Policy recommendations: how to increase the incentives to participate

In document Pension Reform in China: Challenges and Answers (Page 92-95)

groundwork now in order to be able to accelerate the implementation of this reform measure in later years. At present, the government should strictly restrain early retirement and eliminate early retirement abuses. At the same time, flexibility in retirement ages can be supported by paying higher benefits to workers who retire at later ages. Early retirement increases expenditures by increasing the number of retirees. It also reduces the tax revenues generated by people in the labor force. As a result, reforms that increase the early retirement age, or impose reductions in retirement benefits for those who retire earlier, could reduce overall program costs in some cases by 20 to 50 percent. In the long run it is unwise to use early retirement to diminish the unemployment problem. This only shift the payment pressure from unemployment insurance to old age security.

Currently, a large part of pension expenditures represent legacy liabilities – i.e. payments to former employees of state owned enterprises whose careers occurred under the old economic system and who have not participated as workers in the current social security pension system for more than few years.

The implicit pension debt should be converted into explicit public debt. This means, the legacy liabilities of providing pensions to people who participated in the old system should be separated from the new system. It is appropriate to share the costs over many generations, since the benefits of the transition will be shared by many future generations64. Charging today’s workers at a high contribution rate to pay for all of the burden fo financing the legacy liabilities is not reasonable, which leads current workers to feel that they are getting a bad deal from the Social Security system and in turn tends to reduce the incentives to participate in the pension system. Converting the implicit pension debt into explicit public debt would enhance transparency and thus confidence in the system, thus raising incentives for a higher participation rate.

When funding the implicit pension debt, it it is important to diversify the sources of financing. The government could treat the debt as inherited national debt and use public borrowing to finance it at a low current cost. This is particularly true in China’s case because economic growth is rapid, implying that future generations will be much richer than current generations. There is no need to finance all of this debt as the obligations come due65. Instead, the interest on the debt can be serviced at a small annual cost so that the debt remains constant or gradually shrinks as a share of GDP over time.

However, using public borrowing as the only financing source could risk creating a “debt trap” in light of the rising dependency ratio in the next few decades66. It would also be possible to reduce the legacy debt by selling state assets, including SOEs, land, and foreign exchange reserves. China accumulated a large volume of state assets during the past decades. For example, a conservative estimate places the value of China’s SOEs assets at over USD1 trillion for 2001 (James 2002). These alternative revenue sources exist because China currently has a low national debt, high rates of national savings, and large international reserves. These conditions may not exist in the future. Therefore, it is important to move as quickly as possible to fully implement the new system so that it can be self-sustaining in the long run.

Transfer the state assets to the NSSF to finance legacy liabilities would be a right approach. However, capital markets in China are currently underdeveloped and not liquid. Sales of large volume of shares might disrupt the market, hurting both the NSSF and other investors. For these reasons, The shares transferred to the NSSF should not be allowed to sell until such time as both capital markets and corporate governance are on a firm footing in the future. Making the shares held by the NSSF non-tradable gives a strong signal to financial markets and government agencies that their purpose is to provide dividends to finance pensions.

8.2. Unifying the fragmented system

The decentralized set-up of the pension system leads to high fragmentation and significant intransparency. As only groundwork were set up by the central government while leaving the specifics

64 Feldstein 2006

65 Feldstein 2006

66 Deutsche Bank Research 2005

(i.e. policies and administrative issues) at the discretion of local authorities. This resulted in the fact that China’s pension system is a complex of hundreds of different pension schemes and polices applied in different regions. The fragmentation of the system is devastating since it creates labor immobility and economic inefficiency. Workers are less willing to move across administrative borders if they risk losing their old age insurance savings. A less mobile and flexible labor market, however, could be disadvantageous in the sense that it creates market distortions (wage differences might diverge further between provinces), and because it would make labor more expensive in some regions that could otherwise accommodate many more workers under conditions of greater mobility (Salditt, 2007). It also led to inequality across regions regarding the contribution rates and wage replacement rates.

Therefore a more unified pension system needs to be established in China to reduce the fragmentation of the system. This will involve a broader pooling at least at the provincial level, as stipulated by the pension reform document. In practice, most of the pools are still run at the municipal level. The pension system should be ultimately centralized at the national level. In addition, the government should take steps to encourage non-state participation. Pension coverage should be extended to all urban employees regardless of occupations and ownerships, including migrant workers. A unified system could help balance out regional and occupational inequities, enable better risk sharing, save administrative costs and improve the system’s administration.

This also involves issuing a national social security law. The pension system’s unification could be achieved by effectively implementing a national social security law. A national social security law can serve as a catalyst for accelerating the Chinese pension reform. Such a law will provide a legal framework under which a national pension system is provided. In this context, any evasion from the system is against law, thus it is expected to increase participation and coverage rates. In addition, passage of such law indicates government’s determination to conduct a serious pension reform at a national level, thus increasing public confidence in the system.

8.3. Strengthening governance of pension funds

One key aspect of the policy debate has been whether pension asset management should be regulated by quantitative criteria or by the so-called prudent person rule, which is a behaviorally-oriented standard. The debate is a significant one, because its outcome determines who – the state or the pension fund’s governing body – will be responsible for establishing the initial asset allocation parameters for pension investment activity.

China’s pension funds management have been troubled by Low interest rates, slumping stock markets and corporate bankruptcies, which have left many pension funds as well as the old age security of millions of pensioners at risk. Furthermore, in China, corruption has reduced public trust in pension funds, in particular, the social security fund scandal in Shanghai in earlier 200667 involving the misuse

67 In August 2006 investigators discovered that the Shanghai Social Security Fund had invested a large share (approximately one third) of its USD 1.25 billion fund in highly speculative real estate projects. This is clearly not in line with the investment guidelines of the State Council and it has been assumed that officials have personally benefited from these transfers. These circumstances partly explain the people’s reluctance to contribute to a publicly managed pension fund (Salditt 2007).

of retirement funds by officials have greatly reduced public trust in the ability of funds accumulated in individual accounts to serve as an effective investment for their retirement. To tackle loopholes in the pension fund governance, the government and MOLSS should strengthen the governance to guarantee the security of pension funds and should approve more detailed governance guidelines to guard against pension funds mismanagement. At the same time, regulations should be approved to minimize the influence of the local government by granting more power to the local branches of the MOLSS.

In document Pension Reform in China: Challenges and Answers (Page 92-95)