China’s government wants to increase private investment in pension funds, with reforms that could lead to more fundamental changes in China’s financial services sector – and attractive new opportunities for UK insurers and financial institutions, writes Torsten Weller
China’s demographic change has become one of the biggest challenges for Beijing, as policymakers try to avert the unwelcome prophecy of the country ‘getting old, before getting rich’. A dramatic drop in China’s birth rate over the past five years has added urgency to the requirement to establish a sustainable and sufficiently well-funded pension system to ensure that the benefits from the ‘youth dividend’ – which has fuelled China’s economic miracle over the last four decades – can be enjoyed by current and future retirees.
Private pension schemes have long been seen as a major element of this reform and have received a new push following the opening-up of China’s financial services industry. On 21 April 2022, the State Council published a new reform proposal to establish private pension investment plans – similar to the American 401(k) accounts – which would allow Chinese employees to have their own individual pension portfolios.
Yet the Chinese government’s wooing of foreign insurance companies and financial institutions to help set up a functioning market for pension funds also provides a good example of the challenges and complexities China faces in the age of ‘Common Prosperity’ and slowing economic growth.
Following China’s departure from a Soviet-style planned economy and the rapid downsizing of the country’s vast state-owned enterprise sector in the late 1990s, Chinese reformers faced the daunting challenge of creating a new social welfare net which could replace the traditional ‘iron rice bowl’ (the cradle-to-grave coverage provided by one’s work unit). Additionally, the return of Hong Kong in 1997 posed the – albeit long-term – question of how to integrate the city’s developed pension system into a nationwide structure.
The 1997 State Council Document No. 26 outlined the main idea of China’s pension reform, namely the creation of a multi-pillar system for China’s entire urban population. The plan was elaborated further, and in 2000, the State Council published Document No. 42, which designated Liaoning Province and its neighbours as reform pilot areas. At that time, the three Manchurian regions were not only the most industrialised but also the hardest hit by Zhu Rongji’s radical downsizing of China’s state-owned enterprises, with millions of employees losing their jobs virtually overnight.
Yet the initial reform produced only partial results. A key problem – not only for retirement policy – remains the decentralised and highly fragmented nature of China’s administration. Like nearly all social services, pension policies are set at the municipal or township level, thus leaving it up to each local government to set its own rules. Given such budgetary constraints, successful implementation thus often depended on subsidies and support from the central government and international organisations, such as the Asian Development Bank. As Zhu Xufeng from the School of Public Policy and Management at Tsinghua University and Zhao Hui from Beijing’s Capital Normal University have noted in a recent paper, early pension reforms without government support – such as those initiated in Zhejiang province – failed to get off the ground.
Since 2000, several reforms have therefore aimed to both harmonise pension rules across China and open up new financing channels. Below are some of the milestones of China’s pension reform:
- 1997: Outline of a Three Pillar Model (Document No. 26) for urban employees
2000: Launch of pilot pension reforms in Liaoning and other provinces
2006: Plan to extend pensions to all employees in both urban and rural areas by 2020
2009: Creation of New Rural Social Pension Scheme, including for unemployed urban residents
2010: A new Social Insurance Law sets a maximum contribution for all Chinese employees (<20%) and employers (<8%)
2014: Merger of Urban and Rural Basic Pension Scheme
2015: Inclusion of SOE employees and civil servants in a National Basic Pension Scheme
2018: Pilot Project in Shanghai for tax deferral for pension contributions and Nationwide Transfer Mechanism for local pension funds
2022: State Council proposes an individual retirement savings and investing plan (e.g. 401(k)) for Chinese employees
The timeline of China’s pension reform is very much in line with its usual reform development, starting with local pilot projects which are then incrementally merged into a nationwide framework. Yet until the late 2010s, most of these steps targeted just the statutory part (Pillar I) of China’s pension system. It was only in 2018 that the two other pillars – enterprise annuities (Pillar II) and private pension plans (Pillar III) received greater attention from Chinese policymakers.
In February 2018, new regulations for enterprise annuities made is easier for companies to set up their own pension plan. The Chinese government also launched a new pilot project in Shanghai which would allow employees to defer taxes on pension contributions in an effort to make these plans more attractive.
As a result, the performance of enterprise annuities has improved markedly, with the annualised rate of return increasing from 3.01% in 2018 to 10.3% in 2020, according to Bo Sun, a Chinese pension expert. A recent report by EY also saw strong growth in this pillar, with a 43% year-on-year increase in 2020 alone.
Yet the most promising – from a private insurers’ perspective – third pillar has so far received relatively little support. According to data collected by EY, private pension plans still only account for a relatively small fraction of overall pension funds. As of the first half of 2021, only RMB75.6 billion (£9 billion) was invested in private pension plans versus RMB3.5 trillion in enterprise and occupational annuities, and RMB2.9 trillion in government pension funds.
The Third Pillar is taking shape
It is, however, private pensions which promise the biggest growth opportunity in the coming years. According to EY data, the total value of private pensions funds in 2018 was just RMB4 billion. Two years later, the value had increased to RMB57.6 billion – a 1,340% growth. Independent consultancies quoted by Reuters estimate that the value of China’s pension funds could rise to at least RMB1.7 trillion by 2025.
Yet it wasn’t until this year that the Chinese government started taking steps to create a legal framework for private pension investment plans. Inspired by the US model of 401(k) pension plans, China’s General Office of the State Council – an institution similar to the UK’s Cabinet Office – released a document outlining the basis for a Chinese variant of such investment plans.
