What pensions reforms mean for China's capital markets

Talk of economic reform in China has been the norm for the best part of 40 years but there are now growing signs that the reforms are finally beginning to snowball. This can be seen everywhere from the yuan being included in the global currency basket to the loosening of restrictions for foreign investors on the domestic capital markets. But perhaps the most dramatic of the changes yet may be witnessed in the reform of the country’s pensions system.

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)		Chinese Terminology	Contributions	Benefits	Funded Status
State	Zero	Zero: minimum guarantee	n/a	A few hundred RMB	From government
	I	1a: Mandatory social pool old age pension	20% of salaries	Monthlypension based on average local monthly wage	PAYG
	II	1b: Mandatory individual account (IA) pension	8% of salary	1/139 of IA, balance at the end of retirement if 15 years payments have been made	Should be funded
Private	III	II: Voluntary Enterprise Annuity (set up by eligible employers)	ER/EE	Lump sum or annuity benefit	Funded
		III: Other voluntary benefits	ER/EE	Lump sum or annuity benefit	Funded
Private & State	IV	n/a	n/a	Varies	From government or famjily

Enterprise Annuities

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	2014
Return (%)	41	-1.83	7.78	3.41	-.78	5.68	3.67	9.3

Precedents for Pension Reform

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.

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[1] Reproduced from the Society of Actuaries, 5^th SOA Asia Pacific Annual Symposium

[2] See: “Caishui no. 103.”

[3] Leckie, S. (2014), Retirement issues and solutions in China: What the UK can offer. All Party Parliamentary Committeees

[4] Reproduced from the Ministry of Human Resources and Social Security

[5] http://www.investopedia.com/articles/investing/092415/chinas-stock-markets-vs-us-stock-markets.asp

[6] https://www.ici.org/policy/retirement/plan/401k/faqs_401k

[7] https://www.ssa.gov/policy/docs/ssb/v68n2/v68n2p69.html

[8] http://www.forbes.com/sites/pensionresearchcouncil/2015/04/27/argentinas-pension-policy-in-the-last-20-years-chronicle-of-a-death-foretold/#44b40ff84898

The impact of pension reform on China's capital markets

Talk of economic reform in China has been the norm for the best part of 40 years but there are now growing signs that the reforms are finally beginning to snowball. This can be seen everywhere from the yuan being included in the global currency basket to loosening of restrictions for foreign investors on the domestic capital markets. But perhaps the most dramatic of the changes yet may be witnessed in the reform of the country’s pensions system. 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 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 Chinese fund investment industry as well as the economy at large. Enterprise Annuities 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 onwards, 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 deregulating 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 term, 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 2014 Return (%) 41 -1.83 7.78 3.41 -.78 5.68 3.67 9.3 Precedents for Pension Reform 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 1980's, 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 1990's. 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 have 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 growth 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. [1] Reproduced from the Society of Actuaries, 5th SOA Asia Pacific Annual Symposium [2] See: “Caishui no. 103.” [3] Leckie, S. (2014), Retirement issues and solutions in China: What the UK can offer. All Party Parliamentary Committeees [4] Reproduced from the Ministry of Human Resources and Social Security [5] http://www.investopedia.com/articles/investing/092415/chinas-stock-markets-vs-us-stock-markets.asp [6] https://www.ici.org/policy/retirement/plan/401k/faqs_401k [7] https://www.ssa.gov/policy/docs/ssb/v68n2/v68n2p69.html [8] http://www.forbes.com/sites/pensionresearchcouncil/2015/04/27/argentinas-pension-policy-in-the-last-20-years-chronicle-of-a-death-foretold/#44b40ff84898

Fund Management: Enter Google

The fund industry is remarkably consistent for an industry that's supposedly based on meeting or out-performing a bench. There's a cockroach quality to the industry. The comparison isn’t meant to be derogatory to those working in funds, rather an analogy that best suits their staying power: even if there’s nothing left, there will still surely be funds and fund managers. 

With the exception of those fund managers who consistently outperform the market (and there aren’t many of those in fund management) the reason for this is baffling. However, there are some reasons which might have, if not justified their existence, at least convinced their clients that they were justified.

