Pension Reform and Implicit Pension Debt in China

Pension Reform and Implicit Pension Debt in China Jia Kang, Zhang Xiaoyun, Wang Min, Duan Xuezhong (Institute of Fiscal Science, MOF). Evolution of the Pension System for Enterprise Employees in China. Pension system for enterprise employees before the economic reform in 979 China s pension system for enterprise employees was originally introduced at the very beginning of the 950s when the country was faced with heavy financial difficulties less than two years after its establishment. The regulations on labor insurance in China enacted by the State Council on February 95 stipulated that workers could have access to material assistance when they suffered from aging, illness, death, and disability. The interim rules on dealing with retirees issued by the State Council in 958 made single legislation of the system. According to The regulations on labor insurance in China (amended twice in 953 and 958 respectively), enterprises or employers should pay into a labor insurance fund a total of 3% of total wages which were managed and allocated nationwide by the People s Bank of China (entrusted by the All China Federation of Trade Unions). This practice was virtually a pay-as-you-go type. The opinions on the reform of financial management of state owned enterprises (SOEs) promulgated by MOF on February 969 made it unnecessary for SOEs to pay labor insurance fees instead of deducting them from enterprises profits. Accordingly, the social insurance fund was abolished. Enterprises had to raise labor insurance fees on their own, and a pension fund that could be flexibly allocated nationwide did not exist any longer. Simultaneously, institutions for managing social insurance work were abolished, and the pension insurance had become enterprise insurance. The interim rules on retirees and the interim regulations on arranging old and disabled cadres issued by the State Council in 978 had further provided details on the retirement procedures of cadres from government agency, enterprises and administrative units..2 Pension system for enterprise employees after the economic reform in 979 China s urban pension system prior to the 980s was characterized as an enterprise pension. With the deepening of economic reform since 980s, such practice gradually became financially unsustainable. Enterprises run a substantial pension burden out of historical reasons which had done tremendous harm to economic development. On the other hand, some enterprises could not afford to the heavy pension burden caused by the drastic growth of retirement population which had severely damaged the enthusiasm of employees and rendered the society unstable. Some enterprises could

be reduced to bankruptcy if this flawed system continued to operate. Under such circumstances, Chinese government launched a series of adustments since the 979 economic reform with an attempt to improving the pension system. () Social pooling pilot programs for SOEs employees were carried out in some locations from the early 980s. In 984, several cities and counties in Guangdong, Jiangsu and Liaoning provinces initially conducted such pilot programs. In 986, the social pooling was expanded to the whole country. Labor departments was responsible for setting contribution rates and collecting funds while enterprises was responsible for paying benefits. (2) The interim regulations on implementing labor contract system in SOEs enacted in 986 by the State Council had established labor contract pension system, which covered all the newly hired workers in SOEs. The regulation stipulated that the contribution rate for enterprises is about 5% of total wage bill. Newly employed workers should contribute 3% of their wages. (3) In 990, the calculation of pension benefits was changed by the Ministry of Labor therefore the basic pension consisted into two parts. The first part was based on local average wage; and the second part was based on workers length of work. Also the labor insurance agency was set up in each local area. (4) The decision on reforming pension system for enterprise employees promulgated by the Stated Council in 99. Under this regulation, pension should be co-financed by the state, enterprises and individuals. A three-tier pension system was required by the State Council, which was a basic state pension, an enterprise supplement pension and an individual pension based on personal saving. At the same time, some localities piloted social pooling combined with individual accounts. (5) The circular on deepening the reform of pension system for enterprise employees issued by the Stated Council in 995 clearly defined the direction, principle, main tasks and aim of the reform. The aim of the reform was to build a pension system that is characterized with wide coverage, multiple sources of financing, social pooling plus individual accounts. The circular suggested two schemes of practical meanings for localities to choose. In practice, many local governments created a new scheme on the basis of the two plans recommended by the State Council. The first scheme was designed to establish an individual account amounts to about 6% of wage bill, including the total individual contributions(the contribution rate is 3% at the beginning, ultimately reaching 8%), total contributions by enterprises according to a certain contribution rate and contributions by enterprises as 5-6% of local average wage. The pension benefit is a monthly pension payable from the individual account calculated by dividing the accumulated account balance at retirement by 20. This approach was adopted in 7 pilot locations including Shanghai. The second scheme stipulated that the individual account consisted of 5% of wage bill, including total individual contributions and enterprise contributions that exceeds (200-300%) local average wage, the rest of enterprise contributions was transferred to social pooling. The basic pension consisted of three parts: (ⅰ) a social pension equals to 20-25% of local average wage; (ⅱ) a yearly pension calculated by.0-.4% of indexed monthly average wage; (ⅲ) an individual account pension calculated by dividing the accumulated account balance by 20. Five locations including Beiing followed this option. 2

