China is facing a pension challenge of historic proportions. The world’s most populous country is also one of its fastest-ageing. This is expected to put huge strains on China’s state pension system (the so-called ‘first pillar’) in coming years. Occupational (second-pillar) pensions exist but remain small. Instead it is private (third-pillar) pensions that are expected to develop rapidly from their currently embryonic levels, ultimately helping to ensure Chinese citizens can maintain their standard of living in retirement.

Creating a third-pillar system at the scale China requires is no easy task. But China’s policymakers have a unique opportunity to learn from the experiences - and mistakes - of the United States and other countries that have navigated similar stages of development in their own pension systems. Already, a momentous shift is taking place among Chinese millennials who plan to rely less on the traditional state pension program than previous generations. Even so, the Chinese authorities may have to introduce measures such as raising national retirement ages as people live longer or giving meaningful tax incentives to encourage the younger generation to aggressively fund their own future retirement by contributing to third-pillar personal accounts. 

A generational shift in expectations

More and more Chinese millennials expect their own cash savings to become their main source of retirement income, according to a recent survey by Fidelity International and Ant Financial, a Chinese financial services company. This is a dramatic departure from their parents’ and grandparents’ generations, who relied primarily, or even entirely, on China’s once all-encompassing state pension system. 

Source: Fidelity International & Ant Financial, 2019 China Retirement Readiness Survey, September 2019

While a majority (51 per cent) of survey respondents aged 35 and above plan to rely on government pensions as their main source of retirement income, that figure falls to 34 per cent among millennials (aged 18-34). By contrast, 27 per cent of millennial respondents expect to rely on their own cash savings or deposit accounts for retirement income, compared with only 12 per cent among older generations. 

The survey results suggest that expectations are catching up with demographic realities. The proliferation of single-child families that resulted from population policies introduced in the late 1970s means that China’s working age population (i.e. those who actively pay into the pension system) has peaked and is now in decline, while the ranks of retirees continue to swell. While these policies have since been relaxed to help right the demographic imbalances and could bring economic benefits, these effects remain to be seen. 

Against this backdrop of a rapidly greying population, the official retirement age remains, by international standards, a comparatively youthful 60 for men and 50 for women (or 55 for female civil servants).  Meanwhile, improved standards of living have raised life expectancy in China to 76.4 years, compared with 72 years globally.  Raising the retirement age would be one way to ease the burden on the pension system and provide a boost to the economy. Policymakers have discussed changing the retirement age in recent years but have yet to take the plunge. 

Prioritising second and third pillar pensions

All these factors strengthen the headwinds buffeting China’s pension system. The first-pillar state pension system, which consists of various provincial pension plans and the National Council for the Social Security Fund (NSSF), currently accounts for around two-thirds of China’s total pension assets. Returns in the provincial system have been in the low single digits, with some provinces already facing funding shortfalls. 

By comparison, the centrally managed NSSF has performed better, but it, too, is projected to face challenges in meeting the expected increase in pensioner numbers over the coming decades. Moreover, because the state pension system doesn’t feature individual accounts, it is difficult to track personal contributions or predict future personal payouts. 

Addressing these issues is becoming a matter of some urgency. One recent, high-profile study by the Chinese Academy of Social Sciences attracted attention by estimating that the national old age pension fund could turn to deficit by the end of the next decade and dry up by the mid-2030s. The finding has been subject to debate in China, and pension officials have responded that preparations have been made to resolve future repayment risks. 

To ease the pressure on the state system, the government has been working to diversify its pension funds. The NSSF has been allowed to expand its investments from low-yielding Treasuries and bank deposits to include equities and other assets. At the same time, several dozen large- to medium-sized state-owned enterprises are being compelled to transfer 10 per cent of their state shareholding to the NSSF or local state pension funds, providing those pension funds with a source of recurring dividends. A recent report by KPMG estimates that state pension assets could be six times greater by 2030, at 53 trillion renminbi ($7.5 trillion).

Nonetheless, the clear trend in China is towards a managed decline in the importance of the first pillar in favour of developing the second and third pillars, for example by lowering mandatory contributions to state pensions. According to the same KPMG study, state pension assets could decline to less than half of overall pension assets, down from around two-thirds of assets now, due to the greater focus on workplace schemes and individual savings. 

Workplace schemes, to which employees and employers both contribute, have yet to be universally adopted, despite efforts by policymakers to promote them. There are two main types: occupational annuities and enterprise annuities. Occupational schemes are mandatory but their rollout to date has been limited, while enterprise schemes are voluntary programs mainly offered by state-owned companies, where the employer contributes 8 per cent of salaries to the company pension pot and workers put in 4 per cent. 

