China’s pension problems will not be solved by more children

On October 29, China adopted a policy of two children per family, instead of one. This change is, in large part, intended to mitigate the adverse demographic trend plaguing China’s social security system: the rapidly declining ratio of active to retired workers. The ratio is falling from over 6:1 in 2000 to under 2:1 in 2050.

However, the new two-child policy is not likely to have a big impact on the worker-retiree ratio, so China’s retirement system will remain under stress. To sustain social security, China needs to implement other reforms — moving from a local to a national system and expanding the permissible investments for Chinese pensions.

The one-child policy always had exceptions, such as for rural and ethnic communities. These exceptions were broadened in 2013 to cover couples where both were only children. Yet the birth rate did not take off.

Why? A combination of rising levels of urbanisation and housing costs, more education and jobs for women, and rapidly increasing expenses for child rearing. These factors have driven fertility rates down in other south-east Asian countries, such as Singapore and South Korea, without any government restrictions on family size.

Indeed, if China’s two-child policy were to lead to many larger families, the result could well be a lower ratio of workers to retirees for the next two decades. That is because women with two children are less likely to take jobs outside the house until their children have left the nest.

Given the declining worker-retiree ratio, the key to stabilising social security is ensuring that current pension contributions are used to fund the future retirement benefits of current workers.

Since the pension reforms of 1997, urban employers have been required to contribute 20 per cent of each worker’s wages to social security, while workers have to contribute 8 per cent of their wages to an individual retirement account. These high contributions could form the foundation of a viable pension system.

However, such contributions are made to local governments, which often “borrow” a large portion to pay the legacy pensions of pre-1977 workers at state-owned enterprises. These workers were promised retirement benefits during the era of the “iron rice bowl”, when the Communist party took care of worker welfare. At that time, no one tried to fund the future retirement benefits of SOE workers.

The flow of pension contributions and benefits through local governments not only undermines funding of the current pension system, but also erects barriers to labour mobility.

When workers move from one city to another to get a better job, they remain tied to the pension plan in their original city unless they can obtain a residency permit (hukou) for the destination city. And the retirement benefits from an inland town will be much lower than those under the Beijing pension plan.

To address both the funding and mobility problems, I suggest that China’s national government should assume responsibility for legacy pensions and, in return, local governments should stop handling pension contributions and benefits.

Then the national government could ensure that current pension contributions are dedicated to the retirement benefits of current workers. In addition, Beijing could build a computerised central repository of all pension contributions, wherever workers held jobs in China.

At the same time, China should adopt more flexible rules on investing pension contributions. At present, pension investments are generally limited to Chinese government bonds and bank deposits, which pay low interest rates. The main exception is the National Social Security Fund, which was established to help local governments finance the pension system.

The NSSF now has a group of investment professionals who are allowed to invest pension assets in stocks and bonds, including foreign securities.

Thus the NSSF could invest current pension contributions in an internationally diversified portfolio with higher long-term returns than government bonds and bank deposits.

Moreover, the NSSF could play a significant role in developing a longer-term perspective in China’s capital markets, rather than one dominated by day traders.

In short, while the two-child policy is a step in the right direction, it will not move the needle on China’s declining ratio of workers to retirees. To sustain social security, China’s national government should establish separate trusts with current pension contributions, which would be invested to provide future retirement benefits for current workers.

Editor’s Note: this piece first appeared in The Financial Times.