A good reason people buy any under-par product or service is marketing. Fund management is no different. Funds are given attractive-sounding names, often using words like “growth,” “alpha” and “trust.” It’s important to remember here that just because a fund has “growth” in its title, doesn’t make it grow. “Growth” in the name of a fund is the same as putting go-faster stripes on the side of a sports car. It looks good. It doesn’t do anything.

Fund managers are also famously fickle – if a fund isn’t doing well for whatever reason – there’s a good chance it will be shut down and a new fund will replace it. This is what’s known as “survivorship bias,” and means that only funds that perform well are allowed to continue. It’s a bit like being bad at half your subjects in school and only showing the rest of the subjects on your report card – who wouldn’t be impressed by the performance.

A third reason people hand their money over to fund manager is because it’s what they want to put their money in anything which will provide a better return than a traditional deposit account. This is a reasonable excuse and it’s a rare fund that will make less money than a bank deposit account over the long term. Making less on a consistent basis would be a skill all of its own, in fact.

And perhaps the final reason that people trust funds is the same reason that people take on mortgages several times too large based on their current salary: they’re not financially literate and when a financial advisor comes along saying that a fund should be a part of every long term family investment plan, it seems the obvious thing to do.

Enter a new player

There is one word, however, will is currently striking fear in the heart of every fund manager – arguably even more than “benchmark.” The word is Google. The internet search giant looks to be entering the realm of fund management this year or next, having commissioned a large scale research into the industry. Given the size of its cash pile, its reputation, its ability to hire the best talent and the data at its disposal, fund managers have good reason to be nervous.

This might even be the next step in Google’s strategy given that it has already entered venture capital, having invested in nearly 200 firms (including, most notably, the notorious Uber). Unknown to many, it also has invests in government bonds and has its own trading floor. Google is already in finance. It would seem given the huge inefficiencies in the fund management business, that it’s only a matter of time before they enter there, too.

It’s hard to see what’s to stop Google taking over a chunk of the industry. Does it see its future growth tailing off in search? Probably. There aren’t many public companies in the world with more data than Google (in fact, are there any?), so when they make a decision to invest in something, an industry has to sit up and take notice.

Some things never change

Well, the sensible thing to do would be to sit up and take notice. But a Financial Times article from earlier this week, quotes the head of a large UK fund house as saying, “Google would find the fund management market more difficult than it thinks. There are significant barriers to entry and it’s not something you could get into overnight.”

And he wasn’t alone. In fact, several current players in the fund management industry mentioned various factors about why Google wouldn’t find it so easy. Reasons cited included regulatory oversight, industry barriers (just like the industry barriers Google faced in the search industry against Yahoo!) and investor demand.

This all sounds like the fund management is in denial, until you consider that at the outset of the article, two of the bigger players in the fund management industry, Schroders and another unnamed fund house, told the article that they were concerned with one going as far to say that Google’s entry was his “biggest fear.”

The lesson here is perhaps that smaller fund houses will be hit most by Google’s entry if it does happen. Likewise, they’re most often the ones where marketing and spin is what sells their funds more than anything else. The fact that they’re claiming not to be afraid about a Google entry to the market could be just more of the same. A bit like the way the Information Minster in Iraq constantly claimed Iraq were winning the war.

Fund management Industry: RIP?

It’s a little too early to call the end of the fund management industry. For one thing, many of the fund houses in the industry have created disincentives (otherwise known as “exit costs”) for anyone who wants to divest from their funds. Likewise, Google still haven’t confirmed they’re entering the market and when even if they do, they haven’t revealed their fund structure, how much it will cost to enter and indeed, who can enter the fund.

If Google do enter the market, however, and we believe that they will, the advice to all fund managers would be to update your profile on linkedIn to beat the rush. With all due respect to the brightest of fund managers out there (who are brighter than most of us), this is a company who knows about information before you ever possibly can.

Google Trends is just what they’re showing us about the information they continue to collate. The tip of the iceberg. Even if a nice guy from a respected fund management firm gave a good sales pitch and showed good results on a fund which had lasted a while, you’d have to ask him, “what can you tell me about x, y and z that Google can’t?” And there is not a fund manager out there that can reasonably answer that question.