China: Towards Chilean-type individual accounts

By Zhao Yaohui 

[The Asian Wall Street Journal, November 21, 2001]


Despite repeated reform efforts, China's urban pension system is in crisis. The dependency ratio of retirees to workers is rising, reflecting the rapid aging of the system's participating population as the state and collective sectors shrink, while enterprises are failing to fulfill their payment obligations. The solution to this crisis lies in strengthening property rights by giving workers direct control over fully funded pension accounts.

However, the government's response so far has been to shore up the existing, pay-as-you-go system by beefing up collection efforts and expanding coverage beyond the traditional state and urban collective sectors. So far, these measures have shown little success. Participating enterprises refuse to pay and the expansion of coverage is extremely slow.

This failure is due to two reasons. Pension administration agencies lack effective collection instruments and the incentive to enforce the collection. And individuals and businesses lack incentives to participate and make full contributions.

At present, the enforcement is contingent upon collection efforts by local governments, mainly at the municipal and county levels. Pooling pension funds at the provincial level means local firms and
governments lose nothing by shirking their responsibilities.

Thus the only way to solve the crisis is to give individuals incentives to participate. This means putting all pension contributions -- from both employer and employee -- into individual accounts and making sure is entitled to 20% of average local wage at retirement as long as he contributes for at least 15 years. In the jargon of economics, the marginal benefit of contribution above the minimum requirement is zero. Therefore, even if a person is forced to participate, his rational action is to minimize his contributions.

China's central government has been putting pressure on firms to solve the problem of evasion and noncompliance. However, since the pension contribution is a form of tax in the current system, employees have no incentive to help the government. But if individual workers had full incentives to participate, then they would monitor the payments on behalf of the government, and it would be extremely difficult for employers not to contribute.

How would a transition to such a system of fully funded retirement accounts be accomplished? A common concern is that current workers would face a double burden -- simultaneously accumulating funds in individual accounts and paying for the current generation of retirees. Fortunately, this is unfounded.

As long as the rate of return on investment is significantly higher than the growth rate of wages, then the required contribution will be far less than doubling the contribution under the pay-as-you-go system.Assuming that the growth rate of wages is 4% per annum, and the real rate of return on pension investment is 6%, workers would only have to contribute 12.3% of wages to secure a pension of 60% of wages, which is about the level expected in the current system.

The state will have to honor its obligations to workers who have already paid into the old system. A transitional pension payment plan would extend the payment period to until the last person in the old system dies. The period can be made shorter by giving workers recognition bonds that are redeemable at retirement, as was done in Chile. It can also be made longer by issuing long-term debt.

In 1996 the World Bank estimated the total size of the pension debt --the present value of pension obligations to retirees and workers who accumulated pension credit under the old system-- at about 50% of GDP. If GDP grows at 4% a year in the next 50 years, then additional taxation equivalent to 1% of GDP will be needed to pay off the pension debt within this period. Assuming that the wage rate grows at the same rate as GDP, and the urban labor force grows at 1.4% annually, this would require a payroll tax of 5.6%.

So the contribution level needed to make a transition to a fully funded pension system -- funding fully funded personal accounts and paying existing pension obligations -- totals 15.8% of wages. This is far lower than the current contribution rate of 24%.

It is possible to use payroll tax to finance the transition, but to ensure full participation it is more desirable to use general tax revenue, including the sale of assets to pay off pension obligations, and put all pension contributions from both employers and employees into individual accounts.

As an added bonus, with the pension funds clearly defined in terms of individual assets, the pension system can break free from the control of local governments and be handed over to professional managers. The central government has long recognized the danger of letting local authorities handle the pension fund management. Mismanagement and embezzlement are common. Yet the central government finds it difficult to impose discipline on local governments.

International experience has shown that a pension system is better managed by private companies that compete with each other under proper government regulation. A prerequisite for market competition is that individuals have the freedom to choose fund managers. This requires that pension funds be under individual accounts and all of the investment stays in the accounts.

This year, the central government initiated a new experiment in Liaoning province. As a promising aspect of the experiment, individual accounts will be made fully funded. To ensure that no diversion of funds take place, the management of the individual accounts will be separated from the pay-as-you-go pillar.

However, while making individual accounts fully funded is certainly a step forward, the size of individual accounts has been shrunk to 8% of payroll from 11%, while the pooled portion of the pension has been expanded to 20% of payroll from 13%. Thus the system remains largely pay as you go, and the incentive problem in participation is likely to persist as well.

A pension system that is fully funded and based entirely on individual accounts is not only desirable, but also feasible. The sooner China embarks on this reform, the more affordable the transition costs are likely to be.


(Associate professor at the China Center for Economic Research at Peking University).


 

 

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