By George Friedman

The debate over how to reform China's pension fund system has intensified with rumors that locally managed funds would soon be allowed to invest in the stock market. However, such a plan would carry significant risks, and it likely would involve the creation of a centralized investment mechanism, which has incited the ire of local governments hesitant to allow central control over their funds.

Chinese officials have recently intensified the debate over reforming the country's pension fund system. Officials from the country's national pension fund, the National Social Security Fund (NSSF), and the China Securities Regulatory Commission have since made public statements indicating that the pension funds would be allowed to invest in the stock market. Meanwhile, media sources report that a proposal was submitted to the State Council that would allow local pension funds to invest about 30 percent of their assets into the stock market and establish a centrally managed investment institution for local pension funds by the end of 2012. However, a spokesman for China's Ministry of Human Resources and Social Security said Jan. 20 that there are no such plans in the near future.

China's pension funds have long been hampered by the limited channels for investment, relying mostly on low-yield storage in Chinese banks and limited purchases in the country's bond market. As the country's population ages, the funds' weak returns are put under increasing pressure. Officials have debated how best to reform the pension fund system, and the Chinese stock market has been mentioned as an investment avenue, especially for locally managed funds. However, the market's current volatility makes any such investment risky. Additionally, any reforms will be shaped by bureaucracies with separate, competing agendas, and local governments will be unwilling to see control over these funds handed to a centralized investment institution.

China's Current Pension Fund Structure

Broadly defined, China currently has three types of government-sponsored and mandated pension arrangements, including Basic Old Age Insurance, a national pension plan administrated by local governments estimated to total 1.4 trillion yuan (about $222 billion); the NSSF, a strategic reserve that aims for high return to pay off future liabilities and worth approximately 856 billion yuan; and pensions run by Chinese corporations, estimated at 300 billion yuan. The latter two already are allowed to invest in capital markets, mostly through bond issuances and the stock market. As of 2008, about 40 percent of China's 775 million-worker labor force was covered by one of these, and individuals not covered by any were covered by the Minimum Life Security System.

Under current Basic Old Age Insurance, the funds are separated into two types of accounts. For "social accounts," local governments and enterprises contribute a set amount, partially from centrally transferred money. This contribution is determined at the provincial level, but it generally averages about 20 percent of total revenues. The second account type is the "individual account," to which individuals contribute 8 percent of their monthly wages.

Several factors threaten this current system. First, despite healthy returns for the NSSF, it manages only a small portion of pension assets. Conversely, the large majority of Basic Old Age Insurance funds have struggled to retain the value of their holdings given their limited investment options. These funds yield only about 2 percent annually. Adjusted for inflation, which was more than 5 percent in 2011 and averaged 2.2 percent over the past decade, this often means negative returns. Second, China's population is rapidly aging. According to some estimates, more than 8 million people in China will be turning 65 every year after 2015. At the same time, birth rates are decreasing -- some projections say the ratio of workers to retirees will be just 2.5:1 by 2050, down from 9:1 currently. The country already is having problems supporting the elderly -- compounded by the three-decade-old One Child policy -- and these problems will only intensify in the near future under the current pension fund arrangement, particularly Basic Old Age Insurance.

Combined, these factors have caused increasing deficits in locally managed pension funds. According to a Dec. 20 report by the Chinese Academy of Social Sciences, employer contributions to pension funds in 14 provinces and one Xinjiang subregion were running a total deficit of 67.9 billion yuan in 2011, an increase of 25 billion yuan from 2010. The central government has thus far made up for these funding gaps with subsidies, but the problem is expected to worsen; the World Bank projects the deficits of locally managed funds will total 151 billion yuan by 2015. Moreover, the situation is likely to worsen as the central government seeks to increase pension coverage to a greater percentage of the population, particularly to migrants and rural residents, as part of efforts to boost domestic consumption and reduce precautionary savings.

Also, the decentralized nature of local funds means each fund is managed differently and with little oversight, allowing authorities to misuse the funds. For example, while social accounts are nominally funded by contributions from employers and local governments, officials often pull reserves from individual accounts to pay for claims to social accounts. The lack of oversight also creates opportunities for corruption, such as in the case of Chen Liangyu, who was sentenced to prison in 2008 for embezzling from Shanghai's fund, among other corruption charges.

Risks To Entering the Stock Market

Under these circumstances, allowing local pension funds to enter capital markets represents a potential solution to addressing their deficits -- the NSSF, which already has access to these markets, has averaged 8-10 percent yearly returns. Officials in Chinese stock exchanges also see benefits to the massive investment and hope it will reinvigorate the long-beleaguered markets.

However, there are several risks to any such undertaking. First, the money likely will come from individual accounts, further depleting them. Second, while any entry into the stock market is inherently risky, China's markets in particular are plagued with longstanding problems -- such as pervasive speculation, loose financial regulation, poor risk control by securities firms, weak investor protection or confidence and low-quality listed companies -- which have made these markets weak and subject to large fluctuations. Even capital from local pension funds' entry will not necessarily reinvigorate the markets, raising questions over whether this solution will lose more money than the current situation.

Another complication is political. Management of local funds currently is dispersed among the country's more than 2,000 local governments, which count these funds among their top sources of revenue. The suggested framework for investment in capital markets would create unwanted influence by the central government, further undermining local interests and possibly exacerbating financial constraints at the local level.

Plans for Pension Reform

Currently, there are three major plans for resolving local pension investment. The first plan would be for the Ministry of Human Resources and Social Security to serve as the principal stock investor for the Social Security Insurance Business Management Center, while another agency functions as a trustee to work with stock brokers and financial service providers. In the second plan, the NSSF would become the principal investor and trustee for all investments. In the third, provincial and other local governments would work with trustees to select fund managers.

While details of those proposals are ambiguous, the NSSF plan is the most likely to be adopted. The fund's long history puts it in a better position than others to maximize returns, and its joint management by stakeholders from the People's Bank of China, Ministry of Finance, and Ministry of Human Resources and Social Security gives it the best chance of unifying various interests behind the task of dealing with China's looming pension troubles. And in contrast to other sovereign funds, the NSSF is most capable of satisfying domestic interests (especially the National Development and Reform Commission) as a major source of capital for investment in central government initiatives, including infrastructure projects, low-end housing and stabilizing domestic capital markets.

The NSSF already has experience as a centralized manager for local government pension funds. Since 2005, the fund has managed the central government's fiscal transfers to nine of 13 provinces and has committed to fully fund the system of individual accounts and to fully separate them from social pooling. In January 2011, it was rumored that Guangdong province received permission to issue the NSSF a 100 billion-yuan mandate from its local pension fund. Investment will focus on fixed-income assets in early stages but will later expand to high-yield bonds, stocks and mutual funds. This may be evidenced as a pilot project for a more centralized system of managing local pension funds with the NSSF at the helm.

But this success could also be its downfall. If the fund manages to win over all parties involved and become a major centralized manager of local government pension funds, it will likely face a new battle in maintaining its focus on long-term returns instead of projects of politicians' personal interests. Indeed, much of the fund's private equity and trust-related investments approved by the National Development and Reform Commission are directed toward a more centralized management and for central government projects. Moreover, even rising overseas assets could be prone to funding acquisitions by major state-owned firms abroad. The battle to keep NSSF assets focused on pension liabilities for 2030 will be the next major task.


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China's Looming Pension Crisis is republished with permission of STRATFOR.

China's Looming Pension Crisis | Global Viewpoint