(6) The decision on unifying the pension system for enterprise employees released by the State Council in 997. Due to the variation of the plan adopted by the local governments, the State Council realized the problem. Therefore the 997 reform aimed at unifying the pension system throughout the country. (7) The pilot reform on improving urban social security system was launched in 2000. The State Council required that the individual account should be fully funded. Liaoning province was selected to poilot the reform. Because the Liaoning practice was successful another two provinces including Heilongiang and Jilin started to follow the Liaoning practice. 2. The Current Pension System and Implicit Pension Debt (IPD) 2. The current pension system for enterprise employees The decision on unifying the pension system for enterprise employees released by the State Council in 997 is regarded as the guideline of the current pension system reform. Its main points are as follows: () Contribution rate: Enterprise contribution rate should not exceed 20% of total wages. Individual contributions will started from 4% in 997 to 8% with % percentage of increase in every two years. (2) Individual account: The individual account is set to be % if total wag bill. 8% is contributed by the individuals and the remaining 3% is paid by employers. (3) Level of benefits: All pension participants is devided into three types, ie., oldmen, middlemen and newmen. For Newmen 2 one that has an accumulated contribution time span of 5 years can monthly attain a basic pension after his or her retirement that consists of a social pension (20% of local average wage) and an individual account pension (calculated by dividing the accumulated account balance by 20). One whose year of contribution is less than 5 years can not enoy the basic pension. Middlemen will receive an additional transitional pension 3 on the top of the basic pension and the individual account pension. The benefitsof oldmen is still paid under the regulation before the 997 reform. 2.2 Implicit pension debt is a threat to pension reform Based on the experience of other countries, China has adopted a new system which is a combination of pay-as-you-go and fully funded individual account. However the implicit pension debt (IPD) is a problem that the government has to face. 2 New men refer to employees who are hired after the release of The decision; Middle men refer to employees who are hired before the release of The decision and can have an accumulated contribution time span of 5 years at retirement; Old men refer to employees who have retired before the enactment of The decision. 3 Transitional pension was aimed to benefit those who can not have access to an individual account, especially for middle men. 3