Together these workplace schemes, roughly comparable to America’s popular 401(k) plans, account for around a quarter of China’s pension system assets today. However, development has so far been incremental while the focus has been on drafting and implementing the relevant rules and operating framework. Due to the faster growth of the state and private retirement savings pools, by 2030, according to KPMG, workplace pension schemes are expected to fall to around 14 per cent of China’s overall pension assets. 

Note: Projected data are shown for 2018 onwards. Source: KPMG China pensions landscape, Fidelity International, August 2019

It is a different story for third-pillar individual savings. While still a new concept in China, third-pillar pension assets such as pension insurance and other types of retirement-focused investment products are expected to grow quickly. By 2030, third-pillar pension assets could represent as much as 40 per cent of the total assets in the system, second only to the first-pillar government pensions, according to the KPMG projections. 

Third pillar pensions in the US

So what type of third-pillar system might China consider as a suitable model? Typical investments so far consist of retirement products offered by insurance companies, but also include ordinary bank deposits, direct investments in securities and retirement-focused products sold by asset managers. Indeed, China is today where the US was in the 1980s. 

Back then, many Americans kept their personal retirement savings in ordinary cash bank deposits. Individual Retirement Accounts or IRAs (similar to Britain’s cash ISAs, or individual savings accounts) were still relatively new. But they quickly gained in popularity once people began to understand the tax savings and incentives they offered. They gathered steam as asset managers began to offer tailored pension-focused investment products that simplified the process of saving for retirement. 

Target date and target risk funds

Such products include target date funds and target risk funds. Target risk funds generally offer higher or lower exposure to risk (usually by adjusting the allocation to equity versus debt and to foreign versus domestic securities) at fixed levels. Target date funds or TDFs feature a dynamic asset allocation. This means the individual sets their target retirement date and all decisions related to risk-appropriate portfolio allocation are made by the asset manager. The portfolio holdings are de-risked as the investor gets closer to that target retirement date. 

TDFs and target risk funds first became popular in the US in the 1990s. Since 2006, they have been the default options in private corporate retirement plans, like the 401(k). Prior to this, such plans depended on individuals to sign up and opt-in to retirement savings plans, as well as proactively make decisions about allocating their pension portfolio. However, it became clear that the problem with this approach was that educational and promotional efforts had fallen short, and people were failing to set up or fund their accounts, or they were taking on what could generally be described as inappropriate levels of risk for their age. 

Simply put, their behaviour was not rational - in the purest economic sense. So US legislators created strong tax incentives for workers to set up and contribute to retirement savings accounts. These accounts tend to work best when they include dynamic asset allocation. 

But people tended to allocate once and then neglect or forget to rebalance. In 2006, therefore, Congress passed ‘opt out’ legislation that paved the way for employers to automatically include staff in retirement plans, as well as to set default investment plans that featured either target date funds or target risk funds.  The key takeaway from the American experience in building successful personal retirement accounts, be they IRAs or 401(k)s, is not to focus on a large pool of different investment products. Rather, the foundation is a body of laws and corresponding regulations that tacitly acknowledges the irrationalities of human investment behaviour and compensates for this by making participation in ‘automatic’ strategies like TDFs the default option. 

What next for China?

China has already launched several products to serve the third pillar. Last year, 14 domestic asset managers were given the green light by regulators to launch new pension products, which took as their model the TDFs and target risks funds that have proven popular in the US and other markets. However, such products have yet to take off among Chinese savers. 

In our view, for a third-pillar pension system to flourish in China, tax incentives to invest in such programs (similar to those offered by IRAs or ISAs) will need to be rolled out nationwide. More providers will need to be vetted and licensed to offer third-pillar retirement products, be they banks, insurers or asset managers, so that competition for business will keep fees down for the consumer. And the range and diversity of products on offer will need to be expanded to meet different investor requirements, depending on when people plan to retire and how long they need their pensions to last. 

It will take time. When America’s modern third-pillar scheme was getting off the ground in the 1980s the vast majority of retirement savings were held in the form of bank deposits and insurance company annuities. That changed gradually as asset managers began to market funds featuring lower fees and higher long-term potential returns, and by the 1990s most retirement savings were invested in mutual funds. Still, we think the greatest lesson policymakers in China can learn from the US experience is that foundation of a nationwide third-pillar system of individual retirement accounts doesn’t rest on the investment funds being offered. Instead, it is key to get the legal and institutional structure right from the outset (and not wait decades to change the legislation); this means positioning the best solutions as the default options in retirement savings schemes from the start. 

The next crucial next step is education. Policymakers, regulators and industry participants in China will need to come together to educate the investing public about the need to maintain individual savings for retirement, and what options are available to them both in terms of saving for old age and in how to maintain an income once they retire. Only then will China be able to realize the full promise and potential of its plans for a third-pillar pension system that both support its ambitions to maintain economic growth and development as well as look after its retirees.