The rapid aging of China's population, accelerated by the nation's one child policy, will soon put a severe strain on its ability to provide retirement security. Only through the use of market mechanisms can China ensure that it will be able to provide for future retirees.

China has one of the world's fastest aging populations. By 2030, nearly 22 percent of China's population will be over the age of 60. Indeed, as Figure 1 shows, China will experience large percentage increases in its elderly population (the largest percentage increase is among those age 80 and older), while actually experiencing a percentage decrease among the young. The result will be a rapidly decreasing worker to retiree ration. Currently, there are approximately 6 workers for every retired person. By 2030, there will be only 2.3.

[FIGURE 1 OMITTED].

At the same time, China has begun a massive transformation of its traditional system of providing retirement security. For much of the rural population, government-provided retirement benefits have been rudimentary, often little more than emergency relief for "five guarantee" families. Urban workers relied on pensions from state-owned enterprises, financed by government budget grants. (Ling and Dingbo, 1995). But employment at state-owned companies is no longer the centerpiece of the Chinese economy. At the same time, declining tax revenue and the increasing cost of an aging population has made it difficult for the government to continue financing its pension obligations (Joint Economic Committee, 1996).

As a result, China will soon be facing important decisions over the future of its retirements system.

Options for Providing Retirement Security

Despite variations from country to country, it can be said that there are three general models for a national system of retirement pensions: the United States and Europe, Chile, and Singapore.

The United States, Europe, and Japan rely on pay-as-you-go (PAYGO) systems of public retirement pensions. In a PAYGO system today's benefits to the old are paid by today's taxes from the young, relying primarily on a payroll tax. Tomorrow's benefits to today's young are to be paid by tomorrow's taxes from tomorrow's young. A PAYGO structure, therefore, is an intergenerational transfer from younger workers to older retirees.

To be successful, a PAYGO system requires a high worker to retiree ratio. However, As figure 2 shows, that ratio is shrinking in nearly every country. In the United States there were 15 workers to every retiree as recently as 1950. Today, there are only 3.3. By 2025, there will be only 2. In Japan and Europe, the problem is even worse.

[FIGURE 2 OMITTED].

To one degree or another, every PAYGO system is facing financial problems as the system's structure is overtaken by demographics. In the United States, Social Security will be running a deficit as early as 2012 (Trustee's Report, 1996).

Both Chile and Singapore have rejected PAYGO in favor of a mandatory savings system based on defined contributions, individual accounts, and private investment. However, there are important differences in approach between the two models.

Chile was the first nation in the Western Hemisphere to adopt a Social Security system, in 1926. It was a PAYGO scheme that ran into demographic problems. In the late 1970s its benefit payments were greater than its taxes and it had no funded reserves. Based upon the anticipated decline in its Benefit Support Ratio, the problems were only going to get worse. Chile decided to fundamentally restructure its system and not merely reform the flawed PAYGO scheme.

The new system is one of forced savings. It requires workers to contribute ten percent of their wages to their own account at a pension fund company (Administradoras de Fondos de Pensiones or AFPs) which invests the wages in securities such as stocks and bonds. Contributions and investment returns are not taxed but withdrawals are. Upon retirement affiliates have the options of purchasing a life-long annuity, withdrawing a monthly benefit from their AFP account, or purchasing an annuity that is effective at a future specified date. Participants also have the right to contribute an additional 10 percent of after-tax wages to their accounts which compound tax-free.

The AFPs are single purpose companies that are licensed and regulated by the government. Among other obligations, they are required to invest the contributions, distribute the benefits, offer insurance, conduct participant record keeping, and keep a certain level of reserves. Much like the mutual fund industry, the workers' assets are separate from the AFP's assets. If an AFP were to go out of business, affiliates' assets would be transferred to another AFP. Individuals have the right to choose and change their AFP.

The success of Chile's public pension privatization can be measured in many ways. Whereas in the late 1970s there were virtually no savings, now the cumulative assets managed by AFPs are about $23 billion or roughly 41 percent of GDP (Larrain, 1991). During the past decade Chile's Real GDP growth has averaged over 7 percent, more than double that of the United. States. And for the five years ending 1994 the annualized total return of the Chilean stock market was 48.6 percent versus 8.7 percent for the U.S.