Some scholars and pension institutions have estimated the volume of outstanding implicit pension debt but generated different results, ranging from about 000 billion yuan to 3000 billion yuan. The variation of estimated results is due to not only the definition of IPD but methodology including model and data. Table : Estimation of IPD by Researchers and Pension Institutions Social Security World Bank Institutional Guo shuqing Fang haiyan Institute, Ministry of Reform Office Labour Date 995 996 2000 994 997 Result 2875.3 billion yuan 97.6 billion 674.5 billion 050.0 billion 3508.2 billion yuan yuan yuan yuan Samples National population Shenyang, Naning State economic NA census Shanghai units Methods Actuarial estimation Actuarial Actuarial Simple estimation Actuarial estimation estimation estimation Source: He Ping, Estimation report of China s pension fund, Social Security System, 200.3. 2.3 Alternatives in dealing with implicit pension debt From international perspective, there are two ways to resolve IPD. The first approach is that transition cost is entirely covered by budget resource. For example, In Chile IPD is entirely financed by budgetary surplus. Under the second approach, part of the transition cost is covered by budgetary funds and the remaining cost is paid through pay-as-you-go system. This method is used in Argentina, Uruguay, Peru, Poland and Hungary. Three options are suggested to deal with the IPD in China. They are using budgetary surplus, increasing budgetary revenue, cutting budgetary expenditure and adusting pension parameters. The parameters include rate of contribution, level of benefit, pension coverage and retirement age, to name but a few. 3. The Estimation of Implicit Pension Debt The next part of this report is going to estimate the magnitude of IPD for China. It consists five parts. Section 3. gives the definition of IPD of this report. Section 3.2 provides estimation assumptions and data source. The estimation model and proected results are presented in Section 3.3 and 3.4. The impact of extending retirement age on IPD is also analyzed. The last section concludes. 4

3. Definition of implicit pension debt According to pension economists, IPD is the commitment of a pension system to pension participants. It is measured by the accumulated pension rights of retired workers and current workers under the old pay-as-you-go system. In other words, IPD is calculated by the present value of total pension obligations to current pensioners (oldmen) and current contributors (middlemen) if the old pay-as-you-go system terminated. We assume that the old system terminated at the end of 997. Under the assumption, middlemen and oldmen are the only determinant factors of the IPD. Benefit for an oldmen is calculated based on his wage in the year before retirement. It is adusted according the growth rate of social average wage (K). A middlemen will receive a transitional pension in addition to a basic pension and a pension paid from funds accumulated in his individual account. The basic pension, which is 20% of social average wages, is paid through social pool. The transitional pension is adusted according to the years of his work before year of 997. In our calculation individual account pension does not constitute IPD. There is no calculated IPD for newmen either. The estimation period is between 2007 and 2057. The latter is the year that the last middlemen will pass away. 3.2 Estimate assumptions and Data source () Population: The number of pensioners including oldmen and middlemen is calculated by the national population distribution by age and sex. Population death rate for each age is used to work out the probability of survival for each age group of pensioners. (2) Growth rate of social average wage: we assume the social average wage growth rate (K) to be 8% and it keeps stable during the proection period, which is from 2007 to 2057. (3) Discount rate: It is assumed that the interest rate (i) is 3%. (4) Other data: The retirement age is 60 for men and 55 for women. The life expectancy is 80 for both men and women. The longest time span for receiving benefits is 20 years for men and 25 years for women. (5) Adustment parameter of transitional pension (a) is.2%. (6) Benefit adustment ratio (m) is 0.5. 3.3 Establishing the model () Formula to calculate the IPD for non-retired middlemen In 2007, the present value of the basic pension for non-retired middlemen at the age of x (30 x 60) is: 5

60 x 60 x ( ) ( ) Α x= 0.2W + k v p p + k v 2006 x= 60 60+ = 20 Where, W 2006 is the social average wage of 2006, k is the social average wage growth rate, v(v=/+i) is the discount factor, 60 is the retirement age for men, p x = 60 is the probability that a non-retired middlemen at the age of x can live until age 60, p 60 + is the probability that non-retired middlemen at the age of x can live until age 60+. It is assumed that the longest time span for men to receive pensions is 20 years. In 2007, the present value of the transitional pension for non-retired middlemen at the age of x (30 x 60) is: 20 60 x 2007 x= 60 60+ = Bx = a( x 30) W ( + k) p p v Where, a is adustment parameter of transitional pension. It must be noted that the amount of contribution after 997 does not consist IPD therefore should be subtracted from the basic pension. Assume the average working length for male workers is 40 years, the total present value (C) of IPD for non-retired middlemen in 2007 is: 60 x 30 C = L2007, x Ax + Bx x= 30 40 Where: L 2007,x is the total population of non-retired middlemen at the age of x in 2007. (2) Formula to calculate the IPD for retired middlemen The present value of the basic pension for retired middlemen at the age of x (6 x 69) in 2007 is: 80 x X 60 x = 0.2 2006 ( X 60) ( + ) 60+ ( + ) = D W K p k v The present value of the transitional pension for retired middlemen at the age of x (6 x 69) in 2007 is: 80 x = ( 30) E a x W p v x 2007 ( X 60) 60+ x = The total present value (F) of IPD for retired middlemen in 2007 is: 6

