PUBLIC PENSION RESERVE MANAGEMENT IN CHINA A PROCESS JUST BEGINNING Mark C. Dorfman Senior Pensions Economist

1. PUBLIC PENSION RESERVE MANAGEMENT IN CHINA A PROCESS JUST BEGINNING Mark C. Dorfman Senior Pensions Economist

2. Presentation Outline • Introduction • Structure of the Pension System • Financial Products for Investing Reserves • Recent Revisions to Reserve Management • Key Challenges Presented by the Chinese Approach • Directions for Consideration

3. I. Introduction (1) Pension and Social Security Reform is today one of the most important public policy issues in China today. Pension reform is key to the Government’s objective of providing sufficient old-age income protection for urban workers while at the same time undergoing substantial SOE restructuring. This is viewed as critical to maintaining social stability. The unfunded pension liability also represents one of China’s most important fiscal challenges over the next 25 years as demographic characteristics increase dependency rates.

4. I. Introduction (2) A key challenge for public pension management is to create a governance structure by which funded reserves can safely maximize returns relative to a modest risk tolerance and, in the medium term, accumulate at a rate in excess of wage growth. The key questions raised are what such a management structure should look like and what measures are necessary to achieve the required level of governance.

5. II. Current Structure (1) History 1951 - Establishment of enterprise-based pay-as-you-go defined-benefit mandatory public pensions. Iron Rice Bowl - pensions, health, employment, housing, maternity, work injury, basic living support 1960’s - Devolution of pension management to enterprise (SOE) level 1986 - Beginning of pilot programs in municipal pooling 1992 - Beginning of pilot programs in individual accounts 1995 - National mandate for choice of individual accounts and defined benefits

6. II. Current Structure (2) 1997 - National mandate and parameters for three-tiered benefit structure - basic benefit, individual account, supplementary pension and transition arrangements 1999 - Coverage extension to non-SOE enterprises Central sector funds decentralized 2001 - Liaoning Pilot Program, Establishment of National Social Security Fund 2002 - WTO Pension Reserve accumulations in China really only began on a substantial scale this year

7. II. Current Structure (3) Coverage of Urban Enterprise Pension System

8. II. Current Structure (4) Benefits (Phased in from 1996 to 2035): • First Pillar – 20% of Regional Average Wage • Second “Pillar” – Monthly Lifetime Annuity = Individual Account Accumulation / 120 months • Defined Benefit accrual rate 1-1.4%/year prior to 1996 • Voluntary contribution accumulations – phased withdrawal

9. II. Current Structure (5) Retirement Age • 50 for women workers, 55 for women managers, 60 for men; • 5 years early retirement for enterprises in transition + hazardous professions • life expectancy at est. retirement age of 50 for women: Age 77 • life expectancy at est. retirement age of 56 for men: Age 76

10. II. Current Structure (6) Contribution Rates: • Vary by municipality and often by company • Mandatory employer contributions generally 19-28% of covered wages (+ other social security contributions of approx. 13%); rates lower for non-SOE enterprises • Employee contributions generally 5-6% (rising to 8%) • Total contribution rates therefore 37-47% - Competitiveness and Moral Hazard effects • Voluntary contributions up to 4% of wages - tax exempt for employer

11. II. Current Structure (7) Collection Rates: • Very difficult to measure. Reporting and accounting variations. • Moral Hazard because of link between reporting and subsidies. • Estimated at 70% of covered wages • Ministry of Finance Transfers: US$ 5.7 billion in 2000 (approx. 0.5% of GDP) • Wage Reporting - Collections by municipal Social Insurance Agency or by Tax Authority - covered wage for pensions not generally reconciled with wages stated for corporate income tax purposes

12. II. Current Structure (8) Account Administration: • Since Cultural Revolution generally at the State Enterprise level (+ recent coverage extension) • Moving to Government administration by municipal social insurance agencies • In Liaoning - horizontal links to health, unemployment insurance, maternity and work injury

13. II. Current Structure (9) Reserve Accumulation and Management: • Reserve accumulations to date slight (some est. 0.8% of GDP) but varies according to locality • Most Individual Accounts since 1996 Notional - Contributions used to pay retirees and PAYG benefits • Contribution rates minimized discouraging accumulations • Reserves required to be invested in State Banks and State Bonds

14. III. Financial Market Investment Options (1) • Financial Depth (M2 > 150% of GDP ) • Savings rates high (household savings over 40% of income) • But financial instruments largely limited to deposits in banks, treasury and financial bonds and equities • Overseas portfolio investments not permitted by domestic enterprises or individuals, including investments in Chinese companies listed in Hong Kong or New York

15. III. Financial Market Investment Options (2)

16. III. Financial Market Investment Options (3) Treasury and Financial Bonds • Deep market (24% of GDP) and low principal risk • Rates low - recently positive in real terms but not over part of last decade • Rates not fully market-determined • Part of outstanding stock not freely negotiated • Limited depth of long-term but deepening since 1999 • Many positive measures to develop market and more expected

17. III. Financial Market Investment Options (4) Corporate Bonds • Rates freely determined • No domestic risk rating mechanism • Limited use and effectiveness of financial covenants • Weaknesses in corporate governance by bond issuers decade • Limited depth

18. III. Financial Market Investment Options (5) Equities • 1,140+ listed companies on 2 exchanges • 2/3 of outstanding SOE shares not traded • Weak accounting, disclosure and oversight (albeit improving) • Est. 700 unregistered investment funds • Several closed-end mutual funds and recent est. of open-ended mutual fund • Forward market P/E >50 (albeit recent fall in market indices due in part to improving regulation) • Very weak corporate governance and minority shareholder rights