But most important, beneficiaries are receiving much higher benefits. Since the privatized system became fully operational on May 1, 1981, the average rate of return on investment has been 12.8 percent per year. As a result, the typical retiree is receiving a benefit equal to nearly 78 percent of his average annual income over the last 10 years of his working life, almost double the replacement value under the old PAYGO system (Baeza, 1995).

Chile's reforms are seen as such a huge economic and political success that countries throughout Latin America, including Argentina, Columbia, El Salvador, Mexico, Peru, and Uruguay are beginning to implement similar changes. In Europe, Britain has allowed some people to opt out of its upper tier of benefits and Italy has begun to privatize some aspects of its Social Security system. Several former Soviet block countries also are studying the issue, for their systems are in precarious financial condition.

Beginning in 1955, Singapore introduced a compulsory savings program that now covers about three out of four Singapore workers. Both employers and employees contribute to the government-run Central Provident Fund (CPF), which maintains accounts for each worker. Employees have a property right to the funds accumulating in their accounts and are able to withdraw funds for the purchase of a home, to buy life insurance or home mortgage insurance, and may borrow money from their account to pay for the college education of a family member. Funds may be withdrawn at retirement, in the event of permanent disability, or if the individual emigrates from Singapore.

Unlike Chile, there is a single fund and its investment policy is controlled by the government. Until 1986, the government directed all the fund's investment. However, recently the government has increasingly allowed individuals to control more and more of their own investment decisions. Currently, individual's are allowed to direct the investment of a portion of their accumulated balance (approximately 80 percent of funds above in excess of S$35,400) in certain government approved stocks, government bonds, and annuities.

The funds not directed by individuals must be invested in Singapore government bonds. However, because the Singaporean government is running a budget surplus, the funds used to purchase those bonds are not used to finance government expenditures (as is the case in the United States, for example), but are invested through the Singapore Government Investment Corporation. No information on the investment portfolio is made public (it is, in fact, a state secret), but it is believed that most funds are invested abroad. The Singaporean government provides a return on the bonds based on the rates provided by the nation's major banks, with a guaranteed minimum of 2.5 percent.

Similar systems have been implemented in many countries of Southeast Asia and the Pacific (Sri Lanka, Fiji, Nepal, among others), Africa (Kenya, Gambia, Tanzania), and the Caribbean (Dominica, Grenada, St. Luca). The success of these systems has been mixed.

Because provident funds are compulsory monopolies, with government control of investment, the system's success has depended on the success of the government's investment policy. Some countries such as Malaysia and Singapore have pursued conservative investment strategies, heavily focused on their own government debt, which have produced stable--but low--rates of return. In many other countries, however, the government has been tempted to politicize its investment policy, using invested funds to shore up unprofitable state enterprises or make other unproductive investments. Figure 3 shows the return on investment in selected provident funds.

[FIGURE 3 OMITTED].

The Best Choice for China

China has correctly rejected a PAYGO system as the sole basis of retirement security. Despite China's robust rate of economic growth, demographic realities will eventually make a PAYGO system unsustainable. Indeed, given the declining ration of workers to retirees, maintaining a PAYGO system could eventually require payroll taxes as high as 44 percent (Wu, 1997).

The Third Plenary Session of the 14th Central Committee of the Communist Party of China called for a system "integrating social pooling with personal accounts" for urban workers. This has given China a solid foundation to build on.

Urban workers, in both state enterprises and private companies, including the self-employed, contribute a portion of their wages to a personal pension account. Their employer also contributes to the individual account as well as to a pooled social insurance system. China should move beyond this program's modest beginning's to implement a nationwide system of individual accounts based on the Chilean model.

First, a larger range of investment options should be allowed for funds in the workers individual account. Currently, accounts are paid a uniform rate of interest determined by the People's Bank of China. However, evidence from other countries suggests that workers could earn far higher retirement benefits if they are able to take advantage of the full range of retirement options with a competitive environment. As shown by Figure 4, returns from privately managed pensions have exceeded those of even the best government managed system.