69 x 30 F = L2007, x Dx + Ex x= 6 40 (3) Formula to calculate the IPD for oldmen 80 x = Gx = T Π ( + mk ) p v 2007 70+ r= Where: T 2007 is the average pension for retirees in 2007, m is the pension adustment ratio (0 m ). The total present value (H) of IPD for old men in 2007 is: 80 H = L2007, xg x= 70 x (4) The formula to calculate total IPD is: 60 69 80 x 30 x 30 Z = C + F + H = L Ax + Bx + L D + E + L G 2007, x 2007, x x x 2007, x x x= 30 40 x= 6 40 x= 70 The same idea is followed to establish the formula for female workers. 3.4 Estimated results () The amount of IPD Based on the model and data presented above, this report has estimated every year s IPD from 2007 to 2057 (Figure ). Figure : Total IPD from 2007 to 2057 2.5 thousand billion 2.5 0.5 0 2007 200 203 206 209 2022 2025 2028 As is shown from Figure, total IPD will have experienced an upward and a downward trend respectively over time. In 2008, total IPD will have reached its 203 2034 IPD 2037 2040 2043 2046 2049 2052 2055 7

maximum amount that is about 960.7 billion yuan. During 2007 and 205, it is around 900 billion yuan every year. Since 2035, the total IPD starts to decrease and end in 2057 when the last middle men s life terminates. (2) Composition of IPD As stated earlier, IPD is comprised of IPD for middlemen and IPD for oldmen. It is shown in Figure 2. Figure 2. IPD for middle men and IPD for old men from 2007 to 2057 thousand billion 2.8.6.4.2 0.8 0.6 0.4 0.2 0 2007 20 205 209 2023 2027 203 IPD for middlemen 2035 2039 2043 2047 205 2055 IPD for oldmen It can be seen from Figure 2 that the IPD for middlemen constitutes the dominant proportion of total IPD. It has been noted that in our calculation the population of middlemen and oldmen is one of the key elements that affects the estimated results. The larger amount of middle men contributes to a larger amount of IPD for this group of pensioners. The estimated IPD for old men will terminate around 2022. However for middlemen it starts to decrease after reaching to its maximum amount of 89.2 billion yuan in 205. (3) Pension payments each year It is also necessary to compute the pension expenditures every year since it has implications for treasury budget. It is a reflection of total pension obligations that a society has to pay to pensioners, and also an important element to measure financial pressures that the government has to face. The distribution of pension debt to be paid in each year from 2007 to 2057 is shown in Figure 3. It is stable in the first 2 years around 30 billion yuan than begins to move upwards in 2020. It does not show a declining trend until reaches the peak 54 billion yuan in 2040. 8

Figure 3. Distribution of pension expenditures from 2007 to 2057 60 50 billion 40 30 20 0 0 2007 20 205 209 2023 2027 203 2035 2039 2043 2047 205 2055 pension payment per year 9

