The reform of China’s social security system has entered a brand new phase characterised by system integration, synergy and efficiency.
Against this background, what can we learn from the experiences of our international colleagues? What lessons can we find out about high-level design and governance as we examine other pension systems world wide? How can we promote understanding of the needs of this recent stage of development and produce Chinese knowledge and solutions to the pensions of greater than 1.4 billion people?
Current situation and effects
Corporate pension is a type of corporate pension in China introduced by firms and their employees based on their statutory contribution to the state pension.
Company pensions have grown rapidly since their introduction. By the tip of the third quarter of 2021, they served 28 million people and amounted to RMB 2.53 trillion. China also has an occupational pension scheme for employees at government agencies and institutions, just like the 403(b) and 457 plans within the United States.
Corporate pension operations suffer from the “long-term money, short-term investments” attitude. The root reason behind this problem lies within the mismatch between asset ownership and investment decision-making power. In actual operation, asset allocation in corporate pensions can only be based on the danger preferences of those employees who’re nearing retirement. The result’s an emphasis on short-term performance and investing activities, leading to low equity allocations and long-term returns that don’t take longevity risk into consideration.
To solve this problem, we must distinguish between short-, medium- and long-term solutions and ultimately depend on the non-public decisions of individual investors.
Pensions are long-term funds that employees access after retirement and are intended to serve them later in life. You should use long-term funds to earn reasonable returns that increase over time. However, corporate pensions are typically valued on an annual basis, with “positive annual returns” serving as an implicit requirement for fund allocation and investment eligibility.
Under this restriction, investment managers haven’t any incentive to hunt long-term returns as an investment objective. Instead, they have an inclination to hunt short-term rankings and returns, resulting in a short-sighted investment perspective with an emphasis on conservative strategic asset allocation and avoiding negative returns.
The equity share of Chinese corporate pensions has long been between 10% and 15%, while that of the National Social Security Fund (NSSF) is around 30%. Other popular pension systems resembling the Canada Pension Plan (CPP), the California State Teachers’ Retirement System (CalSTRS), and the Ontario Teachers’ Pension Plan (OTPP) have maintained equity allocations above 50%.
This risk aversion implies that corporate pensions produce weaker long-term returns than comparable funds with higher equity allocations. From 2010 to 2019, corporate pensions had an annual return 1.7% lower than the NSSF and a wider return gap than typical foreign pension funds.
Inadequate long-term investment returns make it difficult to administer longevity risks. In the long run, pension returns ought to be linked to GDP and real wage growth, with an appropriate weighting between the 2.
Over the past 40 years, real wages and GDP have increased by 7.8% and seven% per 12 months, respectively, as China’s economy reformed and opened up. Therefore, corporate pensions should deliver a 7% return over the long run.
What could be a smart asset allocation that delivers a 7% to eight% annual return over the long run in China’s capital markets? Using the CSI 300 Net Total Return Index to represent equity investments and the CSI Aggregate Bond Index to represent fixed income assets and calculating from 2005, when the CSI 300 Index starts, to 2020, such an annual return could only be achieved on one stock will probably be allocated not less than 30%.
This suggests that pension plans must have an equity component of not less than 30%. But which means higher net volatility. As the next graphic shows, The annual return is 5.68% based on the corporate’s original asset allocation, with negative returns occurring in just one 12 months – 2011. But increasing the equity asset allocation to 30% gives an annual return of 6% and negative returns for 4 years. The improved performance of the portfolio was accompanied by a big increase in volatility.
The performance of Enterprise Annuity and 30% equity Simulation portfolio
roots of this model
Pensions, especially the second pillar of company pension provision, are divided into two models. In the defined contribution (DC) model – for instance, 401(k) plans within the United States – each the employer and the worker make a contribution, and at retirement the worker’s account balance relies on these contributions and investment returns. In this model, the retirement account and investment decision-making power rest with the person, who can freely make a choice from different financial products.
In the defined profit (DB) model, resembling that of CalSTRS and various state public service pension funds and a few corporate pension funds, the pension plan is included on the balance sheet of the corporate, which is fully liable for the investments. The company pays its employees a predetermined percentage of their salary after retirement. Ownership of assets and decision-making authority over investments due to this fact rest with the corporate.
Both the DC and DB models are aligned by way of asset ownership and investment decision making, and each guide investors towards long-term investments.
However, with the DC model, each individual manages their very own account. Those approaching retirement will are inclined to select a stable and conservative investment strategy with a lower equity allocation, while their younger peers will likely go for the next equity allocation. In this fashion, risk stratification is achieved.
For example, in 401(k)s in 2020, 77% of participants under age 30 invested greater than 80% of their assets in stocks. In total, 60% of assets were invested within the stock markets.
For DB plans, short-term volatility has no impact on an worker’s retirement advantages. The employer will consider assets and liabilities from the angle of the long-term balance between pension plan income and expenses and perform investment activities with a long-term vision.
For example, CalSTRs favors diversified asset allocation. In 2020, the equity share was 58%. The annual return on capital for the last 10 financial years reached 9.3%.
In the Chinese company pension model, the person owns the assets, however the decision-making power rests with the corporate. In other words, the Enterprise Annuity is a DC model in terms of asset ownership and a DB model in terms of investments. The mismatch between these two models results in the conundrum of short-term use of long-term funds.
Because the retirement portfolio brings together employees of various ages, retirement plan participants have different risk preferences, with those nearing retirement most concerned about investment returns and more sensitive to fluctuations in performance.
In this context, firms are inclined to use the danger tolerance of the near-retirement population as a proxy for your entire portfolio when making investment decisions. This acts as an anchor for portfolio asset allocation and ends in low equity allocation in pursuit of positive annual returns. When this mechanism is passed on to investment managers, it naturally results in short-term investment objectives and techniques and even fire sales to make sure positive annual returns.
solutions
Short term, Anyone who’s about to retire should select stability. For example, you might switch from a normal to a specialized portfolio with extremely low or no allocation to stocks three years before retirement to make sure positive annual returns or regular appreciation.
Those with standard pension portfolios could go for greater equity exposure as there is no such thing as a short-term pressure on pension payments. This approach has already been implemented by some firms in China.
Different risk portfolios might be inbuilt the medium term. An example of that is the pension goal risk funds (TRFs) in mainland China. Conservative, stable, balanced, aggressive or lively portfolios might be constructed depending on risk characteristics. Employees can make a choice from them depending on their risk preference. In this fashion, risk stratification might be achieved and the long-term investment potential of partial pensions will also be realized. In fact, some local firms have already adopted this model.
In the long run, the best solution is to expand worker investment options along the lines of the MPF in Hong Kong and the 401(k) within the US. This will allow individuals to pick specific financial products for retirement depending on their circumstances.
On the product side, target-date funds (TDFs) and target-risk funds, that are popular in foreign retirement accounts, have been implemented in China. There are actually greater than 100 such products for the reason that first pension goal fund was launched in September 2018, managing almost 60 billion RMB, and the preliminary work is progressing well.
Nevertheless, the shortage of alternative for employees is a practical issue that should be addressed. Enabling individuals to make their very own investment decisions requires the event of China’s investment advisory industry and higher investor education.
“Pension Management” series.
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Photo credit: ©Getty Images / Igor Kutyaev