The document – simply called Guobanfa  No. 7 – tasked the Ministry of Human Resources and Social Security and the Ministry of Finance to create the regulatory framework for personal pension funds (in Chinese: geren laoyangjin/个人养老金). While the document does not spell out the details, it lays down a few cornerstones:
- Payees need to be enrolled in a basic urban or rural pension scheme;
- Individuals may contribute up to RMB12,000 (£1,400) per year;
- Contributions and risks are borne by the individual (no employer contribution);
- Funds can only be withdrawn after reaching retirement age, or in exceptional circumstances (e.g. invalidity, emigration);
- Contributions will benefit from preferential tax policies;
- Repayment method can be stipulated by payee as monthly, in fixed tranches or as a lump-sum payment, but once set, cannot be changed;
- Personal Pension Plan Accounts have to be set up through an official Personal Pension Information Management Service Platform (managed by the Ministry of Social Security).
The document provides few details on the investible funds and states only that they may include management products, savings deposits, commercial pension insurance, and public funds, as well as being ‘safe, mature and stable, standardised, and focused on long-term benefits’. A list of eligible investment products is set to be drafted by Chinese financial regulators and published on the Personal Pension Information Management Service Platform.
What are the next steps?
Document No. 7 is an important milestone as it is the first nationwide policy guidance that calls for concrete steps to set up a government-led private pension fund platform. As such, it sends a strong signal of government support for private pension funds and will almost certainly boost growth in this industry. Nonetheless, the document’s paucity of details means that several key elements of Pillar 3 have yet to be decided.
First and foremost, it is up to Chinese regulators to decide which financial service providers are allowed to list their products on the new information platform. They will probably include big Chinese insurers and investment giants such as Ping An or CITIC. But foreign insurers also have a good chance of being part of the mix, as Chinese authorities have repeatedly signalled that they would welcome foreign financial institutions. Thus, vice-chairman of China’s Banking and Insurance Regulatory Commission (CBIRC) Zhou Liang reiterated this position in a recent call with CBBC members.
Secondly, Chinese regulators need to define the criteria of included financial products and fund managers. This would not only relate to financial risk management but also set a minimum return-on-investment as is common for many Western pension funds. In his talk with CBBC, Liang indicated that defining such a threshold remains one of the thorniest issues of the reform. Setting it too low could hamper the overall attractiveness of private pension plans, while too high a threshold could increase financial risk, create a moral hazard and exclude more prudent investors.
Finally, Chinese tax authorities need to work out an effective tax policy which incentivises investment in such funds. As researchers at EY pointed out in their recent report on China’s pension reform, fragmentary and unclear tax policies remain one of the biggest obstacles to a healthy private pension market. Creating a uniform and nationwide system of tax benefits for private pensions would clearly help.
China’s decade-long pension reform offers attractive new opportunities for UK insurers and financial institutions as plans to establish a market for individual pensions speed up the volume of assets under management by private pension funds
What challenges remain?
Besides these regulatory requirements, there are also a few other challenges to creating a successful private pension system.
Firstly, pension funds will have to compete with a range of alternative investment options for Chinese people. Although real estate – China’s most popular old-age-insurance – has recently lost some of its lustre due to a struggling property sector, it still ties up a considerable amount of private savings. Other alternatives, such as wealth management products (WMP), have long attracted private investment and often offer higher returns than long-term pension funds. In a high-growth economic environment, such types of investment are likely to receive a larger share of private savings than less liquid long-term investment plans. Most challengingly, changing this will not only require new policy incentives, but also more sober communication by the Chinese government about the country’s slowing economy.
Capital controls are another big challenge. In order to create a high-quality private pension market, sooner or later, Chinese regulators will need to allow pension funds to invest in assets in other, more advanced financial markets, most notably in the US and Europe. Local fund managers will also need a better understanding of international financial markets to ensure that pension funds are managed properly. Stuart Leckie, the founder of the Hong Kong Retirement Schemes Association and a long-term observer of Chinese pension reforms, suggests that an incremental increase of foreign asset allocations in Chinese private pension funds over several years could help local authorities to familiarise themselves with global best practices and slowly lift the quality of China’s own financial services industry.
The biggest issue, however, remains China’s own institutional and socioeconomic fragmentation. Despite past reforms and improved standardisation, pensions are still managed by the local governments and contributions and tax incentives thus vary wildly.
While China’s richer parts in the east and south will set up the necessary infrastructure fairly quickly – and probably also account for the majority of investors – some poorer regions might struggle to attract both investors and high-quality funds. Recent research by Yang Yujeong of the State University of New York College at Cortland shows that areas with a level of out-migration generally rely more on government pension schemes than booming regions with net immigration. Given these discrepancies, a standardised and uniform offer for private pension funds across China might be more useful than sign-up platforms run by local bureaux which would risk a deepening of existing social divisions.
The CBBC View
China’s decade-long pension reform offers attractive new opportunities for UK insurers and financial institutions. The Chinese government’s latest reform proposals to establish a market for individual pension plans will probably speed up the volume of assets under management by private pension funds and help establish the Third Pillar in China’s pension system.
The reform could also accelerate a broader opening-up of China’s financial system as more private investment by pension funds paired with a slowing economy could force Chinese regulators to allow Chinese funds to put their money into foreign assets. Seen from this perspective, the positive effects of China’s pension reform could go far beyond the stabilisation of strained pension funds.
Yet much remains to be done and further reforms are needed to implement the latest initiatives fully. Chinese authorities will most likely apply the well-worn practice of letting local authorities – especially those in the rich coastal regions – come up with solutions which are then applied to the rest of the country. But as past social policy reforms have shown, central coordination and standardisation remains indispensable if the government wants to create a modern and sustainable pension system.