China's pension system urgently needs reform. In its current state, the system is saddled with a wide range of problems, including an increasingly aging population, low contribution rate, low coverage, fragmented management and a low return on investment.

China's pension system urgently needs reform. In its current state, the system is saddled with a wide range of problems, including an increasingly aging population, low contribution rate, low coverage, fragmented management and a low return on investment. [File Photo]

China's existing pension system is based on three "pillars" outlined in the 1991 proposal for pension plan reform for enterprise employees: a social security net (Pillar 0), basic pension insurance (Pillar 1) and supplementary pension insurance (Pillar 2). Under this framework, pension funds are sourced from the government, enterprises and individuals.

In 2000, the central government set up the National Social Security Fund (NSSF), to serve as a buffer mechanism to mitigate pressure stemming from gaps in the pension system. However, the 20 year-old system is still plagued with many problems that threaten its future sustainability.

The collection rate (ratio between contributors making payment on a monthly basis and the general number of contributors) has declined from 25.1 percent in 2008 to 17.1 percent in 2010, though the number of employees joining the basic pension insurance system is growing.

Compliance is low because the mandatory contribution rates for employers and employees are excessively high. At 28 percent of wages, the rate is almost the highest in the world. In addition, employees, especially migrant workers, often have to abandon their individual pension accounts when moving to another city, as the redundant administrative procedures make it hard for them to complete account transfers. These two reasons lead to most participants' reluctance to make regular contributions.

When the problem is measured from the perspective of China's demographic development, it becomes even worse. The most populated country in the world faces a serious aging crisis: the ratio of the population over the age of 65 in the total population is currently 9 percent and is expected to reach 30 percent by 2065. At the same time, the ratio of the population aged 15-64 will fall to 56 percent of the total population. This aging problem will eventually aggravate the burden on the pension system, with the number of pensioners soaring rapidly while the number of contributors grows more slowly.

China's pension system is also faced with the challenges of low coverage and fund allocation equity. About 45.4 percent of the income of elderly residents in China's urban areas comes from the basic pension insurance, while 37 percent comes from the residents' children and 2.7 percent from the other two pillars. Due to the lack of siblings to share the burden of taking care of elderly parents, much financial pressure is placed on the younger generation. In rural areas, the old are even more dependant on their children's financial support (54.1 percent of income) while 37.9 of income comes from their own field work. In contrast to their urban counterparts, rural dwellers are yet to be covered by a well-developed pension system.

More seriously, the dual-track pension system is also triggering great public discontent, as civil servants don't need to make contributions but still get covered by the state budget after retirement. At the same time, the replacement rate (ratio between pension and pre-retirement wages) for civil servants is as high as 80 percent, but only 40 percent for employees at private enterprises.

Challenges for China's pension system also come from its decentralized and fragmented management. As the labor force migrates more frequently, employees may pay contributions in one province, but receive their pension in another after retirement. As the basic pension funds are managed at the local level (provincial or municipal level), those provincial regions with greater labor force inflows will have a substantial surplus in their pension system, while ones lacking in contributions from in-service employees are often faced with a deficit.

In most cases, local governments, short of adequate funds, will use the reserves accumulated in the individual accounts (Pillar 1b) to pay the current pension claims supposed to be funded by the social pooling plan (Pillar 1a), despite the fact that the two are deemed separate and independent, thus turning the individual accounts empty.

By 2010, there was only 203.9 billion yuan (US$32.37 billion) in the individual accounts, rather than the supposed figure of 1.96 trillion yuan (US$0.31 trillion), creating a gap of a total of 1.76 trillion yuan (US$0.28 trillion) for the government to fill. This is why the central government has planned to carry out a centralized management on the pension funds presently controlled by the local governments, so as to diminish the local deficit through re-allocation of assets.

The return on investment for pension funds is also rather low. There's almost no market-oriented investment for the basic pension funds (Pillar 1) to ensure their sustainable development. As for the revenue structure of Pillar 1 funds, only 2.04 percent comes from interest, while 82.8 percent and 14.56 percent are supported by pension collections and financial transfers. The current pay-on-collection mode is rather fragile as it cannot sustain itself in the long run. The whole pension system may collapse if the collection amount cannot meet the ends, which may likely occur in the future.

As far as supplementary pension insurance (Pillar 2) is concerned, its investment returns are also far from being satisfactory. The weighted average return on investment was only 3.41 percent in 2010, far below China's inflation rate of 5.4 percent. A lack of competition is probably the culprit for the sluggish investment returns for this pillar, as there are only 11 fund management companies qualified to handle the pension funds, with five of them controlling 85 percent of the total assets in terms of value.

The last, but not least serious problem stems from the risks hidden in the management of the National Social Security Fund (NSSF). The average annual return rate for this fund was 9.17 percent between 2001 and 2010, higher than the return for Pillar 1 and Pillar 2. However, the strategic reserves highly rely on returns from the equity investment, which accounts for one third of its total assets, well above the average international level. This structure is undermined with high risk and may lead to high fluctuations in the funds market, as was proven by the case in which the NSSF scored substantial returns between 2005 and 2007 when the stock market was on a bull run, but plunged sharply in 2008 after the global financial crisis broke out, and crashed again in 2010. Therefore, it's vital that the asset allocation for the NSSF, as the state buffer mechanism, should be focused on achieving adequate and prudent returns.

The author is the chief economist of Haitong International Securities Group Limited.

(The article was published in Chinese and translated by Zhang Junmian.)

Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.