribute to all beneficiaries, compulsory individual accounts, and supplementary pensions offered by commercial insurance on a voluntary basis. The first pillar imposes a payroll tax of 17 percent (paid by employers) to ensure that employees who have worked more than 15 years have a replacement rate (i.e., pension as a percentage of average wage) of 20 percent. The second pillar (paid jointly by employers and employees) establishes an individual account for each employee. The contribution for this is 11 percent of an individual’s wage. After retirement, the employee gets a monthly benefit from this account of the accumulated value divided by 120. The target replacement rate of the first and second pillar taken together is 58.5 percent. In this system, about 60 percent of contributions will go into the PAYG system, while 40 percent will be channeled into individual accounts.
There are a number of studies which simulate China’s pension reform based on the rationale for a multi-pillar system (McCarthy and Zheng, 1996; World Bank, 1997; Wang et al., 2000). Their results show that the costs of the transition from a PAYG to FF are quite manageable, and several ways to finance the transition are suggested. However, reality is diverging from these projections. A number of problems concerning China’s pension reform have arisen. These include the heavy burden of contribution placed on those enterprises expected to finance the transition cost, which often leads to delays in the payment of pension contributions and outright evasion; the misuse of funds in the supposedly funded individual accounts, which remain notional, and the weak performance of financial markets, which have not generated a satisfactory return to the pension fund. It appears that the transition problems have been underestimated while the returns on private accounts have been overestimated. More research is needed to compare PAYG and FF under Chinese conditions, to consider to what extent the system should be mixed, and how to keep the system financially viable.
The following section discusses the choice of pension reform in China in a neoclassical economic framework by using the Pareto efficiency criterion, paying special attention to the dynamic efficiency of the economy and the relative return of the alternative pension systems. Section III is a continuation of the welfare analysis of pension reform focused specifically on the transition process, where the current situation in China is discussed. Section IV shows the advantages of a PAYG system under Chinese conditions. In section V, the relationship between productivity improvement and the ability of PAYG to absorb increased pension expenditures is simulated for China. The paper concludes with a brief summary of the advantages of PAYG in China.
II . Efficiency Analysis of China’s Pension Reform
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III . The Transition Costs of China’s Pension Reform
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IV. The Sustainability of PAYG
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V. Productivity and PAYG
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VI. Conclusion
In 1997 China adopted a three-pillar pension system for the urban population, with the first and second pillars implemented according to advice from the international economic organizations. Nevertheless, the pension system is currently in crisis. The level of contributions is high, the PAYG system has insufficient income to pay pensions currently due, and individual savings accounts have been used to finance current expenditures. The second pillar has become a (partially) nominally funded system, which undermines confidence in it and also undermines fiscal discipline.
The problems are not caused by PAYG as such, which has the advantages of universal coverage (for the group considered), poverty relief, redistribution, avoidance of capital market volatility, and low administrative costs. The problems are caused mainly by the financing of transitional costs and particular parameters of the system, namely a high replacement rate, poor coverage of contributors (particularly in the private sector), a high rate of growth of money wages, and increasing life expectancy not matched by an increasing retirement age.
Advocates of the Fully Funded system, based on the argument that since the 1930s the economies of the main industrialized countries have been dynamically efficient, argue that the introduction of a FF pension system is helpful to economic growth. The debate about pension reform has moved from its redistributive function to economic growth. However, in China the economy is in a state of dynamic inefficiency and the real interest rate is lower than the rate of growth of wages. Accordingly, a FF system is neither an efficient one now nor is it likely to be so in the foreseeable future. A mandatory PAYG system with wide coverage, low replacement rate and a redistributive function would benefit most of China’s urban population. The aim of such a mandatory pension system would be poverty relief and income redistribution, subject to keeping government commitments within its budget constraint. Financing pensions at a decent level for a growing population of retirees is basically a matter of ensuring that there is sufficient income for this purpose.