A Beginners Guide to Building a RAG App Using Open Source Milvus
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1. J$ 16o0}
POLICY RESEARCH WORKING PAPER 1607
Population Aging As _hinas po ulation age,-
China must acdress
and Pension Systems macroecononicssues
affecting its ol.-age sociai
Reform Options for China securitysysten. rotjust the
designand m,-inagemeneot
pension funds
F. Desmond McCarthy
Kangbin Zheng
The World Bank
Office of the Senior Vice President
Development Economics
May 1996
PublicDisclosureAuthorizedPublicDisclosureAuthorizedPublicDisclosureAuthorizedPublicDisclosureAuthorized
2. IPOLICY RESEARCHWORKINGPAPER1607
Summary findings
Usingan integrated simulation model, McCarthy and Reai income growth is needed to cope with poverty
Zheng estimate the scope and speed of population-aging among the elderly, especiallyin developing countries. To
in China, the cost of supporting the old, and the impact establish an adequate, efficient, and equitable social
of different reform options and pension arrangements. security system, China must maintain long-term
Among their conclusions: socioeconomic stability and sustainable growth.
The scope and speed of popuiation-aging in China China could improve the labor market by removing
make the present pension system financially management rigidities, facilitating human resource
unsustainable, even assuming that GDP grows steadilv in development, making labor markets more competitive,
the long term. Moving the retirement age back would improving the household registration system, improving
provide a temporary fix for the current pay-as-you-go incentives, and rewarding hard and innovative work. To
pension system but would be politicallv viable only reduce unemployment, China can create more job
where there isgreat demand for labor. oppor-tunities in nontraditional sectors, especially its
Pension funds could be made more sustainable by underdeveloped service industries. To shift jobs to the
increasing GDP growth, raising contribution rates, or nonagricultural sector, it can develop medium-size cities.
gradually reducing benefit rates. Blutthe financial costs And to cushion the impact of demographic shocks, China
and social obstacles of those refornmoptions must be should preserve traditional values and maintain family-
carefullyassessed. Ftullyfunded, privately managed community support.
pension schemes might be feasible,but require a sound Drawing onIexperience in Europe and Latin America,
regulatory framework and institutional infrastructure, China should move toward a transparent and
including financial markets that provido adequate siavings decentralized system with (1) a fully funded, portable,
instruments and insurance opt'Ols. defined-benefit pension plan, designed to meet basic
Pension reform is a long term, niuitidimensional needs, and (2) occupational pension plans or personal
problem involving economilic,social, political, and savingsaccounirsto satisfy demand for maintaining or
Cultural factors. Governments should not focus only on improving living standards.
taxes and transfers to redistribute incone to and among
the elderly.
This paper - a product of the Office of the Senior VicePresident, Development Economics - ispart of a larger effort to
study strategic and policy issues for socially sustainable development in developing countries. Copies of the paper are
available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Mila Divino, room
N6-056, telephone 202-47/3-3739, fax 202-522-1157, Internet address mdivino@q?worldbank.org.May 1996. (47 pages)
The Policv Research WorkingPaperSeries disseminates the findings of u'ork in progressto encourage the exchange of ideas about
development issues.An objectiveof the seriesistoget the findingsout quickly,even if thepresentationsare lessthanfully polished. The
papers carry,the names of the authorsand should be usedand cited accordirngly.Thefindings,interpretations,and conclusionsare the
authors' oun and should not be attributed to the World Bank, itsExecutive Boardof Directors, or any of its member countries.
ProdJK d !lEt-i PolicyRcsca- h Dissemination C((intc
3. Population Aging and Pension Systems
F. Desmond McCarthy
and
Kangbin Zheng
The World Bank
Officeof the SeniorVicePresident
Development Economics JEL ClassificationNos: H55, 138
Thispaperispartofalargerefforttostudystrategicandpolicyissuesforsociallysustainabledevelopment
in developing countries. The authors thank Estelle James, Cheikh Kane, Anita Schwartz, and
participantsofan internationaleconomicsseminarat MITforhelpfulsuggestionsanddiscmssions.
5. Contents
I. INTRODUCTION I
II. CHALLENGESAHEAD 4
Traditional Values 7
Demographic Transition and Population Policy 8
Structural Adjustment and Rural-Urban Balance 14
Sustainability of Socio-economic Transition 15
III.A SIMPLESIMULATIONMODELFOR PENSIONREFORMS 18
The Pension Fund Balance 19
Demographic Dynamics and Labor Market 21
Economic and Wage Growth 22
Government Behavior under Different Pension Arrangements 22
Pay-As-You-Go Scheme 23
Defined Contribution System 24
Defined Benefit System 25
Private Pension Fund Accounts System 25
A Multi-pillar Pension System 26
IV. PENSIONSYSTEMREFORMIN CHINA 27
The Current Pension System in China 27
The Need for Pension Reforms: The Benchmark Case 31
Base Year Paramneters 31
Key Assumptions 31
Pressure from Population Aging 33
The Base Case Scenario 35
Policy Simulations for Reform Options 37
Delaying Retirement Age 37
Change of GDP Growth Path 39
Changing the Contribution Rate and the Replacement Rate 41
Fully Funded Individual Accounts 41
V. PRELIMINARYCONCLUSIONS 43
REFERENCE 46
i
6. List of Figures
Figure 1 DevelopmentDiamond 1992 6
Figure 2 Population Aging 10
Figure 3 Population Growth 1985-2150 11
Figure 4 AverageAge of Population 1985-2150 12
Figure 5 Evolution of Age Structure 13
Figure 6 Links Among Pension Performance and Socio-EconomicDevelopment 18
Figure 7 PublicPension System Development 1978-1993 30
Figure 8 Population Dependency Rate With Different Sets of Retirement Age 38
ii
7. Population Aging and Pension Systems
1. Introduction
Whilebeing proud of its civilization as one of the world's oldest, China,though
relativelyyouthful at present, is getting older rapidly and massively. Strict familyplanning
practice has sharplyreduced fertilitysince early 1980s. Better livingconditions and
medical services have cut down mortality and extended life expectancyin both urban and
rural areas. Consequently,the percentage of older persons in the total population
increases continuously, andthe median age of the population rises steadily. Moreover, the
aging process is expected to accelerate in the coming decades as the babyboomers born
between early 60s and mid-70s, currently numbering more than 250 million(twice Japan's
present total population), approach retirement age around 2030. By then as manyas 22
percent of Chinesenationalswillbe more than 60 years old,jumping from9.7 percent in
1995. During the same period, the ratio of working-age persons to the aged is estimated
to be halved from 9.7:1to 4.2:1. Without a properly designedsocial security systemand
strategically formulatedpolicy responses, it would be very difficultfor Chinato cope with
this coming old-age challenge.
The pressure generated from these demographic dynamicsfor Chinainthe 2030s
share some similaritieswith those facing Western developed countries and Japanin the
next decade. However, China is a low-income country, with per capita incomeof US$
490 in 1993 beingless than 2 percent of that in the United States at the current market
exchange rate, or close to 10 percent when measured at purchasingpower parity'.
Apparently, China's quick population aging process and lower levelof developmentmean
that income resourcesavailableto support non-productive aged people willbe far less
I The WorldBank'sWorldDevelopmentReport 1995, page220,presentsa crosscountry
comparisonofPPP estimatesof GNP. HereChina's per capita GNPin 1993is estimatedat US2,330as
comparedwiththatofIndiaat US$1,220.
1
8. than in the developedworld. Even with the Confucian tradition of filialpiety and respect
for the elderly,Chinawith relativelyfewer young will soon finditself in difficultiesto
provide adequate support to its rapidly increasing old-age population.