The World Bank points out that all the prerequisites for running a privately-managed system of fully-funded individual accounts are present in China--indeed, more so than in most countries at a similar stage of development (World Bank, 1994). Although capital markets in China are relatively young, there are many opportunities for sound financial investment. Moreover, the return of Hong Kong to Chinese control will provide opportunities for investment in that stable and lucrative capital market. In addition, there are many foreign institutions that would be willing to jump into the Chinese investment management market if given the opportunity.

Second, the business contribution to pension pools should be phased out, with that contribution being redirected to the worker's individual account. The pension pools are designed to serve several purposes including providing benefits for current retirees and near retirees, ensure a base level of retirement security for all workers, and spreading pension costs between firms with large numbers of retirees or older work forces and firms with few retirees or younger work forces. However, all these functions could be better performed through other mechanisms. Moreover, continuation of social insurance pooling will lead to serious problems in the future.

The pension pools are essentially a PAYGO system. As the number of pensioners increases in future years, while the relative number of workers declines, the required benefit payments will easily overwhelm the system's ability to finance them. The first signs of this future crisis can be seen in the funding problems experienced by pension pools in four provinces in 1991 (Xin 1994).

Finally, China should begin to extend the system of individual accounts beyond urban workers to rural and underdeveloped areas. However, rather than making such a system compulsory, it would be preferable to use incentives to promote voluntary participation.

Health Care

The same reforms used to develop a secure retirement system can be adapted to help China develop an effective market-based health care system.

China is already rapidly developing a health insurance market. However in doing so, China must be careful to differentiate between routine, low cost care and catastrophic, unforeseeable expenses. The later are properly the subject of insurance, which at its core is method for spreading risk. The former should be paid by the individual consumer. When insurance begins to cover routine, low-cost health care expenses, where there is little risk to spread, it simply becomes a mechanism--and an administratively costly mechanism--for prepaying the cost of health care.

Moreover, whenever the cost of health care is paid by a party (such as insurance) other than the individual consuming the health care goods or services, there will be a strong tendency to over consume, leading to strong upward pressure on health care costs.

Therefore, China should combine insurance for risk-bearing catastrophic health events, with a mechanism to enable individuals to save in order to pay for their own routine, low-cost health expenses. Singapore provides an excellent model for such a system. In 1984, Singapore began to require that a certain portion of CPF contributions be put into "medical savings accounts" to provide funds for hospitalization. These accounts operate as part of the country's Central Provident Fund system that also provides retirement. Currently, six percent of an employee's salary is put in a medical savings accounts until the account balance reaches approximately $8,522. As long as that balance is maintained, additional contributions are automatically placed in the individual's ordinary pension account.

Funds in medical savings accounts can be withdrawn to pay for routine, low-cost health expenses. At the same time, nearly all Singaporeans have private health insurance (with a large deductible) to provide protection against catastrophic illness.

Singapore's system has been remarkably successful in holding down health care costs. Not only have Singapore's health care costs been rising at a rate below that of most other countries, but, measured as a proportion of total private consumption, health care expenditures have actually declined since 1986. At the same time, the Singapore government spending on health care has also declined, both as a percentage of the country's total social service budget and as a percentage of total government spending (Heng and Low, 1991).

Experimentation with such a system has already begun. In Jiujang and Zhenjiang provinces workers pay for health care first out of individual accounts (financed through individual and employer contributions), turning to state and employer-funded insurance only as a secondary method of payment. Early results from this experiment indicate that it has restrained medical costs and improved medical service (Wu, 1997).

It should be relatively easy to integrate such medical savings accounts with the retirement security accounts discussed above.

Side Benefits: Public Participation and Economic Growth

While the primary purpose of developing a market-based system for retirement and health care security is to provide for the security and protection of individual workers within the context of a financially sustainable system, there are important side benefits that can be realized from such a system.

China is committed to an economy that combines private and public ownership. However, as Deng Xiaoping pointed out public ownership does not necessarily mean state ownership. In fact, Deng endorsed a shareholding system as a means to provide public ownership (Wu, 1996).

A system of individually-owned, privately invested retirement and health accounts would accelerate the move to a shareholder based economy. Since every worker would have an individual pension account, every worker would have the opportunity to own stocks. Even the poorest worker would become a shareholder.

