China’s pension system is loosely based on the 5-pillar model proposed by the World Bank. It instead controls a 4-pillar system, which can be divided into state, private and private combined with the state (see below)[1]. Pillar II of the Chinese framework referred to as Enterprise Annuities, are currently undergoing quite rapid reform, which may have significant implications for the Chinese fund investment industry as well as the economy at large.
Pillars (World Bank)
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Chinese Terminology
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Contributions
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Benefits
|
Funded Status
|
|
State
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Zero
|
Zero: minimum guarantee
|
n/a
|
A few hundred RMB
|
From government
|
I
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1a: Mandatory social pool old age pension
|
20% of salaries
|
Monthlypension based on average local monthly wage
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PAYG
|
|
II
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1b: Mandatory individual account (IA) pension
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8% of salary
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1/139 of IA, balance at the end of retirement if 15 years payments have been made
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Should be funded
|
|
Private
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III
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II: Voluntary Enterprise Annuity (set up by eligible employers)
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ER/EE
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Lump sum or annuity benefit
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Funded
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III: Other voluntary benefits
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ER/EE
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Lump sum or annuity benefit
|
Funded
|
||
Private & State
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IV
|
n/a
|
n/a
|
Varies
|
From government or famjily
|
Enterprise Annuities (EA), as China’s private pensions are termed, are the equivalent to 401(k) pensions in the United States. Recently, the Chinese Ministry of Finance, its Ministry of Human Resources and Social Security, and its Administration of Taxation issued a circular[2] which provided new tax incentives for these pensions – effectively the first time that these pensions have been the subject of any tax incentives.
The number of EA plans held by the Chinese population is still under 100,000 although growing quite rapidly. This represents less than 5% of the Chinese population. Until recently, only 58 licenses had been awarded to institutions to issue these pensions[3]. However, in January 2016, the China Construction Bank (CCB) received the first EA in just under a decade. It’s unlikely that it will be the last to be issued EAs either.
This is just the latest step in what’s becoming an avalanche of reform. In 2010, the “2010 revision” set new limits for the riskiness of the assets held by EAs. The composition of EAs previously had to be at least 20% in liquid assets; from 2010, onward, this provision was decreased to just 5%. And where fixed income had previously been set to greater than 20% of their composition, it could now amount to anything under 95%. Furthermore, in 2013, non-EA supplementary plans were converted to the EA format.
Above all, it is the new array of tax incentives in EAs to both employers and their employees, which stand to make the pension funds grow so significantly in the coming years. Employee contributions of up to 4% of annual pay are exempt from individual income tax. This percentage jumps to 8.3% of annual pay for the employer’s contribution, providing a real incentive to make pensions a significant part of a firm’s salary provisions.
The performance of EAs over the past ten years has been steady by Chinese standards, if not spectacular (see below)[4]. What’s significant, however, is that as part of the new regulation, the returns are all exempt from income tax. Likewise, the effect that de-regulating pension funds and allowing them to partake in domestic and international equity markets will increase the incentive to partake in equity investments. To put the size of the transformation in context: Only about 2% of China’s population have invested in the stock market compared to close to 50% of the US population[5].
Put in different terms, China’s investment management industry has approximately $3.2tr in assets, of which less than 6% are from pension assets. According to the OECD, pension assets in the United States alone amounted to $14.7tr in 2014. Clearly, the opportunity for growth here is quite phenomenal and more than likely represents the largest opportunity in investment management for this generation.
Year
|
2007
|
2008
|
2009
|
2010
|
2011
|
2012
|
2013
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2014
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Return (%)
|
41
|
-1.83
|
7.78
|
3.41
|
-.78
|
5.68
|
3.67
|
9.3
|
China is not the first country to reform its pension system, allowing to look at precedents in order to scale the potential size of the changes in dollar terms. The 401(k) was introduced in the United States in 1978 but only really took off in the 1980s, as a way employees could take advantage of tax incentives on deferred income. As of mid-2014, 401(k) plans held approximately $4.5tr in assets and represented nearly 18% of the $24tr total US retirement assets[6].
At around the same time that the United States was reforming its private pension system, Chile was doing the same. In 1981, it overhauled its pensions system such that it workers had to contribute 10% of their salaries to 401(k)-style funds, known as AFPs, which invested their funds in domestic and foreign equity and fixed income assets[7]. The model allowed Chile to build its pool of retirement capital to over 60% of GDP. If the same were to happen in China, the private pensions fund would be worth in the region of $7tr.
In Argentina, wide-scale pension reform arrived in the 1990s. In 1993, the government revised the existing pay-as-you-go scheme with a 401(k)-style system which aimed to promote not only labor formality and tax collection but also to provide deeper larger funds for the capital markets (more of which later)[8]. However, implementation of pension reforms in Argentina serves as a warning to the Chinese ministries looking to develop their own private pension system. The design of the system in Argentina combined with falling levels of employment, led to a significant fall-off in people taking up the options for pensions.
Knock-on benefits for Capital Markets
The inevitable growth of China’s EA funds, combined with public pensions new ability to invest up to 30% of their funds in equity will bring huge capital inflows to China’s capital markets. China Business News estimates that the public pension funds alone will mean that around 2 trillion yuan ($310 billion) will pour into the domestic equity market. This figure can be safely doubled when the private funds are taken into consideration – by some estimates, the private pension fund is set to reach 4 trillion yuan by 2020, making it the second biggest supplementary corporate income market in Asia after Japan.
The extra capital that will flow to China’s capital markets has significant implications. As of February 2016, the Shanghai Composite has a market capitalization of approximately $3.5tr. With the additional funds provided by state and private pension funds estimated above, this could grow to as much as $4.5tr by 2020 (assuming that not all the funds flow to the Shanghai composite) – in effect, the pension funds may be providing a one-off bonanza for investment managers looking at Chinese equities. But aside from the one-off bonanza, the pension funds are likely to have an added and far more lasting effect: less volatility in Chinese equities, greater depth of capital pools and more efficiency in stock prices.
[3] Leckie, S. (2014), Retirement issues and solutions in China: What the UK can offer. All Party Parliamentary Committeees
[5] http://www.investopedia.com/articles/investing/092415/chinas-stock-markets-vs-us-stock-markets.asp
[8] http://www.forbes.com/sites/pensionresearchcouncil/2015/04/27/argentinas-pension-policy-in-the-last-20-years-chronicle-of-a-death-foretold/#44b40ff84898
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