Faced by these serious challengesfor harmonizing economic growth with social
sustainability, the Chinesegovernment has begun to take measuresto reform its currently
fragmented social securitysystem. Policy options on pension systemreformshave been
studied, and several experimentsfor social security decentralizationhave been carriedout
at provincial and municipallevels. State and collective enterprises began pooling pension
funds in order to ease unevenburden of retirement costs. However, manylong-term
strategic issues on the interdependencebetween demographic transitionand economic
growth remain to be systematicallyinvestigated. For instance,what is the realfinancial
burden the population agingprocess creates, given the fact that both the incomegrowth
rate and the average privatesavings rate in China rank among the world's highestin recent
years and will probablycontinueto be so in the near future? What are the macroeconomic
implicationsifthe current pay-as-as-go type of pension scheme were not reformed? How
to deal with the insolvencyof pensionfunds associated with state-owned enterprises?
What roles shallindividualworkers, enterprises, and differentlevelsof governmentsplay
to establish sufficient,efficient,and equitable social security systems? How can pension
funds be most effectivelymanaged, privately or publicly? How are differentschemes
sociallyand financiallysustainable? What are the politicalimplicationsassociatedwith
pension system reformssinceany adjustments on this front will inevitablynecessitate inter-
generational transfers andintra-generational redistribution among differentincome
groups? How muchcan Chinalearn from experiences of both developedand developing
countries?
This paper seeks to make a contribution to policy thinking on these important
questions. The theme of the paper is that issues around the old-age social security system
in most developingcountries, such as China, need to be addressed ina broader
macroeconomic sense rather than over-stressing on design and managementof the pension
2
9. funds pe se. The ultimatemeans to endure and improve living standards for the old
population is to maintainlong-term stabilityand promote sustainableincomegrowth,
while reforming micro-incentivestructure to encourage private savings. Workers,
pensioners, enterprises, and differentlevels of governments need to cooperate to improve
labor productivity, create newjob opportunities, preserve traditional andfamilyvalues,
liberalizeand develop financialmarkets, and rationalize government interventionsinthe
social security system.
There exist extensivediscussions, as cited in World Bank (1994), on pension
schemes and social security systems. However, only a few are directlyconcernedwith
policy applications in China2 . Using a simple simulation model similarto that of Schieber
and Shoven (1994) and the World Bank's population forecasting for China(World Bank
1995), this paper attempts to quantitatively illustrate: (a) the scope andthe speedof
population aging and its associatedcost of supporting the old in the future, (b) whether a
typical pay-as-you-go systemis sustainable and how large the cost if no reformswere
conducted, and (c) systemsensitivitieswith respect to alternative policy choices.
Although other kinds of benefitsand compensations, such as health insuranceand
disabilitybenefits, are integralparts of the social security system,the focus here is
maintained on pensions for retired persons.
The rest of the paper is organized as follows. Section II analyzesmajor
challenges China willface duringits demographic and socio-economic transition. Section
Im presents a simple model built around a pay-as-you-go systemwhichintegrates demand
for old age supports with supply of funds available from workers' contribution. Section
IV focuses on the sustainabilitysensitivitiesof different policy alternatives. Section V
concludes this paper with someremarks and suggests directions for furtherpolicy studies.
2 A partiallistofstudiesonpensionsystemreforminChinaincludesAhmadandHussian(1991),
Barkan(1990),DixionandMacarov(1992),Hu(1994),Hussain(1993,1994),HussianandLi(1989),
Lee(1993),Tian(1995),WorldBank(1990,1994),andYue(1985).
3
10. 11. ChallengesAhead
Living on about 7 percent of the arable land of the earth, China's population of 1.2
billionaccounts for about 21 percent of the world's total and surpasses that of India, the
second largest in the world, by more than 30 percent. Significantsocio-economic
progresses, as shown by the indicators in Table I interms of both developmentdynamics
and international comparison, have been made in the past decades. These achievements
are especially apparent within the past 15years, when market reforms andintegration into
the world trade and financesystems resulted in noticeable improvement inproduction
efficiency and incomegrowth. Withinthe period between 1980 and 1994, real GDP grew
at a rate close to 10 percent per annumon average, the number of persons livingin
absolute poverty was halved, and the internationaltrade volume rose by fiveto sixtimes
to more than US$200 billion. Thisremarkable growth was largelyfinancedby domestic
savings, although foreign financialassistance through investmentand lending alsoplayed
an important role. As exemplifiedinthe 1992 Development Diamond presented inFigure -
1, China compares favorablywith most low-income economiesin all four dimensions.
While fundamentaltransformation and economic growth will probablycontinue at
a fast pace in the first decades of the twenty first century, a number of concernsfor long
term sustainabilityare emerging. The old-age security systemis one of more pressing.
Out of many social, political,and economic factors that can generate significantimpacton
the social security systemin the near future, the followingfour intertwinedfactors are
central for policy formationto avert a potential old age crisis:
(a) how to promote growth while preserving traditional values?
(b) how to adjust population policiesto cope with the demographicdevelopment?
(c) how to divert labor force concentration from agriculture to industriesand
serviceswhile maintainingrural-urban balances? and
(d) how to mitigatethe social cost during the transitionfrom a centralplanning
regime towards a competitive market economy?
4
11. Table I
Basic Indicators of Social and EconomicDevelopment
(1993unlessotherwisestated)
OtherLow- Middle-
China India Income Income World
Economies" Economies
Population million 1178 898 1015 1597 5501
Urban % 29 26 27 60 37
GrowthRate(80-93) % 1.4 2.0 2.5 1.7 L7
Total FertilityRate 2.0 3.7 5.5 3.0 3.2
LifeExpectancy years 69 61 56 68 66
AdultIlliteracy % 27 52 49 17 33
PrimaryNetEnrollment % 96 57
Accessto SafeWater % 71 75
GNPper capita USS 490 300 300 2480 4420
GDPGrowthRate (80-93) % 9.6 5.2 2.9 2.1 2.9
Avg.InflationRate (80-93) % 7.0 8.7 27.1 90.1 19.6
Exports US$bil. 91.7 21.5 43.2 648.2 3701.5
GrowthRate (80-93) % 11.5 7.0 1.4
Imports US$bil. 103.1 22.8 62.9 724.6 3778.7
As Shareof GNP
GrossDomesticInvestment % 41 24 17 23 22
GrossDomesticSavings % 40 24 10 22 22
Agriculture % 19 31 37
Industry % 48 27 22
Service % 33 41 42
Source:WorldBank(1995):WorldDevelopmentReport1995:WorkersinanIntegratedWorld
1/ excludingChinaandIndia.
5
12. Figure 1
Development Diamand: 1992
Low-IncomeEconomiesexcludingChinaand India = 100.0
180.0 -
GDP per capita
160.0
14 0
20.0'-
Accessto Safe Water
Life Expectancy
/ / -~~China
- - - Low-IncomeEconomies
GrossPrimaryErollExcludingChina& India
Gross Primary Enrollment
13. Traditional Values
For thousandsof years,traditionalvalues inChinahaveplacedstrongemphasison
the roleof the familyas aunit of production and consumptioningeneral,andas abasisfor
raisingthe young andsupportingthe oldinparticular. Three or four generationsusuallylive
under the sameroof to pool resourcesand sharerisks. Whengrandparentsinordinaryfamilies
becometoo oldto generateincomedirectlyfrom workingoutside,they stayat homenot only
tojust restbut to take care of young grandchildrenand do houseworkinorderto reduce
burdens of the rniddlegeneration. Thissystemworked quitewell,ofteninthe absenceof any
formalmarketwork arrangements. The virtuesof diligence,frugalityandthriftareglorified.
Accumulationof socialexperienceand financialwealth, largelybequest-motivated,by the old
throughtheir life-longhardwork wins them respect fromthe society. Thusthe welfareof
older membershasbeenan essentialresponsibilityof families,as a rewardtothe altruisticspirit
of the oldergeneration.Thistraditionalnaturalharmonybetweengenerationswithinthe family
and amongmembersof a communityis now being disruptedas the economymodernizesand
opens to extemalinfluences.The familiesthemselvesaregettingsmaller,especiallyinurban
areas becauseof housingproblems. Whilea higher percentageof familymembersareliving
longer,traditionalextendedfamilylivingarrangementsarebeingstressedbythe needfor some
membersto becomemoremobileto respond to new economicincentives.Understandablyin
anincreasinglysecularsocietymore activitiesare valuedthroughmarketinteractions,andthere
is often moreemphasison selfgratificationand less on commnunalresponsibilities.
