New Pension Model      

When China began opening up around 30 years ago, the World Bank promoted a pension reform model aimed at reducing the role of the state's pay-as-you-go pension system and building a minimum poverty avoidance pension, while introducing funded individual accounts that would link earnings, contributions and retirement incomes. Starting first in Chile, the funded individual account was gradually rolled out in other Latin American countries and former Soviet bloc countries in the 1990s. China incorporated it in its current enterprise retiree pension model in 1997, and subsequent reforms in the United States, Australia, Sweden and Britain promoted adoption of defined contribution, individual accounts either as part of mandatory retirement or as a heavily subsidized form of private arrangements. The number of workers covered by these defined contribution-individual account arrangements already exceeds those in traditional benefit schemes in OECD countries, and the assets under management in DC schemes are expected to exceed those in defined benefit schemes by the middle of the next decade.

Even before the financial crisis broke out, new individual account pensions were drawing criticism. Chile's system had an advantage because it was launched during a period of high inflation, with a high nominal interest rate regime, which provided for a rapid, early accumulation of funds and helped diminish the impact of high administrative charges. However, schemes launched during the low inflation, low interest era of the 1990s have seen much lower accumulations. DC schemes that started in the late 1990s or early this century having been the worst performers of all, since there have been two downturns so far in this period, and both original capital and investment gains have disappeared.

China's Choice

At this critical juncture, China faces some hard choices over its urban enterprise pension system – choices with which it has been struggling for several years. One alternative is to make a wholehearted commitment to funding its individual accounts. In OECD countries, there is much talk of a second generation of individual accounts with features designed to mitigate some existing problems. These include automatic enrollments and automatic transfers to deal with the predicament created when not enough workers opt to join and many close their accounts when transferring jobs, and the introduction of life-cycle funds which expose contributors to higher return-higher risk assets during the early and middle working years but puts most of their assets into safer areas as they near retirement.
 
Even in Chinese provinces that have implemented the funded account, the system is far from having the character of a true individual account system. Investment channels are very limited, and there is no individual investor choice. There is a single accrual rate which is not necessarily based on the underlying performance of the fund. The funds are not even managed as a consolidated fund, being in part managed by the National Social Security Fund, provincial finance bureau and local finance bureaus, which may hold money in accounts before transferring to provincial authorities.

There also must be doubt over the capacity of the local administration and banking system to support individual account models. Perhaps most significantly, there is still a culture at social security departments that views IA funds as local government money and not participant money, and whose principal interest lies in mobilizing capital to invest in the local economy. All this sits very uneasily with the concept of a genuine individual account.

The second option is the Notional Defined Contribution (NDC) system, which replicates the individual account system but on a notional bookkeeping basis and is, in principle, the same system as currently exists in provinces where individual accounts have not been refinanced. The basic idea behind the NDC approach is sound; it avoids the need to accumulate large pots of money, which may in China already be adding to high savings rates. It is administratively cheap and does not require creation of an investment administration infrastructure (with the dangers of leakage and fraud in a funded scheme). And finally it relies on an observation, generally well supported by historic precedent, that the next generation of workers, even if less numerous, is wealthier than the previous generation and so can afford pay-as-you-go costs.

All this is true. However there are two problems with the NDC approach. The first is the absence of any significant reserve funding. The second problem is that it requires the Government to ensure annual accrual rates are sufficient to accumulate a decent retirement entitlement – something risk-averse governments wary of building excessive future liabilities are generally unwilling to do.

By pegging accrual rates to bank interest rates rather than earnings, the Chinese government has signaled it does not intend accumulation to benefit from wage growth, or commit to long term financial consequences of that decision. Therefore, NDC is an interesting approach, but one in which the short term needs of government finances (of which the present crisis is an example) will always be put ahead of the long term interests of retirees.

The third option is to remodel the current social pool defined benefit plus individual account scheme, as a partially funded DB scheme based on individual average lifetime salary with what is known as conditional indexation. Conditional indexation basically relates benefit adjustment to a fund's underlying value. If fund a value falls in relation to liabilities, benefits may not be adjusted at all and/or contribution rates may rise (as they recently did for Dutch funds). If asset values rise relative to liabilities, the fund may raise benefit levels, although always being mindful of the need to avoid locking in expensive commitments. Through conditional indexation, DB schemes offer much better risk sharing between current retirees and contributors, and between employees and employers.

Where can the funding come from? There are three main sources. Some municipalities with favorable demographics have already accumulated large social pools where a more positive approach to investment would, potentially, allow for large-scale value creation. Second, the Chinese government's massive holdings of foreign currency denominated assets allow for substantial injection of new capital into defined benefit funds established at provincial or "super municipality" level. Such injections of funds would have the welcome aspect of anchoring assets to meet existing liabilities and, at the same time, go a long way to remove the political problem of foreign exchange reserve (especially dollar) overhang. Third, as well as assigning a proportion of large state-owned enterprise shareholdings to the NSSF (which the government recently reinstated), the government could also make similar allocations to new DB funds. This would raise funding levels and broaden the influence of external shareholders on the boards of State Owned Enterprises – a very welcome development for improving their governance and sharpening their mandate to generate real returns.

These sources would not be enough to provide anywhere near full funding unless the legacy costs of pensioners retired since 1997 were removed and their pensions paid from taxation. But it would represent a start.

Finally there is also the major advantage of DB funds operating professionally that seek new investment opportunities, which may go some of the way toward addressing the current limitations of China's financial system: Creating a platform for recycling surpluses inside of China, and contributing to China's growth, not America's over-consumption.

As we know, the clouds of all financial crises have a silver lining. This one is no different. It presents short-term challenges and long-term opportunities. Slightly misquoting Shakespeare's Hamlet, we are now facing a question: Are these opportunities to be taken, or not to be taken?

Full article in Chinese: http://magazine.caijing.com.cn/2009-07-05/110193350.html