As Minister of Labor, Jose Pinera was the architect of Chile's successful privatization of Social Security. He explains the change that privatization brought to the Chilean workers:

The new pension system gives Chileans a personal stake in the economy. A typical Chilean worker is not indifferent to the stock market or interest rates. When workers feel that they own a part of the country....they are much more attached to the free market and a free society (1996).

A Chilean-style pension system would also assist China in the privatization of state-owned industries, as it did in Chile. Pinera notes that by creating the system of pension accounts first, and then privatizing state-owned companies, Chile established a "virtuous sequence," allowing workers to use the funds in their accounts to purchase shares in the newly privatized companies. This not only reduced political opposition to privatization but allowed workers to capture a large portion of the wealth created through the privatization process.

The World Bank has also suggested that Chilean-style private pension funds would help China develop its capital markets and would facilitate privatization efforts (World Bank, 1994).

Finally, it should be noted that a public pension system based on individual accounts and private investment can lead to increased economic growth. Chile's system has been credited with being a major reason behind that country's prolonged economic growth. Harvard economist Martin Feldstein estimates that the privatization of the United States' Social Security system would permanently add 5 percent to U.S. GDP, a present value of $10 to $20 trillion (1997).

Conclusion

The aging of the Chinese population, combined with the restructuring of the Chinese economy, provides a unique opportunity for China to develop market-based systems for providing old-age and health protections. Indeed, given the rapid aging of China's population, its shrinking workforce, and the gradual privatization of state enterprises, only market forces can provide for China's future health care and retirement needs.

Moreover, a health and retirement system based on individual accounts and private investment can promote full participation by workers in China's economic system. Finally, such a system can increase economic growth and assist economic restructuring.

References

Baeza, Sergio, Quince Anos Despues: Una Mirada al Sistema Privado de Pensiones (Santiago: Center for Public Studies, 1995).

Butler, Eamonn, Asher, Mukal, and Borden, Karl, Singapore v. Chile: Competing Models for Welfare Reform (London: Adam Smith Institute, 1996).

Dorn, James and Xi, Wang, Economic Reform in China: Problems and Prospects (Chicago: University of Chicago Press, 1990).

Gao, Shangquan and Chi, Fulin, China's Social Security System (Beijing: Foreign Language Press, 1996).

Heng, Toh Men and Linda Low, Health Care Economics, Policies and Issues in Singapore (Singapore: Times Academic Press,

Center for Advanced Studies, National University of Singapore, 1991).

Larroulet, Cristian, ed., "The Chilean Experience: Private Solutions to Public Problems (Santiago: Center for International Private Enterprise, 1991).

Ling, Li and Dingbo, Xu, "How to Reform China's Old-Age Insurance System--What We Can Learn From the U.S. Experience," paper presented to

Pinera, Jose, "Empowering Workers: The Privatization of Social Security in Chile," Cato's Letters no. 11, 1996.

United States Congress, Joint Economic Committee, China's Economic Future: Challenges to U.S. Policy (Washington: Government Printing Office, 1996).

World Bank, Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth (New York: Oxford University Press, 1995).

World Bank, "China Pension System Reform," World Bank Resident Mission in China and Mongolia, August 22, 1996.

Wu, Jie, "China's Social Security System," paper presented to Cato institute conference on "China as a Global Economic Power: Market Reforms in the New Millennium," Shanghai, China, June 15, 1997.

Wu, Jie, On Deng Xiaoping Thought (Beijing: Foreign Language Press, 1996).

Xin, Renzhou, "Current State of China's Urban Old-Age Insurance Pooling Schemes," Economic Research Materials 2 (1994).

Malaysia was actually the first nation to institute a mandatory savings program with a Central Provident Fund in 1951. India and Indonesia also established such systems, albeit with limited coverage, in the early 1950's. However, the system has largely come to be identified with Singapore.

Interestingly, when China rejected Hong Kong governor Chris Patten's attempt to implement a PAYGO system for the island, China's Hong Kong representative Zhou Nan dismissed it as a "costly Euro-Socialist" proposal, clearly differentiating such welfare-statism from the Chinese goal of a "socialist market economy" (Economist, 1995).

The mandated savings rate for individual accounts and the rate of employer contributions to both the individual accounts and social insurance pools vary from province to province, as do administrative rules.