In China,significantimportanceneeds to be attachedto preservingthetraditionof
respectingandsupportingthe oldon familyand communitybasis. Currently, China's big
population is mostlyrural with low income. About 10 percent of the population are still
living in absolute poverty with an income less than half a dollar a day. In addition, 27
percent of adults are illiterate. For persons 60 years or older, about one inten women and
two in ten men can actuallyread and write. Socialized old-age securitysystems through
operations of pensionfunds and insurance arrangements are unlikelyto play a major role
until later inthe next century, because of China's current developmentlevelof economy
7
14. and infrastructure. Nursery homes,if built to house China's 360 Millionoldpersons inthe
2030s, would be very costly andlabor-intensive, and maynot necessarilyprovide better
services to the elderlythan within a familyatmosphere. Hence, how to preserve and
promote traditional familyvalues shallbe a key policy issue in designingold-age security
systems in China.
Demographic Transition and Population Policy
Another challengecomesfromthe inertia of the demographictransition. China's
population, unevenlydistributedacross regions, is projected to grow at an averageannual
rate of less than 0.9 percent between 1995 and 2030. Thisgrowth rate is onlya half of
the 1.8 percent rate between 1970 and 1980 and substantiallylower than 1.4 percent rate
between 1980 and 1993. But the size of the incremental population is enormousbecause
of the much larger populationbase. Close to a net of 430 millionpeople will be added to
China's population withinthe next 35 years, which is equivalentto fivetimes of the
current total population inGermany. More than half of thisincrease can be attributed to
extensionof lifeexpectancy,whichis forecast to advancefrom69 yearsat birthin 1995to 75
yearsin2030. By 2030, closeto 30 percent of the world's incrementalold-age population,
as compared with that in 1990,will be accumulated in China. The normalpopulationaging
process seenin mostcountrieshasbeen particularlyrapid inChinaduringa longperiodof
steadygrowth, when overalleconomicconditionsimprove andaccessto betterhealthfacilities
becomeswider. In France, 140 years elapsed before the proportion of the populationover
60 doubled to 18percent in 1976. It will take Chinajust 34 years. The old-age
dependency ratio willrise from 15 in 1995 to 38 in2030, while the averageage of the
population increasesby 8.3 years from 29.4 in 1995 to 37.7 in 2030. Table 2 below
summarizes some trendsof the demographic development in China. Figures 2 to 5 plot
some indicative demographictrends of China based on the population projectionsof the
World Bank.
8
16. Figure 2
China: Population Ageing
45.0 30.0
43.0
25.0
41.0
' 39.0
20.0 E
¶~37.0
35.0 15.0
33.0
2710.0 6
31.0 M
29.0 Ml
Female 5.0
27.0 Ae 5adu
25.0 II I I I i Ii 4 -
LO o~ to O) LO o~ U Co La o o LO o n Coco Ca 0) o 0 0o _ _ N N c4) uL rt- 0 N Lo
o) 0) 0) o 0 0 0 0 O 0 0 0 o- o _ -
I%-N N1 0I Nli N N N N N N 0 N
Year
17. _~~~~; iA Z, A 8 8 8 8Cs~ ~~~~~~~~
198 5 , 0 . , , A,l
1985 I I
1990 .
1 / / > ,9951990 X 3
1995 gOOO
J ~~~~~~~~1995
t2000 2000
2005 // 200 w 02005 ~~~~~ ~~~~~~~~~~~2005-
2010 t201-
2010 S n m / c 2015
2015 -4 2025 a
2020 -
1 1
7i 0 .
~~~~~~~~CD20sl § /'8m205 lllilti(
2025 - _ _ _
2030 2
2 050 (is 2050 cm2050- 00---~-
2075 a.0I 05 i
2100~~~ ~~~~~~~~~C 207-'
-
2125 212
2150 21/50__ __
18. Figure 4
China: Average Age of Population 1985-2150
44
42
40
38
j36
34
32 AeaeA
30 Ml
-4-Female
28
Year
China: Youth and Elderly Support Ratio 1985-2150
100 -.
1Total Dependencyl '
J 80- __
60 -
40 /-
_Youth: 0-19 years old
t 20 --
Elderly: 60 years and older
0
ff2 'n 88 0 0 S S S S 0 0,
_N_ _N N N N N N s> N N
Year
20. This accelerated aging process has also been heavilyinfluencedby very aggressive
birth control policies. Especiallythe "one couple-one child" policy has been carriedout
since the late 1970s inresponse to the baby boom from 1960sto early 1970s, andin order
to move rapidly to a balancedsimple reproduction level. Admittedly,this "one-child"
policy has been successfulto reduce the number of the new born, as evidencedby a sharp
decline of the total fertilityrate from 5.8 per woman in 1970 to 2.0 in 1993 andof the
crude birth rate from33 in 1970to 19 in 1993. However, it creates irregularwaves of
population cohorts and imposespressures for frequent adjustmentsin education systems,
employment settlements, and pension systems for retirees. In the worst case,when
persons born under the "one-child" policy reach the age of child-bearing,they may enter
into a 1-2-4 structure, i.e., the middle-aged couple have to support their young child as
well as four old grandparents. Unfortunately, the population age structure mayreflect
past irregularities for severalgenerations before these echo effectsdisappear. Trade-offs
between short-term benefitsand long-term costs have to be taken into considerationwhen
population policies are adjusted.
Structural Adjustment and Rural-Urban Balance
Rural-urban balanceis another importantaspect of the old-agesecuritysystem
evolutioninChina. Asinmostcountries,the share of the populationlivinginurbanareas
increasesduringthe courseof industrialdevelopmentand economicgrowth. Drivenprimarily
by youthfulmigrationfromthe countrysideto big cities,urbanizationchangessocio-economic
profilesof the work forceasworkers shiftfrom predominantlyself-sufficientagricultural
engagementto highlymobileindustrialpursuits and services. Oldpersons,especiallyold
women,inurbanareasusuallyhaverelativedisadvantagesincompetingwithbettereducated
andmore flexibleyoungerworkers inincomegeneration, andthus tendto havea decreased
participationinthe laborforceanda greater need for support. Afterafastgrowthrate of 3.0
percentper annumduring1970s,urbanpopulationin Chinaincreasedat anacceleratedrate of
4.3 percentperannumduringtheperiod from 1980 to 1993. Thisrate ismorethanthree times
the overallnationalpopulationgrowth rate of 1.4 percentinthe sameperiodandsignificantly
14
21. higherthan the correspondingworldaverage of 2.6 percent. Consequently,the shareof urban
populationinthe nationaltotal rose sharplyfrom 17 percentin 1970to 29 percentin 1993.
However, the currentlevelof urbanizationinChinais stillverylow as comparedwiththat of
60 percentinmiddle-incomecountriesand78 percent inhigh-incomecountriesin 1993.
Urbanizationstimulateschangesinthe familystructure andkinshipnetworkswithboth
beneficialand adverseimpactforthe well-beingof the elderly.These changeshaveparticular
implicationsfor oldage securityarrangementsin China. On one hand,youngfamilymembers
livinginurbanareasmaynot beableto provideinmmediateanddirectcare fortheirparentsand
grandparentswho mayremaininruralareas. The deliveryof servicesto the ruralelderlyis
often logisticallydifficultandcostlywhen socializedinstitutionsandthe basicinfrastructureare
not yetin place. On the otherhand,the youngergenerationinurbanareaswithbetterjob
opportunitiesmayhaveenhancedfinancialcapacitiesto support theirparentsandcanaffordto
pay for higherqualityservices,suchas oldage healthcare. GivenChina'scurrentlowlevelof
urbanization,one approachto addressingthisrural-urbanbalancemightbe to use economic
incentivesto reducepopulationconcentrationin large citieswith a populationmorethan one
millionbut developsmallandmediumcitieswith a populationbetween 100to 500thousands.
