How China can strengthen its retirement pillars

Beijing has many challenges to building out its retirement system. Two of them are how best to build out the second and third pillars of the industry. It’s essential to do so, if the government wants to avoid mounting bills and growing impoverishment among its elderly.

The second pillar refers to defined benefit schemes, or pensions in which companies and individuals both contribute. The third is comprised of pension funds into which individuals solely invest.  

“It is critically important that China develops robust and fully funded occupational and personal pension systems – or second and third pillars. The pay-as-you-go financing model on which China now relies so heavily is not fiscally sustainable, given the rapid aging of its population,” Richard Jackson, US-based president of Global Aging Institute, told AsianInvestor.

The three pillars of a pension system having about the same assets under management (AUM) can help to ensure people from different backgrounds have proper pension arrangements. This is where Beijing wants to get to, said KPMG’s Zhang Howhow, director of global strategy group.

To do so, the MoHRSS is mulling to encourage corporate pension funds (part of the second pillar) to invest overseas to better spread investment risks and enhance returns. Now, they can only invest domestically. 

“When referencing international experience, starting overseas investment is an effective way to diversify risk and enhance yields,” Tang Jisong, director of the supervision bureau at the social insurance fund at MoHRSS, according to a media report by a unit of state news agency Xinhua in June.

Lu believes this change will help encourage the second pillar’s AUM to grow. “The success of the second pillar and third pillar depends on the investment return because they are commercial in nature,” he said.

Janet Li, Hong Kong-based wealth business leader for Asia at consultancy Mercer, is less enthusiastic. She noted that letting corporate pensions invest overseas should theoretically improve risk-adjusted return but will not necessarily raise returns. “Investing in a single market is riskier but the yield can be higher because of higher risk premium,” she told AsianInvestor.

Another impediment to growth has been a distrust of external asset managers. While the companies are not generally experts when it comes to investing, there is inadequate regulations covering enterprise annuities (EA) or occupational annuities (OA), the second pillar contributions from companies and civil servants, respectively. 

A lack of sufficient investing-related regulation has left many companies suspicious about external fund houses charging hidden fees for their services. Many have chosen instead to invest their pension funds via passive strategies, said Wu Haichuan, head of retirement business for Greater China at Willis Towers Watson. The MoHRSS is aware of these concerns, and has said it will introduce stricter guidelines in due course. 

In addition, companies and individual pension savers want to see more tax incentives and more investment choice, to better tailor pension plans to individual risk-and-return profiles – similar to the Mandatory Provident Scheme (MPF) in Hong Kong, Wu said. 

Introducing an MPF-like scheme would help build assets, because today’s second pillar is voluntary. If China wants success for pillar two, it should make it mandatory, or make it compulsory with an opt-out option, Li of Mercer said.

A FLEDGLING THIRD PILLAR

The third pillar of China’s pension system is the one most in need of development. To do this the country has turned to life insurers and fund houses, raising hopes of a major new line of business for the industry. 

A one-year tax-deferred annuity pilot scheme, initially in Shanghai, Fujian province and Suzhou Industrial Park in Jiangsu, was launched on May 1. The China Banking and Insurance Regulatory Commission gave at least 16 life insurance companies the green light to kick off annuities businesses.

Policyholders of pension insurance products will not pay tax on their contributions until they start withdrawing funds after retirement, subject to a cap: the lower of Rmb1,000 or 6% of their monthly taxable income. When they start using the funds in retirement life, 25% of the withdrawn amount will be tax-deductible, with the rest taxed at a flat rate of 10%.

Meanwhile, the China Securities Regulatory Commission gave 14 asset management companies approval to roll retirement products out in early August. All their pension products must be funds of funds (FoFs).

Some, such as E Fund, are raring to go and intend to sell such funds “very soon”, a spokeswoman told AsianInvestor. China Asset Management (ChinaAMC) and Fidelity International also announced in August a strategic partnership to tap the pension market. 

“The third pillar will be the blue ocean in the asset management industry in China…. Pension funds are one of the most important sources of long-term funding for the asset management industry,” said a company spokesman at ChinaAMC, also among the first batch of approved companies.

However, there is a fear that the goals of fund houses and insurers don’t always align with the fiduciary needs of people saving for their retirement. 

“The insurers and fund managers have a big commercial interest if insurance policies and mutual funds can be used to provide pension benefits. The Chinese authorities don’t know how to solve their pension issues, so they are prepared to try anything,” said Stuart Leckie, a retirement adviser who has worked with the Chinese government.

He believes it would be wiser for authorities to prioritise further development of the first pillar, providing a minimum old age pension from the government to the urban work force and rural population. To do this the government would have to make tough choices, such as increasing value-added tax to fund pension expenses, Leckie said.

SHIFTING OPINIONS

While Leckie’s comments are open to debate, there are many challenges to successfully build out the third pillar. 

To begin with, China’s citizens have to change their mindset. Most workers believe the government provides them with retirement protection, noted Zhang of KPMG. 

It will require a sustained effort; both Beijing and the financial industry need to make the public understand the importance and benefits of putting aside more money for retirement, said the ChinaAMC spokesman. 

The reception of commercial pension products will also depend on the development of the first pension pillar. If people can expect to receive a public pension fund that is already 70% to 80% of their income before retirement, they will be less interested in buying such products, said Lu.

According to a pension report released by the Organisation for Economic Co-operation and Development in 2017, China’s mandatory public pension scheme, which should mean the pillar one fund, has a gross replacement rate of 76%.

The replacement rates will naturally fall as more of China’s population ages, so the country needs to strengthen the second and third pillar, said Lu Quan, director general of the China Association of Social Security.

To reduce fiscal pressure, the government has already made large prospective cuts to basic pension benefits, and further reductions are inevitable, said Jackson at the Global Aging Institute.

But the government cannot simply cut first pillar benefits without putting anything in their place. If Beijing wants to avoid a social and perhaps even political crisis a decade or two from now, it needs to build second and third pillars, even as it reduces the generosity of its first, he said.

It won’t be simple, but it is necessary.

This story is the second in a two-part focus on China's retirement system, adapted from a feature in AsianInvestor's August/September 2018 edition. Please click here to read the first part.