(4)Implications of retirement adustment Pension obligations in a year depends on various factors including the number of retired workers in that year, social average wage and its rate of growth, pension adustment parameters and life expectancy etc. Under the assumption that the retirement age is increased in the year of 205 to 65 for men and 60 for women, total IPD will be reduced by 95.5 billion yuan. The pension expenditure for that year can be cut by 7%. In the time period of 205-203 and 2040-2057, pension payment is lower compared with the same period when the retirement age is unchanged (Figure 4 and 5). Figure 4. Pension expenditures before and after the adustment of retirement age 60 50 billion 40 30 20 0 0 2007 20 205 209 2023 2027 203 age unchanged 2035 2039 2043 age changed 2047 205 2055 Figure 5. The difference of expenditure before and after age adustment billion 8 7 6 5 4 3 2 0 - -2-3 205 208 202 2024 2027 2030 2033 2036 the difference 2039 2042 2045 2048 205 2054 2057 Note: The positive figures are the decreased amount of pension to be paid after the adustment of retirement age, while the negative ones represents the additional amount to be paid in the 7 years respectively. 0

3.5 Main findings and policy recommendations Based on the models and assumptions the report has estimated IPD for enterprises pension in China. Four conclusions can be drawn: Firstly, in the estimation period of 2007 and 2057, total IPD increases first and decreases later. It has the highest amount of 960.7 billion yuan in 2008. After that it will decrease gradually until 2057 when last middle men s life terminates. Secondly, IPD is calculated by the present value of total pension obligations to current pensioners (oldmen) and current contributors (middlemen) if the old pay-as-you-go system terminated. The estimated IPD for old men will terminate around 2022. However for middlemen it starts to decrease after reaching to its maximum amount of 89.2 billion yuan in 205. Between 2007 and 2057, as the number of retired middlemen increases for a period of time than starts to decrease, the total IPD displays a similar trend. Thirdly, the distribution of pension expenditures each year is stable at around 30 billion yuan in the first 2 years and than begins to move upwards in 2020. It does not show a declining trend until reaches the peak of 54 billion yuan in 2040. Finally, when the retirement age is increased in the year of 205 to 65 for men and 60 for women, total IPD will be reduced by 95.5 billion yuan. The pension expenditure for that year can be cut by 7%(4.2 billion). Alleviating the large IPD burden is of key importance for the financial sustainability of the new pension system. Recommendations available in this report are as follows: () Resolving the huge IPD is critical to not only the basic living conditions of urban retirees, but also the sound operation of the new pension system and social stability. From an international perspective, although technological options employed to cover IPD vary across countries, there is a growing consensus that government should assume the leading responsibility. Therefore, Chinese government should place greater emphasis on coping with the IPD issue. Relevant policies and regulations should be studied and reasonable solutions be arranged early before any problems could emerge. (2) The current pay-as-you-go plus fully funded individual account pension system is established according to China s economic and social conditions combined with international experiences. The new system has made an advanced move than the past. Any future move in reforming the system should be prudent and within the current framework. This can be done by modifying carefully system parameters. Experience from other countries and pilot programs are important to IPD alleviation and a sustainable development of the pension system. (3) Increasing retirement age can somehow reduce pension expenditures and alleviate total IPD. However, when considering the employment pressure now and in near

future, change in retirement age may not be a sensible choice. A high unemployment rate may become the cause of social conflict. If the government has in deed to extend retirement age, other social and economic reforms should be taken into account. (4) To properly deal with the IPD issue, the government should make use of public resources from every channel in order to raise sufficient funds for paying pensions. Responsibilities of pension expenditure should be clearly defined among each level of governments. Only by doing that can social conflicts be avoided and a harmonious society and sustainable economic development be achieved. References. The World Bank (997.9),"Old Age Security:Pension Reform in China",WB,Washington D C. 2. Jia Kang, Adusting Composition of Fiscal Expenditures Is an Important Way to Reduce IPD, Public Finance Research, June, 2000. 3. Song Xiaowu, Report on China s Social Security System Reform and Development, Renmin University Press, September, 200. 4. He Ping, Estimation Report on China s Pension Funds, Social Security System, March, 200. 5. He Ping, Social Security System in Enterprise Reform, Economic Science Press, July, 2000. 6. Wang Xiaoun, China s Pension System and Its Comment, Economic Science Press, February, 2000. 7. Huang Xiao, Actuarial Model of China s IPD, Statistics and Policy, December, 2006. 2