The elderlycanthus livetogetherwithor withina short distancefromtheyoungermembersof
the family. Policyeffortshaveto be formnulatedwell inadvancesincethe magnitudeandthe
speedwillbeunprecedented inhistory: To absorb a halfof about400 millionincremental
populationbetween 1995and2030 and reach anurbanizationlevelof 35 percent,Chinaneeds
to buildup around 1,000citieswithan averagesize of 200,000personswithinjust 35 years!
Sustainability of Socio-economic Transition
Bottlenecksfor establishingawell-functioningold age securitysystemin Chinacan
alsopresentthemselvesintermsof socialand politicalsustainabilityof economic
transition. Asthe economyexperiencessystemictransformationsandbecomesmoremarket
orientedandmoreopento theoutsideworld, it undergoesvarioussocial,political,and
institutionalchangesas well. Economicgrowth togetherwithpensionreformswillchangethe
15
22. originalpattem of incomedistributionamongdifferentinterestgroups. People'sexpectations
anddecisionson consumptionandsavings,on labor supplyandwage demand,andon inter-
andintra-generationalincomeredistributionhave to be reshapedto better reflectthe economic
and socialrealities. To minimizedisruptionassociatedwith the transitionaldistortions,
governmentshaveto formulatestrategiesand policiesto deepenreformsandrnitigatethe
potentialsocialcosts of reforms. Legal and regulatory frameworks have to be set up to
govem design and managementof pension and social security systems andto specifythe
sharing of responsibilitiesfor financingretirement pensions among state, enterprises, and
individualemployees. The labormarketneedsto be moreflexibleand labormoremobile.
Financialmarkets needtobe developedto stimulateefficientresourceallocation.Incentives
areneeded to ensureadequatenationalsavingsandcapitalaccumulation. Administrative
interventionsof governmentsinsupportingthe elderlyneedsto be rationalized.Without
sociallysustainableeconomicgrowth, socialsecurityreformsare unlikelyto besuccessful.
Meanwhile,an appropriateoldage support systemcanbe supportiveto adesirable
growth process, generatinga numberof positiveextemalities. Theseincludestimulating
capitalformationandlabormobility,andencouragingproductiveinvestments.One ofthe most
pressingissuesinChina at present is to integrate pension reforms with restructuring of
state-owned enterprises (SOEs). As in many other historically socialistcountries, SOEsin
China directly provide their employeeswith housing, pension, child care, healthcare, and
other benefits to cover nearlyall livingneeds throughout their lifetime"from cradleto
grave". In some of the older enterprises, the pensioner-employee ratio has reached a level
of one-to-one. In a planned regime,profits were taken away and resources were allocated
according to plan, hence the pensionburden on individualenterprises was not a serious
concem. With marketization, individualenterprises have hard budget constraintsimposed
and become directly responsiblefor profits and losses. Pension expendituretums out to
be a bigburden too heavy to carry forward for many SOEs. Even when the core business
of an enterprise is profitable,it may show losses because of its large pensionoutflows;and
thus its capacity to operate, borrow, and expand suffers. A large numberof pensioners
have not been able to get what was promised to themjust because of the accident of their
16
23. being assigned inthe past to an enterprise that is not making enough moneynow. This
system, insufficientinsome cases and unfair in other cases, seriously impedeslabor
mobilityand productivity andleads to delays for enterprise reforms. Bankruptcy of an
SOE raises difficultissues of how to honor the pension commitmentsand other social
welfare obligationsto its retirees. Therefore, it is very important and urgent to formulate
and implement a strategy to develop a market-based pension system and a robust social
safety net, freeing enterprises of direct welfare responsibilitiesand thereby helpingreform
the enterprise system. In order to de-link the enterprise from provision of allretirement
income and to sharethe costs of retirement programs among enterprises, the central
government has recently encouraged local governments to experiment in setting up
pension pools. Thisto a certain degree has relieved some enterprises of full direct
responsibilityfor their worker's retirement pensions since resources and risksare pooled
among enterprises. However, governments need to accelerate their programsto widen
pension, unemployment andhealth insurance pools and improve financiallinkagesbetween
contributions and benefits. Meanwhile, the pooled pension schemes need to enlargetheir
coverage, especiallyto includeemployeesin collective (township and village)enterprises,
foreignjoint ventures, and individualprivate enterprises, who are becomingincreasingly
more numerous innumber and more important in economic contributions.
These four areasof concernsare closelyintertwinedwiththe overallissueof howbest
to addressthe old ageincomesecurityinChina,when its populationis agingat a remarkable
pace. The keypointhereis that a socialsecuritysystemshallnot beviewedas a purely
accountingor even economicmatter. Pensionreformsneed to take into considerationthe
culturalbackground,respecttraditionalvalues,formulatelong-termvisionson demographic
trendsand economicgrowth,and adjustmacroeconomicpoliciesto smooththissocial
transition.
17
24. Ill. A SimpleSimulationModelfor PensionReforms
To quantitativelyanalyze policy implication of pension reforms, a mathematical
model is a necessary though not sufficient tool. Ideally, a comprehensivedynamicgeneral
equilibriummodel might be better to reflect interdependence of economic factors inpolicy
reforms. However, such a model would impose more data and resource requirements.
This section describesa simplesimulation model, which is composed of four blocks
illustrating interrelations among (a) a representative pensionfund, (b) demographic trends,
(c) development of the economy and labor market, and (d) government behaviorunder
different pension arrangements. Figure 6 below presents key inter-linksamong these
factors.
Figure 6 Links Among Pension Performance and Socio-Economic Development
Govemrment Culture and
~~A ~Behavior Tradition
Demographic > Pension _ Economic
Dynamics 7n nanceDevelopment
| LaborMarket | Pension
Conditions Arrangements
Like the RMSM-X model used in the World Bank for mediumterm projections
and policy consistencycheck, the model proposed here is useful to examinethe financial
sustainabilityof pensionfunds and to show impacts of external changes and policy
alteration. The model, however, has not explicitlyendogenalizedlinkagesbetween the
pension accounts and the affectingfactors, such as savingsthrough pensionschemes and
18
25. GDP growth, andbetween labor supply and wage-pernsion'setting. In addition,the
treatment of uncertaintyis done indirectly, though evaluatingthe effectivenessof pension
reform options encounters numerous uncertainties. To a certain extent, both demographic
dynamics and economicdevelopment are stochastic processes affectedby many
unpredictable factors. With some information on prior probability distributionsof these
random factors, the basic structure of the model can be used to generate bounds of
confidence intervals,such as in the scenario analysisthrough defining"the best" and "the
worst" possiblesituations. Another approach of addressingthese uncertaintiesis through
stochastic numeric simulations(e.g. using Monte Cairo techniques).
Political economy of pension reforms is also difficultto model. Sincepension
reforms necessarilyredistribute income among differentgenerations and among different
income groups withinone generation. Pareto optimalityis difficultto achieveduringthe
reform period. These mayhave serious implications for social stabilityand longer-term
sustainableincomegrowth
ThePension Fund Balance
During the planningperiod t E (to, to+1, to+2,.., to+T}, the balanceof a
representative pensionfund in a specific region at time t, denoted by B,, canbe written as
B, = (1+r,)B,, +I, - O, - AE,, for givenB,1l
where the increment is the differencebetween the current income (as the sum of the
investment returns on the previous balance B,_1 at rate r, and the contributioninflowIt) and
the current expenditure(as the sum of total pension payments 0, and the administrative
expenses AE,). Thisincrement can be negative when the income cannot fullycover the
expenditure, and thus the fund decumulates. Let se {M, F) be sex indexfor male and
female, respectively. GivenA1' for the average first timeworking age andA2' for the
retirement age, the total contribution to the fund can be calculatedas
19
26. I,= z ZC,Wa,N,S
5srM.F} a-AI
where c, is the pension-related payroll tax rate, W'-' is the nominalaveragewage for
workers at age a andN,'-5is the number of workers covered by the pensionscheme. The
summations are conducted over both age and sex. Meanwhile the total pensionpayments
can be calculated as
As
0,= N
sE(M.F) a=A -+l
where A3' is the maximumage and H,'' is a basis for pension calculation,which can be
linked to the pensioners' personal wage history, past contributionsto the fund, the wage
profile of current workers, inflation,or some other social or policyfactors. The
replacement rate, Ot,specifiesthe benefit a pensioner willreceive as a portion of the
pension basis. Thus, in a functionalform,
Ha,s = a` 3 (w, i,)
where w and i are wageand inflation matrices. In some cases, H can be zero if the person
is not eligible for pensionbenefits. The administrative cost is affected by manyfactors,
includingthe fund balance(portfolio management, cash flows, and some fixedcost. For
simplicity,, the administrativecost in our simulation is taken as a portion of the average of
the total income andtotal payments of the fund balance, i.e.,
AEt =ei +
2
where e,captures the cost effectivenessof the fund management.