19. IV. Reserve Management - Recent Revisions A. National Social Security Fund (NSSF) – Funded by Treasury and State share sales proceeds B. Liaoning Pilot Program – Full funding of Individual Accounts and investment into State bonds C. Individual Account accumulations in some municipalities. D. Voluntary Supplementary Accounts (Enterprise Pensions) E. Other Corporate and Personal Pension Plans

20. IVA. National Social Security Fund (1) Only began operation in February, 2001 Funding Sources: • Listed SOEs required to contribute 10% of proceeds of secondary sales of State shares or new share listings to NSSF • Annual treasury transfers • Other sources, including possible national lottery proceeds

21. IVA. National Social Security Fund (2) Cash Flow and Projected Accumulations: • Current capitalization - US$7.0 billion (0.65% of GDP) • State holds est. 70% of the shares of listed SOEs; only 30% of shares to date allowed to be traded. • Sales of State shares on the secondary market limited by the market absorptive capacity (forward P/Es over 50:1). • NSSF not only a recipient of share sales proceeds but also investor in share issuances (institutional investor). • Outflows difficult to estimate - Subsidize provincial and municipal shortfalls for pensions and unemployment insurance

22. IVB. Individual Account Reserves for Liaoning Province • Pilot Program (started July 2001) segregates 8% contribution to individual accounts from PAYG system (with resulting PAYG deficits). • Government considering changing asset allocation from current Bank deposits and Treasury Bonds

23. IVC. Individual Account Reserves - Other Municipalities • To date, very limited accumulations depending upon municipal economic/demographic characteristics (est. 0.8% of GDP). • Segregation of Individual Account reserves results in reduction of revenues for PAYG benefits • Reserve accumulation not mandatory as in Liaoning • Municipal resistance to elevating reserves to centrally pooled fund (s)

24. IVD. Reserves of Supplementary Accounts“Enterprise Pensions” • Tax-exempt contributions currently not linked to specific form of management • Investment guidelines being considered but not issued • Management can be subcontracted/ decentralized • Limited oversight

25. V. Key Challenges 1. Parallel sequencing of reforms to: • banking system incentives + prior losses; • interest rate liberalization; • SOE governance incentives; • securities markets regulation and supervision; and • Pension and social security reform.

26. V. Key Challenges 2. Design of Governance Structure for pension reserve management • Better align the incentives of trustees and fund managers with affiliates through decentralization of selection • Mitigate abuse through strong central governance requirements, investment policy guidelines, investment prohibitions and oversight

27. V. Key Challenges 3. Allow for the placement of contractual savings reserves in financial instruments with: • diversified risk and maturity characteristics; • sufficient transparency and oversight; • improved corporate governance incentives for issuers and corporate managers

28. VI. Directions for Consideration (1) The following general reform measures are critical to achieving greater financial sustainability and equity: • Calculate annuities from individual account accumulations based on life expectancy at retirement instead of the current formula • Gradually increase the retirement age • Index pension benefits to regional inflation • Segregate contributions to individual accounts from PAYG benefit distributions (as being done in Liaoning)

29. VI. Directions for Consideration (2) • Establish the infrastructure for collections, account and fund management and disbursement at the municipal level • Gradually increase the rate of return to funded pension reserves while managing risk

30. VI. Directions for Consideration (3) NSSF (1) – State share sales + IPOs • Establish issuance strategy consistent with market absorptive capacity • Utilize share issues for additional capital mobilization (investment) or modification of enterprise capital structure - avoid dilution

31. VI. Directions for Consideration (4) NSSF (2) - Governance + Investment Policy • Separate short-term and long-term funds • Publicize investment policy objectives and guidelines • Utilize passive investment vehicles by carefully constructing one or more special indices of companies which meet more stringent trading and prudential criteria than the entire market • Disclose criteria for selecting and maintaining external fund managers as a means of as a means of enhancing accountability

32. VI. Directions for Consideration (5) NSSF (2) - Investment Policy • Monitor and disclose investment manager performance against constructed and publicized market benchmarks • Prohibit investments in select assets and companies according to conservative risk assessment • Calibrate asset allocation according to level of market depth, transparency, regulation and oversight • Gradually utilize modest exposure to external markets as a means of investing in Chinese and foreign companies, diversifying risk and utilizing foreign market oversight

33. VI. Directions for Consideration (6) Funded Mandatory Individual Account Portfolios – (including Liaoning) • Short term – Maintain funds in State Bonds • Once infrastructure for account management in place, establish governance structure for municipal trustee responsibility + municipal selection of centrally-licensed fund managers for national portfolios. • Establish central regulatory agency - license investment managers acc. to publicized objective criteria, monitor performance acc. to market benchmarks. • Prohibit investments in certain assets and asset classes.

34. VI. Directions for Consideration (7) Funded Mandatory Individual Account Portfolios – (including Liaoning – Cont.) • Establish and monitor asset allocation parameters calibrated to instrument risk, depth, and oversight. • Utilize passive investment vehicles for part of portfolios as means to moderate risk concentration and mitigate potential abuse. • Long-term - establish limited selection provisions so that affiliate’s portfolios can be tailored to life circumstances and risk tolerance.

35. VI. Directions for Consideration (8) Enterprise Pensions – Voluntary Accounts • Initially – require reserves to be invested in same externally-managed, centrally licensed funds as for mandatory accounts in order to receive tax exemption. • Over time, consider greater autonomy in licensed investment manager and fund risk profile selection according to affiliate preference

36. VI. Directions for Consideration (9) Above measures are meant to increase the incentives for strong governance of pension reserves in the NSSF, individual accounts and enterprise pensions in order to increase returns while managing risk in a way consistent with the development of the financial markets.

37. These are some of the options available for Chinese policymakers.