20
27. DemographicDynamicsandLaborMarket
At time t, the magnitude and age structure of the population canbe presented as a
simple first order Markov chain,
pa,s = (I -ma5)Ia1 +NI' 3 , foraE int(O,A3
5]
where Pt"'is the populationof sex s at age a, mt, is the mortality rate, andNIL' is the net
immigrants into the region.
49
pO's = ( o_ ) a,s
arrap
a=20
where rn,°' is the infantmortality rate for the first year after birth, andf,' is the fertilityrate
of a woman at age a, whichdepends critically on the population policy, socialcustom, and
current and expected economicconditions including the cost of raisinga child. The old-
age dependence ratio, d, is defined as
.re{M,F) a= A2
d =
A4. .'-I
sEJM.F} a=AI
The size of the laborforce can be written as
La,s = a,spa.:
where I,'-'is the labor participationrate across ages and sexes. Here, the participation
rates for the young andthe old are set to zero, namely, I' = I1'f=0 for a E int[O,Al') and
acint[A2 ', A3']. The total employmentE,' is the product of the labor force andthe
employment rate, 1-u,'", namely,
E` = (1- U)La 5 for as int[Aj', A2')
21
28. The pension schemecoverage can be presented by
I{a.sEa.s for A, a<A
lt(E-m')NL"j"', for AX< a<A
where c't" is the contributioncoverage ratio.
Economic and WageGrowth
The economy is assumedto follow a growth pattern, which is affectedby a number
of factors includingpopulationgrowth, labor productivity improvement,technological and
management innovations,and govermnent policies. For simplicity,we onlyemphasizethe
linkage between the increaseof real wage, w,a.',with the growth of per capita output, gt,
i.e.,
where w( ) is a functionalform and the real wage in the base year is setto be 1.
For givenprice levelinthe base year P0 and a path of inflationrates, Tr;the nominalwage
then can be calculated as
Wa,5= Wa,JP n l
r=
GovernmentBehaviorunderDifferentPensionArrangements
The governmentmay have multiple objectives in pension designand reforms. The
simplest approach is to assumethat the government attempts to maximizea well-defined
social welfare function,whichtakes into consideration (indirect)utilityfunctionsof all
individualsin the society. Hence generally, the govermnent's behavior shallbe derived
from the followingmaximizationframework
22
29. Max SWF = SWF(Vi, jEP)
subject to all the relevant constraints. Here P is the union of all categories of people inthe
society and Vi is the expected life-timeindirect utility of an individualj, whichmainly
depends on the individual'sincome stream (wages when he/she works and pensionbenefit
after he/she retires), variationsof price levels, his/her own time preference parameters, and
probability distributions on future uncertainties. Namely,
Vi = E{v'[(Wt', OtH); x,]}
Policy instruments availableto the government vary with differentkinds of pension
arrangements. Four out of many commonlyadopted pension schemes, namelyaPay-as-
you-go scheme, a definedbenefitscheme, a defined contribution scheme,and a private
fund-type scheme, are discussed here. Through some aggregation, policyimplicationsof
reforming to a multi-pillarsystemas advocated by the World Bank can also be simulated.
For the purpose of policy simulationshere, uniformity is assumed across individualsso
that the whole society canbe treated as a unit. When the policy focus turns from the
solvency of pensionfiundsto incomeredistribution, the model needs considerable
modification.
Pay-As-You-Go Scheme
Strictly speaking,this schemerequires that the pension fund be balancedin each
and every single year during the whole planning period. In practice, pensionsare usually
indexed to wages and financedby a pay-roll tax. In this case, B, = 0 for all t, i.e.,
I, = O, + AE,
23
30. where the total incomeof the pension scheme cover exactly the sum of the total pension
payments and the administrativecost at each period t. Given the demographicdynamics,
the pension-wage linkage, and the administrative efficiency,the behavior of the
government can be derived as
3As
l+e' E, ,H, Na,,
* ~~2JEJM,F) a=A2+l
Min c = 2 A2 for all t,
Mm1 1-2 E Wa;yaCC 2 Wr~~z~a.sNt.
sE{CM.F) a=AI
where [cm , c'] is the feasibleregion for the contribution rate. Under the Pay-As-You-
Go system,there willbe no explicit or implicitdebts generated from pensionfund
insolvency accumulatingthrough time. But the required minimumcontribution rate
changes from year to year, and could increase to a level sociallyunbearablewhen the
population ages.
Defined Contribution System
Withinthe definedcontributionsystem,the contributionrate isusuallyfixedat acertain
levelc=ct. The governmentcanchooseto set a uniformreplacementrate (00,) to the highest
possiblewhilethe pensionfund is maintainedwithpositivebalancesduringthe planningperiod.
Thistranslatesinto
Max {(}0[Omi,nmax]
where [e"", O'] is the feasible region for the benefit rate. This maximizationis subject to
Bt> 0 and that all other relations specifiedabove hold. The disadvantageof this kindof
pension system is that when the ratio between the numbers of the pensionersand workers
becomes larger over time, the benefitreceived by the pensioners will declinesignificantly.
24
31. Defined Benefit System
A defined benefitpension system specifies the pensionpath a retiree willreceive
during the period after he or she retires. The government minimizesthe required
contribution rate, whichcan be assumed uniform through time for simplicity,because
doing so increases the disposable income of the workers without scarifyingpensioners'
welfare. Therefore, policy simulationscan be based on all the accounting and economic
relations specifiedabove and the following optimization framework:
Min {C}, subject to B, 2 0,
[c; ]
where [c , c'] is the feasibleregion for the contribution rate. The potential problem
with this systemis that even with a very moderate replacement rate, the burden for the
contributing workers could be too heavy as the population ages.
Private Pension Fund Accounts System
One critical argumentfor publiclymanaged social security systemis rooted in
paternalistic concerns-the beliefthat many individuals,if left to themselves,could be
myopic in their consumption-savingsbehavior and thus would not save enoughto sustain
their living standards after retirement. Therefore, everyone in the society needsto be
mandated to save at least a minimumportion of his or herincome before the retirement
age. A private account can be established to record the savings. Within thissystema
worker pays a certain percentage of his wage to the fund when he works and receivea
pension after he retires according to the amount of his total savings and investment
returns.
Let c be the portion of wage a worker sets aside for his retirement, then his life
time savingsvalues at the time of retirement, A2', willbe
A2A
Al= (CW-AEr)AI (1 + r,
25t=A,' T=I
25
32. where AE, is the personal transaction cost of maintainingthe account and r, is the interest
rate. If the possibilityof receiving and giving bequest is ignored, namely,
BA' =0
and the pension he derives from his personal fund is an annuity fullyindexedwith the
inflation,then
B, =(1+r,)B,l -o07(1+ Jrr) fort E int[A2'+1 A3
1
].
r=A21+l
where 0 is the real annuityvalued at time of retirement. The worker's problem is then to
find an appropriate c for a given 0 or to derive an acceptable 0 for a givenc. The
government can affectindividualworkers choice through its macroeconomicpolicies
which exercisedirect impact on wage levels, interest rates, real and expectedlevels of
inflation, andthe transaction cost of maintainingprivate pension funds.
A Multi-pillar Pension System
Recentworkby theWorld Bank(1994) suggeststhat a combinationof multiplepillars
of oldage incomesupport maybe most suitable. There shouldbe someminimumpension
guaranteedby the stateto allpensioners. Thiswould then becomplementedby a secondleg
whichwould allowfor each personto contributeto an individualaccount. Theideais that the
formerwouldhelpto protectthe poorer membersof societybut alsothosewho arenot ableor
choosenot to savefor retirement. The latterwould allowfor each personto savewith
appropriatesafeguardsandachievecertain.ivingstandardsfortheir old age. In orderto meet
these needs,variousindividualpensionoptionswarrant carefulconsiderationbut it is also
importantto weighthe overallimplications.This mightbe doneinthe contextofthe four
optionsnotedabove.
26
33. IV. PensionSystemReformin China
This section turns to analyze policy options for pension systemreforms inChina.
First, some aspects of the evolution of the Chinese pension systems since 1978 are
reviewed. This helpsto calibrate parameters essential for simulatingpolicy reforms based
on the simulationmodelpresented inthe last section. A benchmarkcase is then worked
out to show that the current pension arrangements are unlikelyto remainfinancially
sustainablefor more thanr-frty years if no reforms are undertaken. Then some policy
simulationsare conducted to numericallyillustrate implicationsof differentreform options.
The Current Pension System in China
Out of a total labor force of more than 600 million,existingpension schemescover
about 150 million,mostlyemployeesof state enterprises,governmentstaff,plusa portionof
urban collectives.Theseschemes,manyof which arenot financiallyhealthyat present,leave
uncovered about75 percentoflabor force, mainlyrural peasants,urbancontractworkers, and
employeesof individualfirms. Permanent workers' pensions are publiclymanagedand
basically financedby payroll taxes on a pay-as-you-go basis. Enterprises share a part of
the financialburden through contributing a portion of permanent employee's current wage
to the pensionpool. Retirement age is relatively young, 60 for men and 55 for women.
Many workers retire early for health reasons or disability,in most cases receivingfull
benefits. Contributionrates vary across regions and sectors and may applyto different
bases. Financialand actuariallinkages between contributions andbenefits are not always
clear. Pension funds are usually deposited in local bank accounts that are often less-than-
fullyindexed with inflation. Local interest in keeping financialresources within the
localitiesdo not alwayslead to investments with highest possiblereturns. Over time,the
aging of China's populationmeans that pension expenditures as currentlystructured will
increase dramaticallyfrom 12.7% of the total wages in 1987 to almost 20% by 1997, to
25% by 2010 andto over 48% by 2030. Table3 belowpresentssomestatisticsthat
quantitativelysummarizedevelopmentof China's formalpensionsystemsbetween 1978and
1993.
27
35. During thesesixteenyearsbetween 1978 and 1993,pension-coveredemploymentgrew
by 56.3 percentwhilethe retireessupportedby the pensionsystemsincreasedby closeto eight
times,leadingthe employee-pensionerratio decliningdramatically from30.3 in 1978to only
5.3 in 1993. Thisratio willcontinueto declinewhen morepeoplewho joinedthelaborforcein
1950sand early 1960sreachthe retirementage. Whilethe pension-wageratio on average
remainedrelativelystablearound80 percent inrecentyears,the total pensionexpenditure
increasedremarkablyfrom3.0 percentof the total wage billin 1978to 10.8percentin 1985,
andthen to 15.4 percentin 1993. Thisoccurred because the pensionschemewasof a defined-
benefittype and thenumberof pensionersincreasedsharplyfrom3.1 millionin 1978to 16.4
millionin 1985,andthento 27.8 millionin 1993. People outsideofthe publicpension
coveragerelymainlyon privatesavingsandfamilysupports for their oldageincomesecurity.
This explains,at leastpartially,whyChina's gross domesticsavings(GDS) rate canbe as high
as 35 to 40 percent.
Real growth of GNPper capita,averagewage, andaveragepensionwerenot closely
correlated. In 1988and 1989,when GNP grew by 11.0percentand 4.0 percent,respectively,
the realaveragewage roseby only 1.0percent in 1988andactuallydeclinedby 6.0percentin
1989. High inflation- 18.5percentin 1988and 17.8percentin 1989- completelyeroded
moderategainsinnomninalwage. Correspondingly,the real averagepensionrose slightlyby
3.0 percentin 1988anddroppedby 6.9 percent in 1989. Thismaybe oneof the reasons
leadingto socialunrestinmanyregionsin 1989. To investigatehow realwagegrowthis
linkedto GDP growth andinflationrate, we run a regressionusing data presentedinTable3
andget the followingresult:
' = 0.8786gt- 0.4060irt, R2= 0.525,F = 7.183
WIl (5.94) (-2.383)
where the numbers inbrackets are t-statistics, showing that the regressionis significantat
levela=5%. Hence, the real wage gains about 0.88 percent if GDP grows by one more
percent, while an increase ininflationof one percent is associated with a 0.4 percent
erosion of the workers' gain. Figure 7 shows historical paths of GDP growth, pensionand
wage movements, and changes innumbers of contributors and pensioners,respectively.
29
36. Numberof Pnsioners in millions In
Growth Ratesin -w
o o > oo1978- v o *E
197S - -l i
1979- t ___^ 1979 -
1981 1980 .
19820
1983 Z~~~~~~~~~~~~
1984
0 1984 j
19938'4
o t: w
1985 0
1985 CD
I~~~~~~~
1986
1I986
CrQ 19871
1987
1988~~~~~~~~~~~~~~~~~~~~18
1989 -
1989- El 0I
-~~~~~~~~ 0 -~~~~~~~~99
1990190
1991
1992 ~~~~~~~~~~~~~~~~~~~~~1992-
1993
1993 0 A - -NI
Number of Emnployeesper 100pmsaasers
37. TheNeed forPensionReforms:TheBenchmarkCase
The model specifiedabove is utilized to simulate policy sensitivitiesof reforming
pension systems in China for 80 years between 1995 and 2075. The basic demographic
information is extracted from the World Bank Population Projections (WorldBank,
1995). Key parameters are calibratedusing historical data published by Chinese
authroties. Essential assumptionsare spelt out based on reasonablejudgment of Chinese
economic outlook in the next century. For simplicity,many indicators are kept uniform
through time, but these can be changed as deemed appropriate.
Base Year Parameters
In the base year 1995,the initialbalance of all pension funds in urban areas, which
are treated as a singlefund hereafter, remains in the neighborhood of 100billionYuan or
1.8 percent of the total GDP. The average annual wages for a male anda femaleworker
in 1995 are estimated to be around five thousand Yuan. A simplereplacementratio
between the average pension and the average wage is used, which stands at 75 percent in
1995. Thus the averagepensions for a male, who retires at age of 60, and a female
pensioner, who retires at 55, in 1995 are estimated to be around 3.75 thousand Yuan.
Key Assumptions
Table 4 summarizessome key assumptions for the simulation exercises.Real
GDP is assumed to grow at an average rate of 10 percent per annum until 2000 and then
at a lower rate of 7.5 percent between 2001 and 2049. Since2050, GDP growth stablizes
at 5% per annum. The annual inflationrate declines from 10 percent during 1996-2000to
7.5 percent between 2001 to 2049 and then to 5 percent starting from 2050. The growth
of real wage depends on the GDP growth and inflation path, accordingto the formula
specifiedinthe regression equation presented in the last section. Nominal wages are fully
indexed to inflation
31
39. During the next 80 years, the replacement rate is averaged at 75 percent, while the
contribution rate is averaged 27 percent under the selected pension arrangements.The
administrative cost is assumed to be 3 percent of the average of pensionfund receipts and
payments. The real rate of returns from investment of the pensionfund balanceis
assumed to be 2 percent across time.
The urbanizationspeedis taken to be 0.3 percentper annum,leadingthe urban
population as a sharein the total national population increasinggraduallyfrom 29.6
percent in 1995to 38.4 percent in2030 and to 50 percent in 2075. Thiscompares with 54
percent inlow-middle-incomeeconomies on average in 1993. The urban labor
participation rate averages 90 percent, and the unemploymentrate is kept around 3
percent.
Pressure fromPopulation Aging
Under these assumptionsfor the benchmark case, the pressure frompopulation
aging is apparent. Table5 below presents a projected population structure and pension
coverage for Chinafrom 1995 to 2075. The population dependencyrate, in terms of the
number of persons older than the retirement age per 100 working age persons, increases
from about 21 in 1995to 44 around 2025 and then rises again to nearly70 in 2075. The
system dependencyratio, in terms of the number of pensioners per 100 contributors,
decreases initiallyfrom 21 in 1995 to 15 around 2000 when the pensioncoverage rate for
the working age populationextends from 25 percent to 38.5 percent, as projected. This
impliesmore contributors willjoin the pension pool inthe near future. However, this
system dependencyrate quickly rebounds to 35.1 in 2025 and approachesthe population
dependence rate in2075, as the population structure and the pensionsystemmature. If the
young dependents are also taken into consideration, the total dependencyrate will be in
the neighborhoodof 100 around 2025.
33
41. The Base Case Scenario
In the current pay-as-you-go pension system continues in to futurewithout any
reform measures beingundertaken, China's pension systemwill not be financially
sustainable. Table 6 below presents simulation results, with four indicatorssuggeststhe
insolvency of the simulatedpensionfund. First, the fund's current balanceturns negative
in 2025, meaningthat total receipts of the fund are not sufficientto coverthe due
payments and administrativecost. Second, the accumulated balance of the fund,which
may peak at more than 30 percent of current GDP around 2010 when babyboomers are
the backbone of the working force and the pension coverage expands quickly,becomes
negative before 2050. Third, on a counter-factual basis, the pension cost rate is defined as
the contribution rate required to obtain zero current balance for a giventotal pension
payment. This cost rate in Chinarises from 12 percent in 2000 to 28 percent in2025 and
then to 54 percent in2075, doublingthe assumed contribution rate. A pension
contribution rate higherthan 30 percent is not likelyto be sociallyacceptable. Finally,the
affordable replacementrate can maintain above the assumed benefit rate until2025. After
that the affordable benefitrate drops to 32.7 percent, about a half the assumedbenefit
rate.
Clearly, financialsustainabilityis only one out of manydemands for reformingthe
pension system inChina. However, the strength of this demand is remarkablystrong.
Since pension policiesimpactover a long period, small incrementalchangeson annual
basis can accumulate into enormous effects across time. As shown inTable6, ifthe
pension systemwere not modified,the negative accumulative balance of the pensionfund
in 2075 can reach an unbearablelevelof 41 percent of current GDP. Or alternatively,
China can only affordto support half of its pensioners, who infact havecontributedto the
pension fund throughout their working life.
35
42. Table 6
China:Pension Fund Accounts under Pay-As-You-GoScheme
(The Base Case)
_ _ _ _ _ _ _1995 1996 1997 1998 1999 2000 2010 2025 2050 2075
With Reserves (Y. Billion)
Revenue Collection 221.4 290.4 373.1 472.6 592.2 736.2 2,904.6 14,345.2 85,098.9 421,487.9
Per-,:an Payments 128.7 151.4 179.6 214.3 257.1 309.5 1,464.7 14,005.7 139,879.8 793,718.1
Administrative Cost 5.3 6.6 8.3 10.3 12.7 15.7 65.5 425.3 3,374.7 18,228.1
Current Balance 88 132 185 248 322 411 1,374 (86) (58,156) (390,458)
As % of GDP 1.6 2.0 2.3 2.5 2.7 2.9 2.9 (0.0) (2.0) (1.7)
Investment Returns 12 29 55 91 141 895 5,355 (20,208) (465,750)
Accumulative Balance 100 244 459 762 1,176 1,728 15,059 81,763 (445,787) (9,324,392)
As % of GDP 1.8 3.7 5.7 7.8 10.0 12.1 31.4 27.8 (15.6) (40.9)
NPV 100 222 379 572 803 1,073 5,740 14,992 (32,187) (284,880)
With Zero Current Balance
Cost Rate (%) 16.17 14.95 13.80 13.00 12.44 12.05 14.46 27.99 47.13 53.99
Affordable Benefit Rate (%) 125.3 139.5 151.2 160.5 167.7 173.2 144.3 74.5 44.3 38.7
Supportable Coverage Rate for the Old 41.8 46.5 50.8 54.6 58.1 61.4 69.6 50.1 35.7 32.7
Needed Coverage Rate for the Working Age 15.0 15.1 15.4 15.8 16.2 16.7 28.2 63.2 110.3 126.7
No. of Supportable Pensioners 57,304 65,226 72,760 80,000 87,027 93,912 145,632 177,252 184,439 185,877
No. of Needed Contributors 98,203 100,346 103,309 107,019 111,415 116,436 216,613 510,440 894,213 1,032,440
An Compared with Benchmark In %
Contribution Rate 59.9 55.4 51.1 48.2 46.1 44.6 53.5 103.7 174.5 200.0
Benefit Rate 167.0 186.1 201.6 214.0 223.6 230.9 192.4 99.4 59.0 51.5
In 1995 Yuan
Real Wage 5.00 5.24 5.48 5.74 6.01 6.30 9.84 19.20 43.11 89.64
Real Pension 3.75 3.93 4.11 4.31 4.51 4.72 7.38 14.40 32.33 67.23
As % of 1995
Real Wage 100.00 104.73 109.68 114.86 120.29 125.97 196.75 384.03 862.11 1,792.83
Real Pension 100.00 104.73 109.68 114.86 120.29 125.97 196.75 384.03 862.11 1,792.83
44. Figure 8
Population DependencyRate With Different Sets Retirement Age
70.0
60.0 M60F55
-4-M60 F60
50.0 -- |BaeM65F60 |BaseC
40.0 Raising the retirement age
30. - by 5 years for female
30.0
20.0a
Raising the retirement
10.0 age by 5 years for
both male and female
_ I II ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~II I I
004O 0 00 0
mc oC o 0g O m
- -4 - s C~4 es s ese
45. Thekeypolicyissuehereishowthe societyas a wholeabsorbsthissegmentof old
age labor. ForChina,the unemploymentand under-employmentintheurbanareasare
becomingmoreapparent.Transitioninagricultureis releasinga largeamountof surplus
labor,closeto 100millioninrecentyears. Thegovernmentneedstoweighthecost
againstthe benefitof dealingwitheitherthe pensionproblemor the unemployment
problem. Thelattermaybe morepoliticallysensitiveandmoreuncertaininfinancial
terms. Withoutexcessdemandinthe labormarket,it wouldnot bea desirableoptionto
increasethe retirementage.
Change of GDP Growth Path
PromotingGDPgrowthenlargesthe pie to be sharedbythe oldandthe young.
Withoutlongrunstableincomegrowth,neitherpensionersnorcontributorscanexpectto
improvetheirlivingstandardssteadily.Better growthperformancemeanshigherreal
wage,leadsto largercontributionrevenueforthe pensionfund,andleavessomeleeway
for adjustmentofbenefitrate. Table7 comparesthree caseswiththebasecase,for
differentGDPgrowthpathsandpension-wageindexation.Thefirstthingtonoticehereis
that, as showninthe lastlineof Table7, one percentagepointchange(fasteror slower)in
the realGDPgrowthrate candoubleor halfthe realwageandpension,as comparedto
that inthe basecasescenario. Themagnitudeof thiseffectdependson thelengthof
pensionplanningperiod(80yearshere). Even allowingthe pensioners'benefitrateto
shrinkovertime,asshowninthe lastcolumnof Table7, theirwelfaremeasuredinreal
pensionincomeissignificantlyimprovedwhenthe GDPgrowsfasterthaninthe basecase.
Secondly,it isnoticeablethatevena combinationof fastergrowthandlessthanfullwage
indexationwillnotnecessarilymakesthe pensionfundfinanciallysolvent.Highergrowth
leadsto higherwage,and thushigherpension. However,thiscombinationdelaysthe first
year forthe currentandaccumulativebalanceof the pensionfundto benegativeby4
yearsand9 years,respectively.Finally,it is worthwhileto lookat thebreak-even
contributionandbenefitratesof thepensionfunds,whichareassumedto beuniform
acrossyearsandtoberequiredto achievea zero accumulativebalanceatthe endofthe
39
46. Table7
China: Impact of GDP Growth on Pension Fund Solvency
Base GDP Growth
Case Slowerby 1% Fasterby 1%
WageIndexation 100% 100% 100% 90%
Break-evenContributionRate 39.6 37.5 41.5 31.8
As % of the Assumed 146.8 138.9 153.7 117.8
Break-evenReplacementRate 51.1 54.0 48.7 63.7
As % of the Assumed 68.1 72.0 65.0 84.9
The First Yearfor
NegativeCurrentBalance 2025 2025 2025 2029
NegativeFund Reserves 2041 2043 2039 2052
Fund Reserveas % of CurrentGDP
2030 18.1 22.7 14.4 21.8
2050 -15.6 -13.7 -16.3 1
2075 -40.9 -47.9 -34.5 -11.4
Real Wage/Pensionas % of 1995 RealPension
2030 479.9 357.2 643.2 536.3
2050 646.6 546.2 1,369.4 1060.1
2075 1,792.8 907.5 3,521.7 2480.4
47. planning period. One percent faster GDP growth plus 90 percent wage indexation
reduces the break-even contributionrate from 40 to 32 percent, and increasesthe break-
even replacement rate from 51 to 64 percent.
Changing the ContributionRate and the Replacement Rate
Another commonlyrecommended policy option is to raise the contributionrate or
to reduce the replacementrate, or both. While knowing that this option is politically
difficult,we conduct a numericalsimulation to examine the financialimplicationof the
policy recommendation. The outcome is presented as a sensitivitytrade-off table, shown
in Table 8. Starting fromthe base case point where the contribution rate is 27 percent
and the replacement rate is 75 percent. Raising the contribution rate to 35 percent or
reducing the replacementrate to 60 percent alone will reduce the negative pensionbalance
levelas percentage of current GDP at the end of 2075 from 41 percent to around 15
percent. Moving towards the lower left corner is the direction for pension solvency,but
objections from both pensioners(for a lower replacement rate) and the contributors (for a
higher contribution rate). To achievea near-zero balance at the end of the planning
period, one needs to set the contribution rate at 32 percent and the replacementrate at 60
percent, or the contributionrate at 33 percent and the replacement rate at 62.5 percent.
Fully Funded Individual Accounts
The individualpension accounts specified in the model are fullyfundedby
definition. They are self-balancedifthe uncertainties on investmentreturns and life
expectancy are carefullyhandled, through pooling, for instance. The relevantpolicy issues
here are the positive linkagebetween the contribution rate and the benefitrate. The
government needs to make sure most people in the society save sufficientfor their own
old age expenditure. For China,the private savings rate is usually around 35 percent.
Therefore, establishingpersonal notionalpension accounts can be a feasibleand effective
reform option in China.
41
49. V. PreliminaryConclusions
Population aging and pension system reforms are serious challengesto both
developed and developingcountries inthe coming decades. Theoretical thinkingand
policy debates in recent years, including Arrau and Schmidt-Hebbel(1994), Diamond
(1995), Iyer (1994), Rein (1994), Sayeed (1984), the World Bank (1994), have
contributed significantinsightsin findingsustainable solutions for providingincome
support to the increasinglynumber of elderly. Thispaper proposes anintegrated
framework linking pension reformsto macroeconomic development, demographic
dynamics, and labor market conditions. With basic assumptionson the future
development trends, the model specified in the paper can be utilized to simulatepotential
impact of different reform options under different pension arrangements. These
simulationsgive decision-makers some quantitative indication on possibleoutcomes a
policy package can generate.
Based on the World Bank's population projection for China, numericalresults
from the simulationexercises conducted in the paper suggest some importantpolicy
messages. Notably, the scope and speed of population aging in Chinamakes the present
pension systemfinanciallyunsustainable, even though the GDP is assumedto grow
steadilyover a long period. Pension reforms are inevitable. For the current pay-as-you-
go pensionsystem, increasingretirement age would provide a temporary fixand would
onlybe politicallyviablewhen there is excess labor demand. Pension fund sustainability
can be improved by increasingGDP growth, raising contribution rates or gradually
reducing benefit rates. But implementation of these reform options need careful
assessmentof financialcosts and social obstacles. Establishingfully fundedandprivately
managed pension schemes can be a feasibleand effective alternative,but sound regulatory
framework and institutionalinfrastructure need to be establishedto facilitatethe transition.
43
50. More generally,the following considerations should be usefulfor formulating
longer-term pension reform strategies.
First, pensionsystemreform is a long-term problem of multi-dimension,involving
not only economic, but also social, political, and cultural factors. The governments
should not over-concentrate on the old age income security system pe se, relying
exclusivelyon taxes and transfers to achieve the goals of inter-generationalor intra-
generational incomeredistribution. A more strategic approach with broader policy
options needs to be explored. Country characteristics, mostlyimportantlythe cultural and
traditional values as well as expectations and reactions of differentinterest groups, have to
be taken into consideration..
Second, real incomegrowth is the ultimate means to cope withpoverty amongthe
old, especiallyin developingcountries. An important policy objectivein Chinafor the
next fiftyto one hundredyears should still be to maintainlong-term socio-economic
stability and sustainablegrowth. This is clearly a precondition toward establishinga
sufficient,efficient,and equitable social security systemin China.
Third, internationalexperience should be studied to avoid repeatingthe same
mistakes others made before. Countries in Europe and Latin Americahave experimented
with differentkinds of reform options to improve their pension systems. Their experiences
show that in order to get out of the lurking population aging trap, Chinashould move
towards a systemthat combines two elements. One is a fullyfunded and portable, defined
benefit pension plandesigned to meet basic needs. The other is occupationalpension
plans or personal savingsaccounts to satisfy demand for maintainingor improvingliving
standards.
Fourth, specificaction plans need to be worked out for long-termtargets of
establishinga sustainablesocial security system. Real economic growth can be reinforced
through improvementof the labor market; for instanceby removingmanagementrigidities,
44
51. facilitating humanresource development, strengthening competitivenessin labor markets,
reforming the householdregistration system, bettering the incentive structure, and
rewarding hard and innovativework. More job opportunities can be created innon-
traditional sectors, especiallyservice industries which are still under-developedinChina at
present, so that the unemploymentrate can be lowered. Whilerapid urbanizationmay
create some troubles, development of medium-size cities can be a feasibleway to convert
some of rural populationmainlyengaged in agricultural activitiesto urban populationless
dependent on land. Preserving traditional values and maintainingfamily-community
support -- the informalsystemfor income security of the aged with no governmentand
little market involvement-- willcushion some impact of demographic shocks. Financial
markets should be liberalizedand developed so that people can have adequate savings
instruments and insuranceoptions, and private savings can be stimulated andput into
productive investment. With proper inflation control, workers can buildup financial
assets now to pay for expenditure later. Management of pensionfunds needsto be
transparent and decentralizedto reduce both corruption and administrativecosts. The
balance of pensionfunds should be invested efficientlyto generate prudent returns.
However, manykey issues need further exploration, includingamongothers, the
cost of switchingfrom one pension system to another more desirablesystem,the
endogenous choiceof aworker with options to select from differentpension
arrangements, the linkagebetween pension systems and labor supply,and the
interdependence amongsavings through pension arrangements and through other
channels. The modelingtechnique needs improvement, for instance,in the direction of
generational accounting(see Auerbach and Kotlikoff, 1985, Auerbach. Kotlikoffand
Hagemann, 1989,Boll,Raffelhuschen and Walliser, 1994). Meanwhile empiricalstudies
should be extendedto cover regional disparities and sectoral differences.
45
59. Policy Research Working Paper Series
Contact
Title Author Date for paper
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